Wednesday, January 21, 2009

Markets Fear Scale of Bank Bailout

I often write articles in advance of publication. I wrote yesterday's piece - Why Bitter Medicine may be necessary before knowing details of the government's latest bailout for the banks. A couple of hours after publication, it was already starting to look a little dated.

The problem is that given developments of yesterday, the 'bitter medicine' of bank bailouts appears even more painful with no guarantee of making the ailing patient (the UK economy) much better.

Outstanding public sector debt for the moment remains at a reasonably respectable 44% of GDP. Compared to our competitors this appears actually quite good. But, the problem is that this headline figure only tells part of the story.

When we take into account potential liabilities from underwriting the banking sector, the figures theoretically threaten the solvency of UK plc.

If the bank bailout works and the economy recovers, then these liabilities and guarantees may never have to be honoured, and in due course, the government will be able to repay some of its debt and breathe a deep sigh of relief.

But, by offering to underwrite so much of the banking sector, the government is in danger of lowering Britain's credit rating. This is actually quite serious. If markets fear there is a chance Britain could default on debt, it will be more difficult to sell bonds, bond yields will be pushed upwards and there could be a flight out of Sterling. This would cause a rapid inflationary fall in sterling - quite different from the gradual depreciation of recent months.

This is why yesterday the Pound fell to another low against the dollar.

This is all still a long way off happening, but, if the crisis continues to worsen who can predict, with any certainty, what will happen?

We face awkward economic choices. There are really serious potential problems of underwriting so much of the banking sector. But, there are also risks in doing nothing. Do we let banks run short of cash and risk and severe contraction in aggregate demand? or do we bailout the banks and threaten the credit worthiness of the UK?

I still hope that this bailout will work. That it will enable lending to resume, shorten the recession and prevent a banking collapse. We shall soon see whether this hope is justified.

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