The Default Line: THE INSIDE STORY OF PEOPLE, BANKS AND ENTIRE NATIONS ON THE EDGE (11 page)

Still, the DMO had to find buyers for a hefty £340 billion worth of gilts. As it happens, changes to the regulations governing insurance companies and pension funds obliged these institutions to buy gilts, and their holdings went up by £112 billion over the past four years. Banks, too, upped their purchases of gilts by £70 billion over that period, but other financial institutions (such as hedge funds) sold £77 billion of their holdings. Altogether, of that £741 billion increase in Britain’s outstanding debts, only about £200 billion needed to be raised on world markets. As it happened, foreign buyers snapped up £213 billion extra worth of UK gilts over the four-year period. No breakdown has ever been given regarding which countries are bankrolling Britain. The numbers are huge, though. From 1995 to 2005 the UK owed a steady £50 billion to foreign bondholders, around 20 per cent of its debts. By 2008 that proportion spiked to over a third, to 35 per cent. Subsequently, the Bank of England’s quantitative easing programme helped reduce that figure to below 30 per cent. (The proportion of foreign purchased gilts issuance rises to 62 per cent if you ignore the bonds purchased by the Bank of England.) Britain’s dependence on foreign lenders was still at historic highs. But the proportions remained small in relation to other debtors. Eurozone crisis nations such as Ireland, Spain and Greece owed 70 to 80 per cent of their government debts abroad. The UK government argues, even in a market rigged by the Bank of England, that the very large increase in foreign holdings of UK gilts is a testament to the credibility of its austerity plan.

In September 2010, Lord Sassoon, the commercial secretary to the Treasury, led a sales mission to Saudi Arabia, Kuwait, Abu Dhabi and Dubai. The centrepiece of the roadshow was Robert Stheeman of the Debt Management Office, whose role it was to sell British gilts to the region’s oil-fuelled sovereign wealth funds and central banks. Britain, also an oil nation, had mysteriously misplaced its own sovereign wealth fund, squandering its North Sea windfall on current spending and tax cuts. Still, the Gulf nations could be relied on after being reassured about the solidity of gilt investments. A British minister had never gone on a roadshow like it before. The strategy was to see the ‘customers’ for Britain’s gilts, as soon as possible, at the highest possible level. It was a delicate operation, as none of the funds were keen to disclose their holdings. The objective was modest: to offer sufficient re-assurance that the foreign buyers would maintain Britain’s weight in their portfolios of assets. George Osborne’s team argue that this is where austerity, or at least credible austerity plans, really scored: the chancellor’s fiscal credibility has enabled the UK to lower the rates of interest payable on the nation’s growing debts. Participants on these roadshows were surprised, however, by the toughness of the questioning and the detailed technical knowledge of Britain’s position they encountered. But they were ‘pushing at an open door’. The pre-election fears expressed by bond trader PIMCO of gilts ‘sitting on a bed of nitroglycerine’ had long been forgotten. Investors were generally impressed by the transparency of Britain’s deficit reduction plan, versus other problematic European nations. Britain was winning the ugly contest on public finances. There was one concern, though: the interaction of public borrowing and banking stress. These conversations were and increasingly will remain Britain’s default line. The country that, a century ago, had been the world’s superpower was now dependent on the kindness of friendly strangers and strange friends.

Britain was never heading for actual bankruptcy: such a fate is basically impossible for a nation with its own currency and its own printing press. That was amply illustrated by the Bank of England’s massive gilt purchases, though the Bank argues that helping the Treasury was incidental rather than the aim of its policy. Britain, unlike Greece for example, had a credible long-term record of either extracting more tax from its people when required, or carrying out spending cuts. Another reason why Britain has not gone bankrupt is the length or maturity of its debts. The average length of gilts, the time when the principal sum borrowed would need to be repaid, is fourteen years. This is around double the average length of bonds issued by France, Germany or Greece. Ireland and Spain had an average debt maturity of five and six years respectively in 2010.

Britain has much longer to pay back its admittedly large debts. And who should George Osborne be thanking for that? Gordon Brown. Yes, Brown was responsible for a large swathe of debt with his pre-crisis deficits, and with his role in the financial crisis, which indirectly triggered the epic crisis deficits. But Brown secured a good mortgage deal for his mountain of debt. In the late 1990s Britain’s debt maturity was already nine years on average. By the start of the financial crisis, Brown’s creation, the Debt Management Office, had extended that out to fourteen years on average by issuing thirty- and fifty-year debts. There was less roll-over risk, and less of an immediate financing need of the type that felled Greece and Portugal. In fact, under George Osborne, the DMO extended the average out further, to fifteen years.

Britain’s long-term mortgage did not mean that it could skip repayment or tough decisions. But it did offer time, space and options. The credit-ratings agencies repeatedly mentioned the quantitative easing programme and the long debt maturity as reasons why the UK kept its gold standard AAA sovereign rating, even though its debts mounted. The chancellor had invested a huge amount of political capital in the AAA rating. But that would be taken away by Moody’s in February 2013, and by Fitch two months later, while the chancellor was at a meeting of finance ministers at the IMF. It was quite some watershed. Moody’s had rated the UK AAA since modern sovereign ratings were started in 1978. Way back in the First World War, John Moody himself, founder of the craft, personally researched and signed off a triple A rating to four different types of UK government debt. So February 2013 marked the first time the AAA had been stripped since 1918, almost a century earlier. The fact that the USA and France had already lost at least one of their ratings cushioned the blow. Mr Osborne impishly claimed both that the need to keep the AAA and his eventual historic loss of Britain’s ratings were vindications of his fiscal policies. In Opposition he had vocally called for an election when Standard & Poor’s merely threatened to take their AAA rating away from Alistair Darling’s Treasury.

So Britain lost its prized historical AAA rating, even though it wasn’t going bankrupt. George Osborne’s austerity programme probably helped reduce the risk of interest rates rising in Britain, albeit at the expense of a severe regime of cuts in some Whitehall departments. But the Bank of England was the overriding reason behind those low rates. Furthermore, senior figures at the Bank were adamant that the alternative plan from Labour – to deal with the deficit over eight years – would have been sufficient to retain market credibility, if fleshed out. In summer 2013 I asked Mr Osborne if he recognised that ‘bankruptcy’ was impossible. ‘No, I don’t,’ he told me. ‘It depends what you mean by bankruptcy: if you mean by bankruptcy a complete loss of international confidence in your ability to fund yourself, and a big spike in market interest rates such that you get into a terrible spiral and end up needing market support, I think that it was an entirely possible situation for the UK.’

As it turned out, the fiscal plans were missed rather spectacularly. Even more borrowing was required. Growth remained stubbornly flat. The recovery inherited from the previous government flattened, partly because of the Eurozone, partly because of oil prices, and partly because of the tax rises, confidence-sapping effects and early spending cuts of the austerity plan. Britain was to lose its AAA rating anyway. The chancellor was to veer off-course from his debt target, and delay the eradication of the British structural deficit by two years. Britain’s ‘fiscal brutality’ was a patchy affair (see Epilogue,
here
), focused on specific areas such as housing, transport, local councils, benefits, business support and spending on infrastructure. Overall spending increased in cash terms. Mr Osborne’s
ex post facto
rationalisation for low growth was that the hangover from Labour’s credit bubble was always going to be difficult. If that was the case, then he may have chosen the wrong cuts. He was pressured for a change of plan, which we shall return to. But given the relative ease with which his civil servants borrowed money abroad and from the Bank of England, what was all the fuss about austerity?

The answer lay in a PowerPoint scattergram circulated inside the Treasury in the first weeks of the coalition. Britain’s government debts and deficits were
a
problem but not
the
problem.
The
problem was the combination of public debt, private debt and bank debt. Britain could not take the risk of immediately losing its AAA rating, resulting in much higher gilt rates, not because of the risk of sovereign bankruptcy, but because of the interaction of sovereign-debt funding with banking funding stress. This was the so-called doom loop. The gilt salesmen were peppered with questions from foreign central banks about Britain’s over-large financial system. And in the PowerPoint scattergram (‘Risks from financial sector and fiscal position’), which mapped domestic banking assets (UK – 500 per cent) as a percentage of GDP against structural deficits (UK – 8 per cent), it was the UK that was off the scale, a lonely cross in the far northwestern corner of the chart. Britain was worse than every advanced economy on both measures, bar the Greek deficit, and even then only just. It was the combination of public and private debt that created the risks for Britain. The IMF would at first call UK austerity ‘an insurance policy’ against the collision of these twin deficits. But it was the private debt, the zombie businesses, households and banks that dragged on the economy. The banks that some of the bond vigilantes actually worked for were fairly high-level causes of the fiscal criminality that so irked those very same vigilantes. In some ways it was the mess that Britain’s banks had got themselves into that made the austerity programme especially necessary. As Chancellor Osborne describes the situation he was met with in 2010: ‘There’s an 11.5 per cent deficit: a hung Parliament… and what’s toxic is the potential fiscal link to the banking sector.’ And given what the banks had been up to, that would have been a difficult argument for a candid politician to explain to the public. Few dared to.

Dramatis personae

Davíð Oddsson, prime minister of Iceland (1991
–2004), governor, Central Bank of Iceland (2005–09), editor of the Icelandic newspaper
Morgunblaðið
(2009
–)

Bjartur, an indebted peasant character in Icelandic folk novels

Már Guðmundsson, a rather jovial successor to Mr Oddsson as governer of the Central Bank

of Iceland

Armann Thorvaldsson, London boss, Kaupthing bank

Sir Mervyn King, governor of the Bank of England (2003
–13)

Alistair Darling, UK chancellor of the exchequer (2007
–10)

Steingrímur Sigfússon, the Left-Green Party leader elected to government in the aftermath of the crisis, finance minister of Iceland (2008
–13)

Ólafur Hauksson, Icelandic special prosecutor of financial crimes

Katrín Júlíusdóttir, 38-year-old finance minister of Iceland (2012
–13)

Sigrún Davíðsdóttir, Icelandic broadcaster and commentator

‘You’re safe with these banks.’ So Davíð Oddsson, governor of the Central Bank of Iceland, told me in February 2008.

It’s the sort of quote that in a decade of reporting economics, and in three years of studying it at university, I had never expected to hear. No doubt bankers would think it, and want to hint at it. But to actually say it? In fact, to have the governor of a central bank say it? Absolutely not a chance. Why? Because the moment you have to say that about a bank, or an entire banking sector, then it pretty much becomes instantly untrue. As an attempt to boost confidence, it is inevitably both self-negating and self-defeating.

And yet the governor did indeed utter these words and he spoke them in a hyper-modern fort-like structure, a forbidding black bat-cave of a building overflowing with modernist art, overlooking the Reykjavik fjords and set against a backdrop of the towering snow-capped Mount Esja. The Central Bank of Iceland is possibly the most stunningly situated central bank in the world. And its governor made this statement seven months before it faced a collapse that was every bit as stunning as its setting. In February 2008 the Central Bank of Iceland was on the cusp of bankruptcy. In a room on the ground floor, a ruffled, agitated Davíð Oddsson stood before me. I had no idea why he had agreed to give me an interview in the circumstances. In his shoes, I would never have agreed.

Not much time was to pass before Oddsson’s reassurance was to turn out to be demonstrably untrue. He had offered that reassurance because two of Iceland’s big three banks had, amazingly, in the face of sceptical world markets, started to fund themselves with billions of pounds from ordinary British and Dutch family savers. So he did have a sliver of a reason for attempting to reassure the rest of the world.

‘The banking system has grown very fast,’ the governor told me, ‘and they have had very sound, handsome profits year by year by year. Last year, the three major banks made £1 billion profits, and the latter part of the year was not the easiest. The risk management has been good too. Now you can say they are northern European banks with headquarters in Iceland, because more than 50 per cent of their revenues are coming from outside Iceland.’ I asked him why his banking sector had made the strategic decision to woo foreign depositors. ‘I think we should applaud them for that,’ Mr Oddsson replied, ‘not punish them… I think it was a very good idea, good for both the banks and the people putting deposits into these banks, which are very sound and good banks.’