There can likely be no repeat of the 2008 bailouts, sovereign states do not have the capacity. But the accumulating debt is now so large, the point of no return may have been breached. Euro collapse could trigger far wider meltdowns.
Debt is as old as history – and so are defaults. It is part of human life. Most of the time debt is not a major problem but sometimes it can become catastrophic. Unfortunately, in recent years the amount of debt outstanding in the western world compared to total economic output has massively increased. As a result, the risk of a disastrous financial breakdown in the world economy may be much greater than many people realise.
Throughout history, the major protection against there being too much debt has been creditors’ concerns that, if they lend too much with too little security, they might not get repaid. This has not, however, stopped many spectacular defaults taking place. Almost every country in the world has failed to pay its debts at one time or another. Companies large and small, from Lehman Brothers (owing just under $700bn) to corner shops, have gone bust. In the UK about 135,000 individuals currently declare bankruptcy each year and a further 1.2m in the USA. Default is endemic to human society and most of the time the economic system is resilient enough to absorb the consequent bad debts.
This relatively benevolent state of affairs may, however, be changing as a result of three factors coming together. These are globalisation, massive credit creation and austerity. The result is much more debt than there was before combined with much less capacity to repay it. The danger now is that the defaults which may be looming up at present are going to be so large that they destabilise the whole world’s economic system.
Globalisation has been responsible for footloose capital swilling round the world – arguably generating much less benefit than is provided by free trade. But a bigger systematic problem has been the massive imbalances between the export performances of the countries which run foreign payment surpluses and those that run deficits. In 2010, for example, China had a current account surplus of 6.0% of its GDP; Singapore 13.8% and Switzerland 18.6% The UK, by contrast, had a deficit of 2.5% and the USA 3.2% while Spain chalked up 4.5% and Greece 10.5%.
These one year figures are destabilising enough, but it is when big surpluses or deficits continue year after year that the position becomes unsustainable. During the 2000s, the UK accumulated nearly £300bn in foreign payments deficits. Both Switzerland and Singapore, by contrast, have accumulated net foreign assets which equal about twice these countries’ national incomes. Some of these assets and liabilities are reflected by ownership of operating companies or real estate but a huge proportion of it is paper debt, not least in the form of sovereign bonds. As long as the creditor countries are in a strong enough position to service the debt and to stop it accumulating to unsustainable levels, the situation is essentially fairly stable. But what if this condition ceases to apply?
A big part of the reason why these enormous imbalances have been able to accumulate is because nothing has stopped banks being able to create credit on a huge scale, especially since the 1990s. Over the last couple of decades the ratio between world liquidity and world GDP has roughly doubled. This explosion of bank credit has recently been augmented by the steps taken by governments and central banks to increase liquidity and to keep interest rates down, to try to get economies which are stuck in the economic doldrums to start growing again. Both sources of finance have facilitated the absorption of the huge amounts of borrowing and lending required to finance the world’s foreign trade imbalances. It has also encouraged financial institutions to lend more and more money to consumers, many of whom, particularly in the UK and the USA, have been only too keen to take on far more debt than is good for them.
The combination of trade imbalances and credit creation on a huge scale has also had a major impact on another form of debt, especially, although not exclusively, in countries with big foreign payment deficits. The last year during which the UK paid its way in the world was 1985. Since then our deteriorating foreign payment position has sucked sufficient demand out of the economy to make government deficits inevitable - and getting bigger the worse the economy performs. This then leads to the third factor which is that what makes debt unmanageable is when it is accumulating faster than the debtor’s capacity to service and repay it. This is the trap into which much of the western world is now falling. Debt then accumulates which is likely never going to be paid back and which can only be serviced at increasingly unbearable cost. Default can then only be staved off by the creation of more unsustainable debt, which only makes the eventual collapse worse.
This is the situation which has probably already been reached in the Eurozone. It is unfortunately where the UK and the USA are also heading. The danger now is that the debts owed by governments and correspondingly to banks are so large that there can be no repeat of the financial rescues which took place in 2008. Then governments had sufficient creditworthiness to be able to recapitalise stricken banks, thus stopping the world economy melting down. This condition may not hold in future, as several key factors come together.
In the Eurozone, where growth has ground to a halt, the sums of money required to finance the deficits of the austerity countries are growing exponentially – and much faster than Eurozone GDP. It is European Central Bank funding on a massive scale which is keeping the Single Currency together, but at the risk that the losses, if eventually there are large devaluations among the austerity countries as the Single Currency breaks up, are beyond the capacity of either sovereign states or banks within the euro area to absorb. In both the UK and the USA too, sovereign debt is rising much more rapidly than either economy’s capacity to repay it. The US dollar’s role as the world’s main reserve currency may put off the evil day when the markets realise that the game is up for the USA, but the UK has no such protection. Sooner, rather than later, sterling will be devalued either as a matter of policy or by market pressure. The weakening position of both the USA and the UK may therefore leave the IMF critically short of credit worthy members if the situation in the Eurozone goes from bad to worse, as it may well do.
What can be done to make it less likely that there will be a financial melt down across the western world, spreading to everyone else? A break-up of the Eurozone in as orderly a fashion as possible before the debt involved in keeping it going gets larger and larger would reduce the risk of unmanageably large defaults if and when holding the Single Currency together becomes impossible. Encouraging exchange rate adjustments which reduce huge trade surpluses which have to be matched by deficits elsewhere would certainly help too. Reining in excessive credit creation would make it more difficult to finance ultimately unsustainable borrowing. Whether any of this will happen remains to be seen. We face a future which may be much more catastrophic than many people realise.
John Mills is a donor to openDemocracy.