The turbulence in the world financial markets during 2008 is blamed on a failure in the banking system. While it is certainly true that many leading banks acted imprudently and incompetently, the crisis was made worse and will be perpetuated by the high levels of both government and consumer debt in the US and EU. This escalating level of debt is an indication of the decline of the west.
When the UK bank, Northern Rock announced it was in difficulty in late summer 2007, the reason given, and accepted by the UK authorities, was a drying up of funds in the wholesale market. The Bank of England was forced to intervene when newsreel of the lines of worried depositors outside branches of Northern Rock circulated around the world.
The lack of understanding of the UK authorities concerning the nature and scale of the impending global crisis was demonstrated by their portrayal of Northern Rock using a flawed business model. At this stage, the authorities evidently believed that the major UK banks were well managed. The credit crunch had not, as yet, been identified.
In comparison, the US lender, New Century Financial Corporation, the second largest subprime lender in California had gone bankrupt. The assets comprising the loan portfolio were grossly overvalued and foreclosures were mounting for borrowers who clearly should have stayed in modest rental property as opposed to becoming homeowners.
If there was a flawed business model, then making loans to unfortunate persons who will struggle to make repayments is a paradigm example of bad business practice. The irony of the situation is that Northern Rock had very few foreclosures when it ran into funding difficulties.
The increasing momentum of the unfolding crisis became apparent when the Fed mounted the rescue of Bear Stearns in a matter of days during March 2008 by offering a facility of US$30million to JP Morgan as part of a takeover deal.
By September 2008, it was clear that no major financial bank or institution in either the US or UK was safe when Lehman Brothers filed for bankruptcy.
At the heart of the problem is the behaviour of banks. The liberalisation of financial markets, primarily in New York and London, and the easy credit of the 90’s era led to a sense of ‘irrational exuberance’ as described by Alan Greenspan in December 1996.
Although his comments were primarily focused on stock market values, they were equally applicable to residential property valuations. The tragedy is that Greenspan did little or nothing to cool the bull market run.
The central issue is debt. Consumers in both the US and UK have developed a culture of immediate consumption based on credit. Total UK consumer debt is touching GBP1.5 trillion. This has overtaken GDP(Gross Domestic Product) which stands at GBP1.4 trillion. Average household debt in the UK is GBP9,600 excluding mortgages and GBP59,670 if mortgages are included. Average household mortgage debt, for the 11.7 m households who currently have mortgages is GBP104,058.
Concern about debt is not limited to consumers. UK Government Debt is estimated at GBP1.6 trillion, which again exceeds GDP. This is some GDP53,000 per UK household.
In the US the National Debt stands at US$10.6 trillion or US$38,000 per person. US debt is around 65% of GDP. However, many commentators take the view that governments have massaged these figures in recent years in order to conceal the enormity of the debt problem from the electorate.
The paradox of the current situation is that US, UK and EU governments are currently attempting to stimulate their economies by reducing interest rates, increasing the National Debt and printing money. In other words, their proposed solution to the current crisis is a dramatic increase of debt.
A basic principle of bookkeeping is that every debit has a corresponding credit. This means that all debts are owned by creditors. The US and UK consumer is only able to borrow money and increase their debt if there are willing lenders. Similarly, the US and UK governments are only able to increase the National Debt if there are persons or agencies who are prepared to hold US Treasury Bonds or UK Gilts.
Another basic principle is that a debtor is beholden to his creditors, or is even at their mercy. While there is some comfort in long term debt, where the borrower will not be required to settle his obligations upon demand, short term debts can normally be called in by the creditor at any time. This is precisely what banks in the UK and US have been doing, and with disastrous results for small and medium sized businesses.
Most of the US and UK government debt is held by overseas agencies. These take a variety of forms and include foreign governments such as Japan and China, sovereign wealth funds which include the Gulf States, foreign companies and individuals.
The world economy is inter-related. China maintains a Balance of Payments surplus with the US by exporting consumer goods, and is prepared to hold US bonds in exchange. Similarly, the Gulf oil exporting states use their funds to invest in western companies and London property. What this means is that the wealth of the US and UK is steadily being transferred to overseas owners and that our continuing consumer consumption is being financed on a debt basis.
During 2008, we have witnessed the collapse of major international financial institutions while others have only survived with massive government bailouts. The debt of banks has now become the debt of the US / UK governments and taxpayers. This process may ensure the survival of banks, but it could raise the issue of the creditworthiness of western governments.
The British pound has lost some 25% of its value in recent months while the US dollar has remained stable due to its status as the world’s reserve currency.
Both the US and UK are now vulnerable to trade and political pressure from overseas creditors. Their inability to respond robustly to Russian aggression in Georgia over the breakaway province of South Ossetia is a portent of things to come, whereby the foreign policy of the US will be heavily influenced by overseas holders of dollar securities.
The financial crisis of 2008 has thrown into relief the unsustainable spending habits of western consumers and their governments. The transfer of wealth and power to foreign shores signals the decline of the west.