False sense of security

The Government’s tineared ineptitude has put us on course for another global financial crisis

‘Like an outgoing tide, rising interest rates are exposing the wrecks that were hidden by cheap money’

How thoughtful it was of the Government to mark the 30th anniversary of the last sterling crisis by organising another one. Yet the pound’s renewed spot of difficulty in recent weeks raises a wider question.

Are we on the brink of another global financial crisis (GFC)? It’s not hard to make the case after last week’s shenanigans in the gilts market, which looked uncomfortably like the canary in the mineshaft. Be that as it may, major financial institutions seem at this stage to be remarkably sanguine about the dangers; the possibility of systemic meltdown in markets is generally dismissed as unlikely, even if recession in the UK and the eurozone is now judged to be inevitable.

What bankers instead worry about is pockets of high leverage vulnerability, or those who took on excessive levels of debt in the belief that interest rates could never go beyond 3pc. Lest it be forgotten, that was still the presiding assumption a few months back.

Look no further in the search for high leverage than Western governments, who since the financial crisis of more than a decade ago, have been piling on the debt as if it was going out of fashion. This gave a false sense of security. If it is as easy as that to raise money cheaply to finance the likes of furlough, Liz Truss and her Chancellor, Kwasi Kwarteng, figured, then surely nobody is going to worry too much about £47bn of tax cuts. How wrong they were.

Other European countries have been similarly turning on the fiscal spigots anew – this time to pay for the energy crisis; they are in for a rude awakening. Even for governments, credit is becoming a whole lot more expensive.

This change is going to find its expression in all kinds of mini-financial crises in the months ahead, many of which we can at this stage only guess at. The danger is that these random fires eventually erupt into a giant and all consuming fireball.

As was the case prior to the great recession, financial markets are about to discover that they were not as good at defusing risk by spreading it around the system as they thought. The gilts market debacle provides a foretaste of wider dislocations to come, where a strategy intended to protect pension investors from volatility had precisely the opposite effect, and ironically ended up amplifying the sell-off rather than reducing it.

Indeed, it is possible to think of the contagion in structural uncertainty we are witnessing today across financial, economic and political spheres as merely an extension of the crisis of more than a decade ago. There is a sense in which the GFC never truly ended, but was simply anaesthetised by cheap credit and central bank money printing.

The underlying cause of the GFC was excessive credit, yet since then, debt as a proportion of global GDP has continued to rise. Aggregating all borrowing together – public, household and corporate – global debt is today more than a fifth higher than back then at around 250pc of GDP, according to estimates by the International Monetary Fund.

Like an outgoing tide, rising interest rates are progressively exposing the wrecks that were previously hidden by cheap money. Thanks to ultra-easy monetary policy, we never had the mass liquidation the global financial crisis invited; instead we had debt forbearance and the creation of a whole generation of zombie companies and households kept alive on a drip feed of central bank money printing.

This approach just about worked while inflation remained low, even if it seemed to poleax previously robust levels of per capita economic growth. But now inflation is back, and central banks deem themselves duty bound to do something about it.

Leading from the front is the US Federal Reserve. Aggressive monetary tightening has put rocket boosters on an already strong dollar, sucking in capital from abroad. Countries and companies that have chosen to borrow in dollars, rather than their own national currencies, will be in a lot of trouble.

The last time this kind of phenomenon occurred in the mid1980s, it resulted in the Plaza Accord, when G5 nations determined collectively to intervene in currency markets to depress the dollar. But back then the strong dollar had been seriously undermining the competitiveness of US industry and agriculture, so it suited the Reagan administration to have a weaker currency.

No such compulsion exists today, leaving other countries free to contemplate John Connally’s observation about the dollar – that it “is our currency, but it is your problem”. The former US treasury secretary was not wrong. Almost alone in the G7, the US seems thus far to be coping with today’s cocktail of economic negatives reasonably well. It is hard to say that about anywhere else.

How the tables turn; following the financial crisis, the Chinese political class delighted in rubbing our noses in it, contrasting their own country’s economic miracle with the near-death experience of Western democracies.

Well, now the boot is on the other foot. The Chinese economy is in an almighty mess, with buoyant growth grinding to a halt under the combined pressures of a property crash and ongoing zero-covid policies; one way or another, its troubles are going to leach into the rest of the global economy.

Outside China, political uncertainty abounds, again the pernicious effect of more than a decade of economic stagnation. America faces brutally divisive midterms; Italy has elected its most Right-wing government since the war; the UK is politically paralysed; Brazil is going up in flames; the war in Ukraine is unresolved; and we seem, to boot, to have shot ourselves in the foot by imposing sanctions that are economically far more damaging to the West than they are to Russia.

To cap it all, Europe’s improbably constructed single currency is again about to have its defences tested close to destruction by rising interest rates.