Backup for breakup
Pundits say Britain needs a plan B to boost growth. What it really needs is a contingency scheme to handle a euro explosion. The central planks should be for the government to keep adequate fiscal firepower in reserve to handle a crisis and to shore up the country’s banks.
The two points are linked. If the government used all its fiscal headroom now in an attempt to prevent a double-dip recession, it might find it had no capacity to react if things go from bad to worse across the English Channel. Debt is already forecast to peak at 78 percent of GDP in 2014/2015, according to the Office for Budget Responsibility. But that assumes the euro zone finds a solution to its problems. If not, the UK will be dragged into a deep recession and its debt will balloon: the tax take would fall, social expenditure would rise and money would be pumped into the banks.
If the single currency breaks up, there will probably be banking panics across the euro zone. Britain’s lenders would also be vulnerable. That’s partly because they hold 15 billion pounds of the sovereign debt of Greece, Portugal, Italy, Spain and Ireland. But the main problem would be their 144 billion pound exposure to those countries’ private sectors. A euro collapse would turn many good loans bad. Royal Bank of Scotland, Barclays and Lloyds Banking Group would be the three banks most in the firing line.
Extra capital alone wouldn’t stop these banks running out of cash in the aftermath of a breakup. The government and Bank of England would also need to provide them with a liquidity backstop, as they did in 2008. As then, support could have two elements: the Treasury could guarantee new issues of wholesale bank debt; and the BoE could restart its Special Liquidity Scheme, which allowed lenders to swap illiquid assets for government bonds for a period of three years.
One option would be to wait until a breakup before doing any of this. But the UK might then find itself on the back foot, having to fight a full-blown panic. It would be better to get at least part of the contingency plan moving now.