Cloud Cuckoo Land

Almost every day I walk from our flat to the Tube station over Hammersmith Bridge. I'm often listening to the radio news, marveling not only at the beauty of the Thames but also at the economic improbabilities I hear emerging from the mouths of government ministers. Day after day, billions upon billions of pounds in headline-grabbing initiatives are being promised to the voters in the runup to the next general election, which Prime Minister Gordon Brown must call before June of next year. Meanwhile, the British economy, like the global economy, is contracting, unemployment is rising and the government is going deeper and deeper into debt. Short of ratcheting up income taxes beyond the 50-percent top band that was recently imposed, is there any way in the world that what I'm hearing on the radio makes any sense?

No. Just look at the broad outline of Britain's predicament. Banking is absolutely crucial to the UK economy, more than a quarter of which is made up of financial and business-related services. London and New York are for all practical purposes equal in size as financial centers, but of course London's importance to the domestic economy is maginified because the population of the UK is one-fifth of that of the US. Three of the world's five biggest banks (Royal Bank of Scotland, HSBC and Barclays, measured by assets) are headquartered there. As a result of bailouts, the British government is the proud owner of about 70 percent of RBS, whose assets of nearly $4 trillion are much higher than British GDP ($2.7 trillion in 2008). What wrong with that? RBS - "too big to fail" - is a sick bank; that's why it needed to be rescued.

No wonder Bloomberg today is running a story about the possibility of a sterling criss. How's this for sobering news to accompany my radio listening? Bloomberg quotes the British economic historian Niall Ferguson, author of "The Ascent
of Money: A Financial History of the World," which is essential reading for those of us who are not economists and need to know how we went from 15 years of prosperity to where we are today so seemingly abruptly: "The probability of a real sterling crisis is around one in three, and the probability of major tax hikes and cuts in public spending is roughly one in one." Quoting Bloomberg now: "Ferguson's concern stems from the deterioration in the UK's public finances, which prompted Standard & Poor's to warn on May 21 that the country could lose its AAA debt rating. The firm estimated the cost of propping up Britain's banks at 100 billion pounds ($166 billion) to 145 billion pounds and said government debts could double to almost 100 percent of gross domestic product by 2013."

I emailed somebody who knows much more about of all of this than I do. This is what he had to say: "The [financial] crisis has ended thanks to extremely aggressive government intervention. The banking system [in the UK] did not collapse only because the government extended a colossal insurance blanket over everything: it assumed the banking system's worst risks as its own, which of course means that British citizens have taken on the banking system's risks. There really was no choice but to save the banks. Now there is an assumption that, since the British government will do whatever is necessary to save the banks, that all is well; the economy will gradually recover and the risks will just wither away. Banks rallied very strongly during the third quarter (the price of Barclays more than tripled from the bottom), reflecting the market’s trust that the government’s insurance policy is Warren Buffett quality and not AIG quality. But as Ferguson implied, there is the serious risk that the financial world will start to see UK financial insurance with an AIG stamp and will suddenly stampede, dumping pound assets. Government debt and deficits are truly eye-popping, and we have yet to see how well the market will absorb the massive government bond issues in the months ahead."