Sean O'Grady: What would happen if the country really went bust?

A British sovereign debt crisis would make sub-prime look like a tea party

Is Britain about to suffer a "Black Swan" event? This, if you follow trendy financial ideas, is the one that shocks observers who assumed such a thing could never happen, just as the first Western visitors to Australia to see a black swan were similarly startled. The idea was popularised by a former financial trader, Nassim Taleb, whose The Black Swan became a bestseller soon after its publication in 2007, at a time when the unthinkable was happening to the big banks and markets every day, and black swans were biting us with painful frequency.

For an intellectually rudderless financial community, Mr Taleb's ideas were seized upon and they made him a great deal of money. The Black Swan was, perhaps, no more than an updating of Keynes' sadly forgotten distinction between risk and uncertainty, but someone did need to remind the world about that.

The bankers had never been much interested in it, and assumed all risks and uncertainties could be modelled mathematically. This mispricing and misunderstanding of risk, for example through the mistaken rating of sub-prime mortgage-backed securities as "safe", brought us to the brink of another Great Depression. It may yet happen: just because you've seen one black swan doesn't mean another one isn't round the next bend in the river. Or a whole eyrar of them.

So what would a British Black Swan look like? An ugly beast, I should say. It would probably take the form of a formal downgrade of the debts the British Government issues, or gilts, by the leading credit agencies. The markets would then go on a "gilts strike" – refusing to buy our debts except at ruinous interest rates.

Such a cataclysm has never happened, though successive governments have a shameful track record of inflating the British national debt away, effectively perpetrating a massive fraud on domestic and foreign holders of UK Government securities. That is the United Kingdom's dirty little secret, but the niceties have always been observed, the coupons paid, and the AAA-rating preserved.

What if it went, the Black Swan Event? It could easily be triggered by the failure of a new government, of whatever party or parties, to produce that "credible" plan to tame the deficit investors are impatient to see. A hung parliament might not help: delay could turn plans to mush, and interest rates would soar.

If the market wants to demand 7 per cent to take on British debt, that will be transmitted to your mortgage, car loan and credit card bill. It would mean hundreds of pounds a month extra for millions of households on their mortgage bills, and a severe squeeze on spending. It would tip the UK into a full-blown slump. "Double dip" wouldn't really do it justice.

An even more extreme impact of a downgrade would be felt in the big banks, insurance, pension and investment funds. These institutions are, ironically enough, required by regulators to hold substantial stocks of UK gilts in their portfolios and as capital because gilts are supposedly ultra-safe. If their value is shredded and they are demonstrably not safe, then the destruction of wealth that follows will indeed be unprecedented, and devalue every pension pot in the land.

It would rapidly trigger another financial crisis, as the banks would have to scramble to raise money, and the pension funds would find themselves facing insolvency as the worth of a large proportion of their assets (gilts) shrinks while their liabilities (pensions) stayed the same.

They might have to sell gilts and their shares at fire-sale prices in order to reinvest in the remaining government bonds that are deemed safe, such as US Treasury bills – though there is no guarantee that even the mighty US might not follow the UK and Greece into financial ignominy. (Given that the $18 trillion of US government securities are the most widely held assets in the world, then all bets really would be off then).

In Hollywood terms we are waiting for "Credit Crunch 2". The British would be faced with the "too big to fail" problem again, but on an even grander scale. It is unthinkable that we would let pension funds, insurance groups and big banks go bust – but the Treasury would no longer be able to issue gilts to pay for bailouts.

As a nation we would be bust, risks transferred from markets to banks to taxpayers, but ultimately unmanageable. We would have to go to the IMF and would qualify for a bailout, but it would be with very painful conditions.

A British sovereign debt crisis would make sub-prime look like a tea party. And we would all know what a Black Swan looks like.

s.ogrady@independent.co.uk

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