Sovereign crisis now the biggest risk

Allister Heath
DOWN, down, down – that is how it has felt in the markets over the past few days. Once again, politicians are making matters worse, with Angela Merkel’s obsession with bashing financial institutions especially disturbing. If she is unhappy with the disastrous state of the Eurozone, she ought to consider focusing her ire on her predecessor but one as chancellor, Helmut Kohl, who waved Italy into the euro, despite its obvious non-compliance with the Maastricht criteria for sound finances. Sceptics were outraged at the time; and it is now obvious that the Cassandras were right all along.

The market chaos is only good in one respect: it reminds us that sovereign risk, broadly defined, is at least as much of a threat to the recovery as the sub-prime crisis and the credit crunch were two or three years ago. In fact, dodgy government debt poses an even greater risk, for two reasons: the first is that mainstream financial theory always assumes that the government bonds of developed economies are free of default risk, so all models are based on this completely erroneous hypothesis; the second is because the volume of state debt is much larger than that of private sub-prime debt.

It is important that those in charge of stress-testing at private institutions as well as at regulators begin to look at some previously unthought of scenarios; private investors ought to do the same. Among the scenarios that ought to be considered are a 20-30 per cent write-down of government debt across the Club Med countries, including Italy; widespread sovereign credit downgrades, which would trigger the mass selling of bonds by some restricted institutions and major problems for firms that have been ordered to hold supposedly safe government debt as capital; a break-up of the Eurozone and the redenomination of hundreds of billions of government bonds into new currencies; much higher inflation; capital controls; and extreme anti-bank and anti-speculator legislation. None of these scenarios have a very high probability of materialising; some indeed remain a low probability risk. But no responsible risk manager can any longer afford to dismiss any of these as completely unthinkable.

There is plenty of good stuff in the Liberal-Conservative coalition manifesto, released yesterday; and also some bad stuff. But one policy could have revolutionary and entirely positive consequences: the new rules that all council spending above £500 and the full details of all central government spending above £25,000 will have to be published. While the limit could and should have been even lower for central government expenditure, this will help expose the vast waste and incompetence at the heart of the state. It will put massive pressure on the authorities to reduce their costs; no longer will it be possible for politicians or bureaucrats to claim that all spending is productive and spent on front-line services. Taxpayers will suddenly discover what is really happening with their money – and they are bound to become much tighter as a result. The expenses scandal which destroyed dozens of MPs and changed British politics for ever was made possible by the Freedom of Information Act, introduced by the Labour Party; sunlight of the kind being dreamt up by the Lib-Con coalition will prove to be an even more powerful disinfectant for the rest of the public sector.