S&P’s warning on the U.K. government’s credit rating, plus yesterday’s bad day for U.S. Treasuries, has got ten me (and other people) thinking about where we might be headed here in the U.S. The worst case scenario is that of Iceland, where the currency collapses, all the banks fail, and the populace is suddenly 65% poorer relative to the rest of the world. As soon as all that happened last year, people started worrying in London about the possibility of a Reykjavik on Thames.
The U.K., like Iceland, is a country with an open economy, a currency that doesn’t happen to be a global reserve currency, and a banking system that had grown extremely large relative to the economy. In Iceland the single biggest problem was that banks had been doing much of their borrowing in foreign currencies (by attracting deposits from the UK, the Netherlands, and the like); U.K. banks had some of this going on as well, although not to quite the same extent. The main difference is that the U.K. has a much bigger economy and its banking sector is about half as big, as a share of GDP, as Iceland’s was.
So the crisis wouldn’t play out exactly same way. Economist Willem Buiter–who had warned Icelandic bankers and government officials of their coming troubles early last year–gave the definitive account of how it might all play out in his blog in November. Buiter’s account is so definitively long that I can’t even begin to summarize it, but one key lesson I take from it is that the size of the U.K.’s government deficits, and credibility of plans to service the resulting debts, are the key factors. The U.K. is less likely to be hit by the sort of self-fulfilling panic that destroyed Iceland’s economy, but it’s possible that bad government policy could bring on an entirely justifiable panic.
Which brings us to the U.S. Our banking system is much smaller as a share of GDP than Iceland’s and the U.K.’s, our economy and financial system are much less exposed to the rest of the world, and foreigners have proved willing to keep buying our currency and our government debt even in the midst of a financial crisis that we unleashed (Treasuries are rebounding today after yesterday’s troubles, by the way). So whatever sort of debt or currency problems we have down the road, they’re likely to be drawn out over years and years. That’s great, in that it gives us the leeway to stimulate our economy with gigantic deficits right now. It’s dangerous, in that without the ferocious external pressure to shape up that countries like Iceland, Ireland and the UK have and will face, we might not be able to help ourselves from spending and borrowing our way into really serious trouble.