Banking on the banks
Oct 15th 2009
From The Economist print edition

The rescued may turn out to be rescuers

Illustration by S. KambayashiTHERE can be few more extraordinary sights than politicians indulging in a fit of tightfistedness ahead of an election. Normally party leaders compete to bribe voters with their own money. But the British party-conference season, the last before polls expected to take place in May or June, was dominated by a series of pledges to cut government spending.

The public has not driven this shift in tone. An Ipsos Mori poll in September found that only a quarter of Britons thought spending cuts were necessary. In America, where “tea party” anti-tax demonstrators have captured media attention, only 3% of respondents to a CBS News poll this month thought the deficit was the most important issue facing the country. Nor have markets forced politicians to put on their hair shirts. Governments are able to sell bonds yielding just 3-4%. Rather it is the sheer scale of government deficits that seems to have triggered the change. Both Britain and America have shortfalls of more than 10% of GDP, a level seen only during world wars.

Beyond saying that such a deficit is unsustainable, however, it is not obvious when a crisis point will be reached. How about a total government-debt level of 100% of GDP? Measured by gross financial liabilities (excluding the assets that governments might own) that level has already been surpassed by five OECD countries—Belgium, Greece, Iceland, Italy and Japan. Iceland aside, economic life in those countries seems to carry on.

There are three main fears about excessive government deficits. First, that the need to divert savings into buying public-sector debt will “crowd out” private-sector investment. Second, that servicing the debt will be a burden on future generations. And third, that governments will therefore be tempted into inflation or devaluation as a way of softening the blow.

The final two concerns mainly preoccupy countries that owe their debt to foreigners. To the extent that domestic borrowers are paying interest to domestic creditors, these problems should be manageable. Foreign debt is a much bigger headache, as the example of Iceland, a small country which assumed the foreign-currency debts of its banks, shows. Unlike Belgium, Greece and Italy, it does not have the shelter of euro membership. Unlike America it does not have the luxury of its debt being denominated purely in its own currency.

Eventually, of course, the high levels of British and American public debt will create problems with both countries’ creditors. But it is very hard to say when.

Worrying about a debt catastrophe may also draw attention away from the “crowding out” issue. This too is not a problem in the short term. A big reason why many economies have just experienced a recession is that the private sector has been unwilling (or unable) to borrow.

But in the medium term the British and American public sectors will still have big deficits to finance and may not want to depend on the kindness of sovereign-wealth managers. The temptation will be to lean on the banks. Proposed regulations (such as Britain’s new liquidity rules, unveiled earlier this month) will require banks to hold more government bonds. And one reason why central banks have kept interest rates so low is that it allows the banks to earn more money and rebuild capital by borrowing short term and investing the proceeds in higher-yielding longer-dated government bonds. The same trick was used by the Federal Reserve in the 1990s.

These tactics help the weekly government-debt auctions go with a swing. Barclays Capital estimates that banks in Britain and America have each bought around $240 billion of government debt over the past year. In Japan this trend is long-established. Morgan Stanley calculates that financial institutions (other than the Bank of Japan) bought ¥224 trillion ($2 trillion) of the ¥383 trillion of Japanese government bonds issued in the decade to 2008.

Like two drunks leaning against each other to stay upright, this leads to an odd symbiotic relationship in which governments have stepped in to rescue the banks, only for the banks in turn to finance the government. In the long run the danger is that this cosy relationship means lending is diverted away from productive private-sector projects and into government spending. Economic growth will be slower as a result.

A debt crisis, with Western governments defaulting or devaluing, is only one possible outcome. Japan shows another: a long period of stagnation in which debt constantly gnaws away at the economy like the eagle on Prometheus’s liver.