Buiter: Pound at Risk

I’ve missed Willem Buiter, who offered wonderfully trenchant commentary at his Financial-Times hosted blog, only to be forced into dreary moderation (at least in his public pronouncements, I suspect his has difficulty containing himself in private) by taking a job as Citigroup’s chief economist.

Buiter has long been concerned about the vulnerability of the UK, eventually calling it a potential Reykjavik on the Thames in November 2009:

… this is a good time to revisit a suggestion I made earlier on a number of occasions….that there is a non-trivial risk of the UK becoming the next Iceland.

The risk of a triple crisis – a banking crisis, a currency crisis and a sovereign debt default crisis – is always there for countries that are afflicted with the inconsistent quartet identified by Anne Sibert and myself in our work on Iceland: (1) a small country with (2) a large internationally exposed banking sector, (3) a currency that is not a global reserve currency and (4) limited fiscal capacity.

And Buiter, in a May 2008 post, explained that the issue is not one of gross foreign liabilities per se (how much a country’s government, citizens, and domestic firms owe foreigners) but foreign currency denominated liabilities:

The UK has a very large financial and banking sector, which conducts much of its activity by buying and selling financial instruments denominated in foreign currencies rather than in sterling. As a country, the UK has massive gross external liabilities and assets. These are well over 400 percent of annual GDP each, as compared with under 100% of annual GDP for the USA and around 700% of annual GDP for Iceland. It is not much of an exaggeration to describe the UK as a hedge fund, a highly leveraged entity, borrowing shorter than in lends and invests. It has a lot of short-maturity foreign-currency-denominated foreign liabilities and quite a lot of illiquid, non-sterling denominated foreign assets

It’s not a bad way to make a living, but it means the country needs a lender of last resort and market maker of last resort. It has one for sterling-denominated financial instruments. The Bank of England, after malfunctioning temporarily following the onset of the crisis in August 2007, now performs this function effectively. The Bank of England, however, cannot print euros, dollars, Swiss francs or yen. That means the Bank of England cannot be an effective lender of last resort or market maker of last resort if UK banks find themselves unable to roll over their foreign-currency-denominated short-term liabilities or if they find themselves unable to sell their foreign currency-denominated assets in international wholesale markets that have become illiquid.

To deal with a run on the non-sterling short-term liabilities of the UK banking sector or with a ’strike’ in the wholesale non-sterling markets, the Bank of England would be dependent on the goodwill of other central banks, through swaps and credit lines in foreign currency. They would have to be willing to go long sterling when the markets are yelling: ‘go short’. Possible, but an (uncessary) risk.

The key question is: is the UK more like the USA and the Euro Area or more like Iceland? I would argue that, from the point of view of being able to act as an effective, credible lender of last resort and market maker of last resort in financial instruments that are not denominated in the national currency, the UK is more like Iceland than like the Euro Area and the USA. Only the USA and the Euro Area are serious global reserve currencies, with around 60 percent and 26 percent of the global stock of reserves respectively. Sterling, with around 4 percent, no longer plays with the big boys and girls.

Buiter gave a characteristically gloomy update at the Financial Times today:

There are good reasons for the weakness and volatility of sterling. Among industrial countries, Britain’s economic fundamentals are uniquely awful. As regards public debt and deficits, Britain’s true fiscal circumstances are about as bad as Greece’s reported situation, once we allow for the understatement of UK public debt through the off-balance-sheet accounting tricks of the past decade (the private finance initiative, unfunded public sector pensions, student loans and other Enron-like constructs).

The fiscal weakness of the UK is largely government-inflicted, rather than a result of the financial crisis and global contraction. During the long boom preceding the crisis, fiscal policy was relentlessly pro-cyclical, with public spending rising steadily as a share of gross domestic product. The size of the bank bail-out reflected failures of UK regulation that permitted the financial system’s balance sheet to pass 400 per cent of GDP.

Yves here. Note that Buiter believes that stimulus would be in order now provided the UK government had credibility, which he contends it lacks:

When a government has credibility – its promises and commitments are believed by its citizens and by the markets – the best policy is not an immediate fiscal tightening. A credible government would implement an immediate fiscal stimulus of, say, 2 per cent of GDP and commit itself to sufficient future tightening to restore fiscal sustainability…..

A commitment now to a three-party government of national unity could stabilise matters immediately. Failing that, all three parties could agree the size of post-election tightening now, with only the mix of tax rises and spending cuts to be decided after the election. I am not holding my breath.