Mervyn King, former governor of the Bank of England, is worried about debt. More than anything else, it’s currently the biggest issue for the financial system. And it’s “not just in the US and UK, but across the world”, King told Bloomberg earlier this month.
“Debt in the private sector, relative to GDP, is higher now than it was in 2007, and of course public debt is even higher still.” Tax cuts, pushed through by the Donald Trump administration in the US, are only making the situation worse by increasing the size of the US government deficit (the amount by which the government overspends the tax-take each year).
Banks generally have more capital (particularly in the US and Europe) than they did during the last financial crisis, but the system is not invulnerable. It’s possible that we could see enough defaults to unnerve investors and get them to revise their views of “the value of assets on the balance sheets of financial institutions”. If that happens, then not only does the value of those assets fall, but so would “the value of the equity cushion available to absorb losses”.
In the worst-case scenario this could be enough to “induce financial panic”. Sure, it “may never happen”, but it’s the sort of thing that regulators and central banks should be paying close attention to.
King is also worried that if there were a financial crisis, central banks might struggle to deal with the problem. Indeed, in response to the last crisis, US politicians – “understandably so” – tried to “restrict the discretion of the Federal Reserve to provide liquidity to institutions and markets”. That’s a mistake, says King, and one that could delay the Fed in an emergency. Instead, the Fed should have the ability to exercise discretion in lending as it deems necessary, “but under a set of conditions agreed with Congress”.