SMALL events in faraway places can reverberate a long way. No sooner had the acrimonious war of words over George Osborne’s Budget got under way last week (Stimulants v Austerityites, Round Ten) than coverage gave way to the unfolding financial crisis in Cyprus.
Small though its economy may be, there is a truly ominous feel to events. Not for the first time in Europe, it is the little things in history that can set in motion the grinding wheels of fate.
To raise ¤5.8 billion (£4.9bn) to meet the terms of an international financial bailout, the Cypriot government pondered a dramatic solution: a raid of up to 9.9 per cent on the bank and savings deposits of its citizens.
The island erupted in fury. Parliament dropped the plan and has now been desperately seeking alternative funding before the country’s banks re-open this week.
The European Central Bank says it won’t budge on its conditions for a bail-out. Germany insists on a Cypriot hara-kiri. Russia has muscled in – and looks to have pulled out. Eurozone officials and finance ministers look on aghast as the clock ticks down on a bank run in the coming week that would ignite civil unrest, plunge the Eurozone back into crisis and threaten to trigger a financial panic across Europe’s most indebted countries. The question trembles on a million lips: after Cyprus, who next?
So far, financial markets have been calm in the face of the awesome possibility of contagion. It may be that after three years of monetary stimulus markets have been numbed by the continuous drip of central bank methadone and lost their ability to price risk correctly. Or it could be a conviction that despite the limitations of the ECB mandate, its president Mario “whatever it takes” Draghi will agree an accommodation.
But the problem with this is the precedent it sets and the implication that, however big (or small) the problem is, rules will always be broken and monetary policy eased. It comes at a colossal cost to the credibility of the ECB and the euro.
When a country is swamped in debt and stuck in recession, the unthinkable starts to happen. So it has proved in this case. Moves by Cyprus to entice Russia into extending or increasing its existing loan – a dangerous foray into geo-political power politics – collapsed at the end of last week as Russia withdrew.
With the country now at the mercy of its threatening creditors, queues have been forming at ATM machines across Nicosia, businesses won’t accept credit cards or cheques and the country is running out of cash.
Cypriot president Nikos Anastasiades has been locked in desperate talks with representatives of the bailout “troika” – the European Commission, the ECB and the IMF.
All this can be traced back to the ultimate flaw in the euro project – the attempt to ram together 17 disparate economies, political systems and cultures in a single currency experiment. For the past three years it has been almost continuously dogged by sovereign debt scares, market swoons, emergency meetings, crisis summits and ever larger bail-out packages.
“We’re not in the Eurozone so we don’t have to worry much” is the first comforting reaction here in the UK. But with the Eurozone already stuck in recession, unemployment rates reaching into double figures and debt-laden Spain, Italy and Greece looking on with foreboding, hopes for an export-led recovery here are set to prove forlorn.
“It couldn’t happen here” is another comforting assumption. But government debt as a percentage of GDP is already heading for 85 per cent of GDP on the government’s own measure. And a slow motion bank raid is already in progress.
Savers have been stealthily robbed of £43bn of the real value of their savings since the Bank of England froze interest rates at 0.5 per cent. Such is the malign effect of officially sanctioned inflation on bank and building society depositors’ purchasing power. And there could be worse to come with the incoming Bank governor, Mark Carney, being given a more flexible remit on inflation targeting and monetary stimulus.
Anyone not apprehensive about the outlook for inflation and its consequences needs a serious reality check.
Inflation is no less a threat to our savings than a Cyprus-style full-on seizure. The crucial difference, of course, is that one is being undertaken by stealth. The other sought to proceed through a parliamentary decree and in the full glare of publicity. Result: uproar.
It is against this baleful background that the war of attrition continues over economic policy here. Barely had Chancellor George Osborne sat down after delivering the Budget than he was assailed for failing to stimulate the economy by enough to get business investing and tax revenues flowing.
The core of the “more stimulus” case is that, while government borrowing and the budget deficit would increase in the short run, it would enhance government revenues and lead to an eventual fall in borrowing as the economy recovered.
But this argument is blind to the unprecedented amount of stimulus that has already been undertaken. Between 2009-10 and 2012-13, government borrowing has totalled £565bn or 37 per cent of GDP.
Add in quantitative easing and the total rises to more than 60 per cent of GDP. Says Tim Morgan, global head of research at Tullett Prebon, “the problem, then, is not that government hasn’t tried Keynesian stimulus, but that it has been tried by the bucket-load – and hasn’t worked”.
And the “more stimulus” call is blind to risk. On the Maastricht Treaty basis used by our European comparators, public debt already stands at 91 per cent of GDP, and even the government expects it to push through 100 per cent in the coming three years. And if you add government, household and business debt together, aggregate indebtedness is more than 500 per cent of GDP.
There’s no urgency about paying off this debt, but as Tim Morgan reminds us, servicing it is the critical issue. Government debt interest payments are already set to rise from £47bn to £71bn over the coming five years, but a rise of just one per cent in interest rates would add £12bn to this figure.
A rise in interest rates forcing up government borrowing costs would, he points out, either drive the deficit upwards or other spending down. “Higher rates would hit house prices hard, creating huge banking losses, and the slump in mortgage-payers’ disposable incomes would not only have a gravely damaging impact on GDP but could also create another wave of bank losses in commercial property.”
And we need no reminding that the government’s own balance sheet is in no fit state to cope with such an outturn. Gradually, the full galling extent of the debt problem we face is sinking in. We’re not Cyprus, of course. But let’s not pretend we do not face a truly historic problem that could yet sink us.