The events of the last two years have brought to the fore the levels of debt resident within consumers, corporates and governments. Traditionally, making a purchase had to be planned in advance and saved for. Unfortunately, that concept seems to have been lost somewhere along the line. In many ways debt became a necessary fuel or drug to power us to greater levels of wealth. For now, that belief has largely been consigned to the history books.
Consumers have once again taken to saving and the savings ratio, according to the OECD 2010 Factbook, is now climbing back to more reasonable levels in Europe (12.3% ’09 vs 12.2% ’08 ), the UK (7.0% ’09 vs 1.5% ’08) and the US (4.35% ’09 vs 3.4% ’08). European companies have also taken the same approach paying down some €350 billion worth of debt over the last 18 months. This bodes well for the long term as both consumers and corporates are on a path to financial stability.
Governments, on the other hand, have not been able to take the same approach. Faced with the financial meltdown triggered in some large part by the collapse of Lehman, governments do not have the stomach to allow another collapse of a major institution. It is feared that this may cause another 1920s style depression. Confidence is still fragile. Swift and decisive action was needed to stave off economic disintegration.
Largely governments of the developed economies have so far managed this but the risk of a double dip or, worse still, a shift to a deflationary environment remains. Phenomenally large sums of money have therefore been pumped into economies in various guises to try and create growth; monies that governments did not have, but have borrowed. In fairness they had little choice.
The modern financial system has created a level of interdependence that feeds off itself. Confidence is key.
Outside Malta, government debt is predominantly taken up by financial institutions, be they banks, insurance companies or pension funds. In the event of a sovereign downgrade the banks holding this debt are left holding lower quality debt. In isolation this may not be an issue but the weaker banks are likely to suffer disproportionately. To instil confidence, amidst numerous downgrades and a crumbling financial system, EU governments widened and deepened the deposit compensation scheme.
Ireland, for example, has guaranteed deposits equal to 200 per cent of GDP. But to save institutions more sovereign debt is being created. One need only look to the ballooning fiscal position of many European governments with debt/gdp ratios well in excess of (and growing) the Mastricht Treaty imposed limit of 60 per cent. Quite naturally questions are being asked about the sustainability of this cycle and the ability of governments to finance this debt in the future.
It is interesting to note the ECB’s role in this explosion of debt. One of the main thrusts of governments’ attempt to kick start economies has been the provision of liquidity into the banking system (by the time this article is published the Fed will have announced its much expected second round of money printing, better known as QEII. The key is going to be size. Will it be a few hundred billions or many hundreds of billions?) Central banks have played an active role in switching on the printing presses, partly hoping that this liquidity will cascade down the chain and be used to provide credit to corporates and individuals.
Instead this liquidity has been used to buy government paper and other bonds which are then used as collateral with banks to borrow further funds that are then used to buy more government backed paper. In this way, banks alone have bought some €420 billion worth of securities issued or backed by EU governments since October 2008. While banks have therefore not responded to these initiatives by providing credit to the economy, the ECB has certainly played, and continues to play, an important role in the recapitalisation of banks.
It is interesting to see how this debt has dissipated throughout the European financial system, the implications that this has for the stability of the EU sovereign debt markets and the impact that this has had on the yields currently available in sovereign bond markets. In next week’s article I will look at who is holding this debt and why the problem associated with this debt is very much a European problem and not an individual country problem.
The content of this article is sourced from a presentation given by the author to the Financial Markets Committee at the Central Bank of Malta on October 19.
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Mr Curmi is managing director of Curmi & Partners.