With a bit of luck, by the time I wake up tomorrow morning, most of the west-European banking system and a fair number of other highly leveraged systemically important institutions like insurance companies, will be in public ownership, with the US not far behind.
That would be the good outcome. The bit of luck required for the favourable outcome to materialise, is that national fiscal authorities are capable of providing credible financial support to their financial sectors. Nationalising the banks need not be fiscal-resource-intensive. At a zero price for bank equity, even an impecunious state can claim ownership of the banks (and other financial institutions) in its jurisdiction. Providing the financial system with the resources required to restore confidence, to permit a resumption of interbank lending and to guarantee an adequate supply of external funds to households and non-financial enterprises is rather more costly.
The nightmare scenario is a repeat of the ‘Iceland problem’. In Iceland, the funding gap of the banking system exceeded the unused fiscal capacity of the government. All three formerly internationally active Icelandic banks are now in receivership. The economic prospects for that country and its people are dreadful.
The unused or spare fiscal capacity of a government is the amount by which it can increase the present discounted value of its current and future primary surpluses. The government’s primary surplus is its revenues minus its expenditures, excluding net debt interest. When we include the central bank in our definition of the state, as we should, the state’s revenues include the central bank’s revenues from running the printing presses – seigniorage.
If the debt of the banking system is mainly denominated in domestic currency, the state can always blow it away through a bout of high, unanticipated inflation. This is in principle an option in the US and in the euro area, where much of the debt of the banking system is indeed denominated in US dollars, respectively euro. For this to work, the US government would have to be willing and able to force the Fed into engaging in what under normal conditions would be considered reckless monetary expansion. Although the Fed is the least independent of the leading central banks, I don’t consider it likely that it would be party to a programme of accelerated amortisation of dollar debt (private and public) through an unanticipated burst of inflation.
In the euro area, the odds on an inflationary resolution of the bank debt problem are even lower. The ECB is über-independent and has an official mandate that is lexicographic in price stability.
West-European countries outside the euro area, like the UK, Sweden, Denmark and Switzerland would not receive much fiscal joy from the inflation tax (assuming their central banks would play ball, which seems extremely unlikely) because much of the debt of its banking system is denominated in foreign currency.
The ‘Iceland problem’ is sometimes referred to as the problem of small countries with large internationally active banking systems. But it really is the problem of any country, large or small, whose combined fiscal and monetary authorities cannot achieve an increase in the present value of their combined primary budget surpluses at least equal to the funding gap or solvency gap of their banking system.
If the discretionary use of the inflation tax is ruled out, the ability of a government to borrow more is constrained by its ability to generate larger future primary surpluses through higher conventional taxes and lower public spending. The ability to cut public spending and raise taxes is determined by political-economic factors that may have little to do with the size of the economy or the wealth of its citizens.
From that perspective, the position of the Netherlands (a centralised, unitary state) may well be stronger than that of Belgium, with its precarious federal structure. Switzerland’s confederal constitutional structure is also unlikely to be helpful in this situation. The position of the UK (a unitary state again, if we ignore the fiscally subordinate nations of Scotland and Wales) may well be stronger than that of Germany, a federal state. The UK is certainly in a stronger position than the US, a federal state with a surfeit of checks and balances at all levels, deeply polarised and currently without any sense of national purpose. The response of virtually every voter and every interest group to a request to pay higher taxes or to give up any of the benefits from existing public spending programmes is likely to be: after you.
The tension between spare fiscal capacity and the funding gap or solvency gap of the national financial system may be such that it can only be resolved either by government default or by international financial support – aid. We will know before the year is over which nations’ governments will have to be bailed out if their national financial systems are to be bailed out.