I've been meaning to take this chart apart for ages.
It first appeared towards the end of 2011 and caused a considerable stir. Writers around the world castigated the UK for its profligacy. And from some Americans there was almost palpable glee that the smug UK was in a worse mess than the US. The French were facing a ratings downgrade at the time, and at least one writer used this chart to justify Sarkozy's argument that it was the UK that should be downgraded, not France. Review after review highlighted this "excellent" chart, and went on to blame the UK's dominant world position in financial services for its debt crisis. And it's still doing the rounds. It popped up on Twitter again last night. Which reminded me that it really, really needs debunking.
Not one of the many articles featuring this chart that I have read questioned its accuracy or pointed out that Morgan Stanley had provided neither an explanation of how the chart was constructed nor information on its data sources. Nor did anyone except Steve Keen notice that there were several other charts around at the same time which showed total debt from all sources, and Morgan Stanley's figure for UK financial sector debt was more than twice anyone else's. This chart from the ONS has private sector debt at 450% of GDP, of which about half is financial sector debt:
There is something else odd about the Morgan Stanley chart too. What on earth is "Europe"? In this chart, the UK and Sweden are shown separately from "Europe", even though both are members of the European Union, and Norway is also shown separately even though it is part of the continent of Europe. This is to say the least confusing for people who don't understand European geopolitics. Presumably by "Europe" Morgan Stanley mean the Euro area, though that is inaccurate and misleading: Europe is much more than just the Euro area - in fact it is more than the European Union, too.
Now the Euro area has a sovereign debt crisis, does it not? Er, not according to this chart. The public debt of "Europe" is considerably less than Japan's and only slightly more than the US*. So as Joe Wiesenthal points out, "Europe" actually doesn't have a debt problem. Now that would be true if "Europe" were a full monetary and fiscal union like the US. But it isn't. It's a collection of sovereign states which adopted a common currency because they thought it would benefit their own economies, not because they wanted to share with others. It's a collection of sovereign states which have agreed to some common laws and a certain amount of power-sharing, but who jealously guard their right to fiscal self-determination. It's a collection of sovereign states who DO NOT ISSUE COMMON DEBT. There is no equivalent of federal debt in Europe. This chart is effectively comparing the federal debt of the US, UK, Canada etc. with the MUNICIPAL debt of the Eurozone (not even the whole EU). If we included the municipal debts of the US in its total debt pile, the US wouldn't look nearly so good, would it - since we know that several of its states are virtually bankrupt?
Anyway, to return to the UK. According to this chart it is by far the most indebted nation on earth and is crippled by the debt of its bloated financial services sector. Is this justified?
"Partly", I think would have to be the answer. Other sources show that household debt/GDP is indeed very high, at around 100% of GDP. And non-financial corporate debt is also very high at around 110%. Public debt actually isn't as bad, at just under 60% in 2011 according to HM Treasury (Morgan Stanley marks the debt to market, giving a higher figure of about 80% due to rising gilt prices). But overall, excluding the financial sector, the UK does indeed have something of a debt problem.
We should remember that a high proportion of household debt is mortgages, because the UK has a very high level of home ownership and property is relatively expensive. Mortgages on primary residences are generally regarded as reasonably safe forms of debt, because people will cut discretionary spending to the bone to protect their mortgages. But a lot of people are financially stretched in the UK because of high levels of unsecured debt, rising unemployment and, perhaps more importantly, UNDER-employment (people forced to take part-time work when they want full-time), and high cost of essentials such as fuel and heating. Mortgage interest rates for many are at all-time lows because of the very low interest rate policy and unconventional measures pursued by the Bank of England, and it is probably fair to say that mortgage defaults would be far higher than they are if interest rates were at historically normal levels. Also, the UK has not suffered the catastrophic property market collapses of the US, Ireland and Spain: this is mainly due to housing shortages, but it is also due to capital flight from the Eurozone (London property is a favourite safe haven for the Greek and Italian wealthy) and active support for the housing market from a Government worried about funding for elderly care (the over-50s own much of the higher-value housing stock).
Non-financial corporate debt, although very high, is not quite what it seems. Corporations also have unprecedentedly high cash balances. Exactly why they are carrying so much cash while also maintaining loan finance is a bit of a mystery (although it is sensible to have long-term loan finance coupled with a positive cash balance) but I would say has to do with worries about cash flow and access to working capital finance in the future, since banks are reducing unsecured lending. And that brings me to one of the major issues with this chart.
The financial sector's debt is, to a considerable extent, the savings of the household and corporate sectors, both in the UK and overseas. The size of these figures suggest that they include all forms of debt including domestic deposits (for comparison, the McKinsey chart below excludes domestic deposits from financial sector debt). It therefore shows the assets of the domestic non-financial private sector as the financial sector's debt, and in so doing gives a misleading picture of the UK's domestic finances. On this chart, every personal and corporate current account and deposit account balance is (presumably) included in "financial sector debt". This is also true for the other countries, of course - which should really make one rather worried about New Zealand. It has high household debt but apparently almost no financial sector debt. Do New Zealand companies and households have no liquid assets? And we should also take Japan's figures with a pinch of salt. Japanese households save like crazy, and this is reflected in relatively high financial and public sector debt levels (most of the Japanese government debt pile is owned by its population). But the real issue in the Japanese financial sector is asset quality, not debt: their banks are still hampered by high levels of non-performing corporate loans. The lack of granularity in this chart, and the absence of supporting data (or even attribution of data sources) makes it seriously misleading.
So is the UK's financial sector really as much of a problem as this chart suggests? Is financial sector debt really 600% of GDP? As Morgan Stanley do not give their data sources and the chart is no longer on Haver Analytics' archive list (and their website does not have a search facility) it is impossible to check how they arrived at this figure, but it is way out of line with other sources. McKinsey, in their paper on the progress of global deleveraging, (link at bottom of post) gave UK financial sector debt as 219% of GDP:
This is consistent with the ONS figures from the chart further up the post, which was quoted by HM Treasury in its 2011 Budget report. And interestingly, McKinsey and Morgan Stanley both say they obtain their data from Haver Analytics. So why is the Morgan Stanley figure so much higher? Including domestic deposits can't possibly be the sole cause.
Grossing-up of interbank balances might be one possible explanation. Financial institutions lend to each other through the interbank unsecured and repo markets, and they also place deposits with and borrow from the central bank. The borrowing and lending of funds on a daily basis is the lifeblood of the financial system, and ensures that at the end of each day the financial system is fully funded overall, even though individual institutions are temporarily in debt to each other. This chart only considers debt. Could it be that interbank borrowings are included in Morgan Stanley's UK financial sector debt figures? If so, it is a gross error. Interbank borrowings should be netted, and only the difference (if negative) shown in debt figures.
But grossing-up interbank balances does not explain why the UK's financial sector is apparently so inflated relative to the rest. My guess is that Morgan Stanley have included in the liabilities of the UK financial sector debts incurred by UK subsidiaries of overseas financial institutions. In particular, they may have included derivatives issued and traded in London.
McKinsey say they do not include asset-backed securities in figures for financial sector debt, because that would cause double counting of the underlying, which is mostly domestic loans of various kinds. But they claim that Morgan Stanley do include them. By far the largest issuers of ABS are US financial institutions. Global Finance say that if ABS were included in figures for US financial sector debt, it would be 350-360% of GDP. Yet on the Morgan Stanley chart, US financial sector debt is shown as about 100% of GDP (as against 40% on McKinsey's chart).
Including in UK financial sector liabilities the debts incurred by UK subsidiaries of overseas financial institutions is perhaps an understandable approach, since these subsidiaries are usually UK-incorporated legal entities, but it creates considerable distortions. Just one example should be sufficient to show the distortionary effect: using this approach, the losses incurred by JP Morgan's Chief Investment Office in London earlier this year would have been counted as losses of the UK financial sector, not the US. And it raises the question who would be responsible if a systemically-important US financial institution suffered sufficient losses on its London trading activities to cause its failure.
In the financial crisis, the US government bailed out AIG even though most of its losses were incurred in London. But Iceland, facing a similar problem, repudiated the debts incurred in London. There was considerable ill-feeling between the UK and Iceland over Iceland's behaviour towards its banks' overseas creditors, and at one point the UK prime minister used anti-terrorism legislation to prevent Icelandic assets being moved out of the UK: relations between the UK and Iceland are still strained, particularly as Iceland now appears to be experiencing economic recovery (unlike the UK). However, the UK did nationalise and dispose of the UK subsidiaries of both Kaupthing and Landesbanki, and compensated insured UK retail depositors with Icesave. So it could be that because of the Icelandic experience, Morgan Stanley have assumed that the UK would in future have to accept financial responsibility for debts incurred by UK subsidiaries of overseas financial institutions, and have therefore included those debts in the figures for the UK financial sector.
I don't think this is remotely reasonable. Iceland's behaviour is not generally considered by the international community to be a good blueprint for the handling of major banking failures. Economically, it was unquestionably the right decision for a small country whose banking sector incurred losses that would, if taken on to the public balance sheet, have overwhelmed it - as Ireland's did. But suppose the US did the same? Suppose it decided, in the event of collapse of the global derivatives bubble, to repudiate all debts incurred by overseas subsidiaries of US financial institutions? That's the kind of behaviour that starts wars.
The Icelandic "solution" should be recognised for what it was - sovereign default - and rejected outright as an acceptable approach to resolution of major financial crises. Instead, there needs to be acceptance by the international community that no one country should have to bear the entire cost of major systemic failure. And an international legal framework should be developed for assigning responsibility and distributing losses fairly. In the 2007/8 financial crisis, most of the losses were borne by the US. But if the US had behaved like Iceland, most of those losses would have been borne by the UK. That's what I think the Morgan Stanley chart is showing us - and it is a terrifying prospect. We must learn from it.
* Eurostat figures show the Euro area combined sovereign debt at 88.5% of Euro area GDP in July 2012.
Debt and deleveraging: Uneven progress on the path to growth - McKinsey Global Institute (pdf download available)