When the UK Previously Looked to a Canadian to Run the Bank of England

Just a quick historical note on the somewhat stunning news that Mark Carney, the current head of the Bank of Canada (and a Canadian citizen), has been asked and has accepted the job of running the Bank of England.

Graham Towers and Montagu Norman 

I say 'somewhat' because students of history may know that as Montagu Norman's 24 year reign at the Old Lady of Threadneedle Street was winding down the then head of the Bank of Canada, Graham Towers (also a Canadian citizen), was considered as a leading candidate to replace Norman.

Norman and Towers worked closely together during World War II to support the price of sterling during the Battle for Britain, and much of the UK's gold (as well as France's) was sent to Canada to protect it in the event of a Nazi amphibious invasion of Britain. However, for reasons possibly lost to posterity Towers was either never offered or accepted the job.

Analogies about how England's national football coach is often  foreigner and how the Carney choice really isn't all that different are of course flooding the media airwaves right now. Perhaps the economic, patriotic, and security considerations that come with heading the national football club and central bank aren't really as far apart as one might think?

An issue which isn't under much doubt is that Mark Carney, like Graham Towers in his day, is simply a very good candidate for the job.

Looking ahead, the one thing that is certain is that Mr. Carney will have very big shoes to fill. Even with the financial crisis and the challenges faced by the City of London over the past several years, there can be little doubt that Sir Mervyn King has proven to be one of the finest central bankers of his age. Sir Mervyn recently gave an excellent lecture at the LSE on inflation targeting, which can be viewed here.

Another point is that the Carney choice further confirms London's status as the most welcoming of the major financial centers to foreigners and capital alike. Take that New York!

Video: Mervyn King on Twenty Years of Inflation Targeting

A very accessible, excellent talk from the Governor of the Bank of England on the past two decades of financial and central bank history, and the need to rethink the policy of inflation targeting. 

Podcast with better audio quality here.

Speaker(s): Professor Sir Mervyn King

Chair: Professor Craig Calhoun

Recorded on 9 October 2012 in Old Theatre, Old Building.

Since 2008, we have experienced the worst financial crisis and recession since the 1930's. What challenges does this pose to the intellectual foundations of monetary policy? Do we need a new approach?

Mervyn King is the Governor of the Bank of England. Before joining the Bank he was Professor of Economics at the LSE, and a founder of the Financial Markets Group.

On the Topic of Financial Collapse Fear Mongering

"Ireland is in a death spiral" -FT

"After the November President election the U.S. is facing a fiscal cliff" -Federal Reserve staff

"Eurogeddon!" -The PolyCapitalist

On and on go the warnings of cataclysm and pending financial doom. Technical jargon and existential risks are bandied about in frightening fashion, leaving the general, less-economically literate with very little ability to understand what's actually happening or just how bad things could really get if say Greece leaves the Eurozone, or another country defaults, or something like this occurs.

This blog is not entirely innocent of this criticism, and this post is a brief attempt to quickly address the question of whether our global financial system is on the precipice of a financial collapse if say something 'really bad' happens in Europe?

The short answer is no.

Now before I expand on that answer I would like to clarify something very important: this post is about financial collapse and not about the extremely high levels of unemployment, which have reached approximately 50% for young people in countries such as Greece and Spain. The youth and general unemployment problems today are serious and something to be very concerned about. But this post is not about that but instead about whether another Lehman-style event could occur where the world's financial system risks implosion if say a country like Greece pulls out of the euro, the current 'bank jog' in Spain accelerates, etc.

So why isn't the risk of financial collapse as bad as some would have use believe?

For starters, we have to keep in mind that our financial world is a virtual world. Today, money is largely a set of numbers on a computer. This means that even in the most extreme scenario of financial disorder, where policymakers completely blow it and the ATMs stopped working and the stock market tanked, that everything that is real and tangible - the houses, the food that is farmed, the physical assets - none of this goes away and will all be here the next day when you wake up in the morning.

Now having said that, a financial implosion would definitely have a major impact on our lives, particularly for those with fewer resources or who are unprepared. But life will go on for nearly everyone and could actually rebound quite quickly given other historical cases. For example, Argentina began recovering within months following its utterly complete financial meltdown in 2001 even though the country achieved the relatively rare trifecta of a currency collapse, a banking crisis, and a sovereign default all at once. Iceland has had a relatively quick turnaround following its 2008 financial implosion. And other Asian countries in the late-90s also turned the corner pretty quickly following major financial crises.

In the case of Argentina, dozens of people died in Dec. 2001 riots, so I don't want to minimize the very real suffering and dislocation which comes with a financial collapse. But Argentina's experience is a far cry from the level of suffering of say a war or severe natural disaster. In short, a 'cataclysm', it was not.

A further point needs to be made about the above examples, which is that they were all relatively isolated, contained crises that did not threaten a systemic collapse in arguably the same way as the current crisis. But this leads me to point number two, which is that a systemic collapse is extremely unlikely, particularly given two facts:

1. what was learned from the recent Lehman-experience in 2008 by the current crop of policymakers.
2. the world's central banks, especially the Federal Reserve, still have loads of financial ammunition.

Regarding the first point, current policymakers got a first-hand glimpse of just how interconnected the world's financial system is and how the failure of a seemingly small cog in the wheel could threaten to topple the whole system. So while yes, Greece's financial implosion could lead to a chain reaction that threatens the entire global financial system, it is utterly inconceivable in the wake of the Lehman crisis that policymakers would sit back and let that happen given what they learned and how they responded in 2008-2009.

So I hear you asking whether all our problems are solved then because central banks like the Federal Reserve are all powerful, financially speaking, and able to contain any crisis which comes its way? Over the long-term, I would say no, they are not all powerful financially. But in the short-term, meaning right now and over the next few months at least, they are all powerful financially, and here's why.

Central banks like the Fed, ECB, Bank of Japan, and Bank of England which operate fiat currencies have an extraordinary power, which is that they can create an unlimited amount of money.

'Unlimited', meaning a truly infinite amount of money? Yes

What this means is that even if, for example, all the depositors in Spain and Greece withdrew every last euro from their local banks the ECB can supply all the notes that citizens want to hide under their bed mattresses. In short, the ATMs should never, ever run out of money in a fiat money system which is being managed by competent professionals.

But earlier I alluded to the fact that even though central banks can print an unlimited amount of money that they were not in fact financially omnipotent over the long-term, so what did I mean by that?

With the magic that is the computer a central bank could literally go and create and infinite amount of money. But there are side effects with central banks creating a lot of money, namely inflation. Without getting technical, simply put inflation is a rise in prices. Hyperinflation is a very large, sudden rise in prices.

But here is the crucial point to remember: rising inflation acts as a brake on a central bank's ability to create money. In other words, a rise in inflation is perhaps the key to understanding when central banks would be constrained in any effort to bail out the financial system.

Today, most of the world's advanced economies (North America, Europe) have relatively modest inflation, meaning low single digit annual percentage increases in official measures of core inflation. And even though they would say otherwise, the central banks in these advanced countries would be more than willing to trade an increase in inflation to stem the risk of a systemic financial collapse.

So how much more inflation would central banks be willing to tolerate as a tradeoff for not risking financial collapse? As the Bank of England has demonstrated in the past couple years, inflation creeping up towards 5% is not enough of a concern to prompt a significant deviation in policy. So my guess (it is a guess) is that at the extreme central banks like the Fed could tolerate up to 10% if they perceived the risks of collapse to be great enough before they would think twice about pulling another post-Lehman style bailout of the world's financial system. And since we're still in low single digit inflation this gives the Fed a decent amount of runway to maneuver.

This room to maneuver is what is meant when it is said that the Fed, which controls the world's most important reserve currency, and other central banks still have lots of ammunition.

The existence of this ammunition is likely a factor behind why given all the current distress in Europe that the stock markets haven't fallen further. In other words, the markets expect central banks to step in and flood the financial system with money if Greece leaves the euro or a banking run accelerates. Even the supposedly hemmed in by the Germans/hard-money crowd ECB. After LTRO and all the sovereign bond debt purchases, anyone who still thinks the ECB won't step in to save the system if things go completely pear shaped by creating a lot money is living in a fantasy. And this flood of central bank money would likely be very bullish for stocks in the short-term.

Should inflation increase significantly, then the ability of central banks to rush in and save the day could be diminished. But for now, they have the power to act, and that's why (for now) a general financial collapse is not on the immediate horizon.

So in sum, if you want to understand when it might be time to get worried, keep an eye on official measures of core inflation, particularly if it starts creeping up near the 5% level as that is about the time a proper central banker will begin to twitch over fears of runaway inflation.

Now, in terms of how you want to position your investment portfolio given the above, the very first post on this blog just over two years ago argued for allocating some of your portfolio into gold, which is arguably the best hedge against excessive central bank money printing. Even though the price of gold has gone up significantly in the last two years this blog still stands by that recommendation for long-term investors.

Why the Vickers Report on Banking Reform Failed the UK and the World

Kotlikoff rips the Vickers commission's final recommendation:

The Independent Banking Commission’s final report is a grave disappointment. The ICB (chaired by Sir John Vickers) seeks to reinstate Glass-Steagall by ring-fencing good banks and letting bad banks do their thing and, if they get into trouble, suffer the consequences. This proposition was tested by the collapse of Lehman Brothers, whose failure nearly destroyed the global financial system. 

The commission retains the current system apart from some extra requirements primarily imposed on the good banks (the retail banks). The main impact of this is likely to be to foster more financial intermediation to run through the bad banks, i.e. if you impose more regulation on financial companies that call themselves X and less on companies that call themselves Y, companies that call themselves X will start to call themselves Y. In short, the commission has in effect taxed good banking while sanctifying shadow banking. The commission has also chosen to regulate based on what a bank calls itself, rather than on what it does.

A year back, Mervyn King, Bank of England governor, described the current banking system as the “worst possible.” In a speech, delivered at the Buttonwood Conference in New York, he called for the analysis of Limited Purpose Banking — a reform plan that I developed, which replaces traditional banking with mutual fund banking and makes no distinction between financial intermediaries.

At the end of last year, I travelled to London and met the commission staff to discuss Limited Purpose Banking. I had thought the commission would take the proposal and my discussion with them seriously. That was not to be. In fact, the commission spent very little space discussing the proposal, despite Mr King’s urging that it be carefully studied, and notwithstanding its remarkably strong endorsement by economics Nobel Laureates George Akerlof, Robert Lucas, Edmund Phelps, Edward Prescott, and Robert Fogel as well as by former US secretary of state and former US secretary of the treasury, George Shultz, by Jeff Sachs, Simon Johnson, Niall Ferguson, Ken Rogoff, Michael Boskin, Steve Ross, Jagdish Bhagwati, and many other prominent economists and policymakers.

Do the opinions of the governor of the Bank of England and all these prominent authorities on finance and economics deserve to be dismissed in seven sentences? For seven sentences is all the commission was able to spare when it came to discussing Limited Purpose Banking, notwithstanding the 358 page length of its report.

Full article here.

Keynes on Printing Money, and Do Loss-Suffering Central Banks (i.e., ECB, SNB) Need Capital?

Weimar Germany during the early-1920s hyperinflation

A 1924 quote from John Maynard Keynes reflecting on events in Weimar Germany and Lenin's Russia:

"A government can live for a long time, even the German Government or the Russian Government, by printing paper money." 

However, "In the last phase, when the use of the legal tender money has been discarded for all purposes except trifling out-of-pocket expenditure, inflationary taxation has at last defeated itself."

The above quote was excerpted from a 1997 paper by the IMF's Peter Stella titled 'Do Central Banks Need Capital?'

Can Central Banks Go Bust?

Technically speaking, the answer according to Stella is no, central banks do not require a capital buffer to absorb losses in the same sense that a commercial bank does. However, Stella states:

"Weak central bank balance sheets invariably lead to chronic losses, the abandonment of price stability as a primary policy goal, a decline in central bank operational independence, and the imposition of inefficient restrictions on the financial system to suppress inflation. 

...if society values an operationally independent central bank capable of attaining price stability without resorting to financial repression, the transfer of real resources to recapitalize the central bank becomes necessary when chronic losses are sizeable."

In other words, the overarching reason for central banks to hold sufficient capital is that it helps maintain confidence in the soundness of the central bank and the value of the currency it issues.

Has the ECB Become Europe's 'Bad' Bank?

As the European debt crisis has spread and intensified, central banks in Europe have been suffering heavy losses for over a year now.

The Swiss National Bank has reported losses in the tens of billions of swiss francs on its euro purchases over the past 12+ months. Whether or not the Swiss government will move to recapitalize the bank is unclear. So far as I know the Swiss central bank is unique among major world central banks in that it is publicly-traded with both government and private shareholders.

There has also recently been speculation that the relatively thinly-capitalized European Central Bank will need to be recapitalized again if it were to continue to suffer heavy losses on its purchase of European sovereign debt. The ECB recently began purchasing tens of billions in Italian and Spanish debt, which comes on top of the tens of billions in Greek, Irish and Portuguese debt it already holds. The prospect of the ECB needing additional funding is not sitting well with Germany and other rich European nations which will have to foot the bulk of the bill.

Interesting times in the world of central banking.

How to Fix Our Optimism Deficit

Europeans, Japanese, and even rose-colored glasses wearing Americans are suffering from what has been described as an 'optimism deficit'. This rather unthreatening sounding phrase should not be mistaken for an insignificant economic problem.

Optimism fuels all sort of important economic activities, such as entrepreneurship, saving for the future, and social cohesion. It may in fact be the most fundamental immediate challenge facing the developed world today. But with pre-election political gridlock setting in, our leaders are big on rhetoric and short on concrete actionable ideas which can restore confidence.

There is one idea, however, that I believe could make a significant impact on restoring optimism, but before getting to that a brief personal backstory.

Blowing Bubbles

I lived in San Francisco and worked in tech during Dot Com bubble and bust a decade ago, and it taught me a lot of lessons. But perhaps the most important one didn't come until several years afterwards.

Having been away from California for a few years since the burst, I moved back (this time to Southern California) in 2003. To my disbelief I began noticing similarities between the still nascent housing bubble and the one which I had just recently had a front-row vantage. The tech bubble seemed still too fresh in my mind for the kind of speculation on housing that was taking place. While the assets were different (tech stocks vs. real estate), the underlying psychology was eerily familiar.

I did not have the foresight of Michael Burry, Steve Eisman, and the founders of garage startup hedge fund Cornwall Capital to cash-in on this observation. Instead I simply ignored peer pressure and pesky real estate salespeople who warned me that if I didn't purchase a home now I would be "priced out of the market forever". Another memorable ribbing from that era was the "you're throwing your money down the drain" by renting year-after-year. When the 2008 financial crisis hit it made the Tech Bubble look like a small financial radar blip.

Forget-Me-Nots

Witnessing two significant financial crashes in such close proximity to each other left an indelible lesson, which was to never underestimate how quickly a large number of people can forget a traumatic financial event.

This month marks the four-year anniversary from what was arguably the canary in the coal mine moment, the July 2007 collapse of two Bear Stearns hedge funds, both of which were heavily invested in mortgage securities. Bear Stearns itself blew-up approximately nine months later, and it would take until September 2008 for the crisis to reach its nadir with the simultaneous implosion of Lehman Brothers, AIG, Merrill Lynch, and a bevy of other financial firms.

The case of Citigroup bears special mention. Its collapse and bailout marked the third time in last quarter-century that the firm needed to be rescued by the government (the other two instances being the 1982 Latin America debt crisis and the late 1980s bust in commercial real estate which sparked the S&L crisis). Yes, that's right, about once every 8 years on average Citibank blows-up and needs a taxpayer funded bailout. If an inglorious banking prize equivalent to baseball's golden sombrero doesn't already exist then one should be created and promptly awarded to Citi!

While Rogoff and Reinhart caution against the following type of thinking, I do suspect that this time is different from 2003-2004. I don't believe as many people have forgotten the financial crisis as did the dot com bust, and not just because the 2008 crisis was much more spectacular in its magnitude. There are two big differences between then and now:

1. Protracted high unemployment, which in the U.S. is at 9.2%, and in places like Spain is over 20%.

2. The sovereign debt crisis that is hitting not just European countries such as Greece, but is also hammering away at confidence in the U.S. with daily headlines about nearing the debt ceiling.

A sense of widespread and growing economic unease can be seen in recent polling data:

A New York Times/CBS News poll finds that 39 percent of respondents believe “the current economic downturn is part of a long-term permanent decline and the economy will never fully recover.” (in October, only 28 percent of people believed the U.S. economy was in permanent decline -- marking an 11-point increase between now and then) 

The survey is only one of a recent spate indicating widespread distress over the state of the economy. On June 8, a CNN poll found that 48 percent of Americans believe another Great Depression is either very likely or somewhat likely.

The 2008 financial crisis was a severe blow to economic confidence and optimism, by far the biggest since the Great Depression. The most important and personal asset for the vast majority is housing, which lost one-third of its value from the peak and recently began a double dip. This combined with high unemployment and the suffocation of too much debt is at the heart of the current economic unease.

What Did Taxpayers Receive in Exchange for Bailing-out Banks?

The fundamental instability of the financial system was laid bare for all to see during the 2008 crisis. The public also got a glimpse of just how dangerous Too Big to Fail financial institutions are as governments around the world rushed to bailout megabanks and firms like AIG with taxpayer money. What did taxpayers get in exchange? As much as Paul Volcker, Adair Turner, Sheila Bair, and other well meaning and respected technocrats would like us to believe that Dodd-Frank, Basel III, etc. repaired the foundational cracks, the ongoing sovereign debt crisis casts serious doubts on these claims.

Today, people aren't wondering whether the next proverbial shoe will drop. People are instead bracing for when the next economic tsunami will make landfall. Will it be this week with Greece, end of this month with the U.S. debt ceiling, or sometime around the next major elections, when historically (and peculiarly) financial crisis seem to appear? The exact timing is uncertain, but there is broad understanding that another major financial crisis will strike, and perhaps soon.

This sense of pending chaos has left many people in a state of economic paralysis and dealt a collective blow to confidence and optimism. As Austin Powers would put it, we've lost our economic mojo.

A Key to Fixing Our Optimism Deficit

A big key to restoring economic optimism is the establishment of a sturdy foundation for the financial system.

Our current financial system is opaque and not well understood by the general public or many experts, such as macro economists, almost all of which failed to see the crisis coming. Apocalyptic terms are often employed when discussing it, and a fear that it may come crashing down at any moment feeds existential worry and creates a drag on productive economic activity. For example, concern of another crash inhibits lending and investment, reduces entrepreneurial risk taking, and may be responsible for the stockpiling of cash we're seeing at many large corporations, like Apple which is sitting on approximately $60 billion.

How best to provide the financial system with a rock solid foundation? Is simply restoring Glass-Steagall enough? I don't think so.

The most far-reaching, comprehensive and achievable plan is the one outlined by Professor Laurence Kotlikoff, which he calls Limited-Purpose Banking. I believe that title may in fact do a disservice to his well thought through ideas, which go far beyond banking and include insurance and other areas of the financial system (e.g., regulatory consolidation of the 120 government agencies currently charged with supervising various elements of the financial system).

Professor Kotlikoff has written a book on his ideas, which you can find in the Good Books and Films section of the right-side column of this blog, titled Jimmy Stewart is Dead: Ending the World's Ongoing Financial Plague with Limited Purpose Banking (the Stewart reference is to the thespian's role as the likeable community banker, George Bailey, in It's a Wonderful Life). You can listen to an excellent talk he gave at the London School of Economics here. His proposal has generated bi-partisan political, regulatory and intellectual support around the world. Mervyn King of the Bank of England has been one of its foremost champions.

Without going into all the technical details, Limited-Purpose Banking basically removes leverage from the financial system and makes the entire system more like mutual funds, which did not collapse or suffer from fraud during the recent financial crisis.

Here are some of the promises of Limited-Purpose Banking:

• We’ll never have another financial collapse.
• We’ll never see a run on banks ever again. 
• We’ll never see insurance companies insuring the uninsurable. 
• We’ll get rid of all the con jobs underlying the current financial system. 
• There will be no more insider rating deals, liar loans, director sweetheart deals, bonuses which amount to corporate theft, bribing of Congress. 

In short, we’ll have a financial system that’s honest and that we can trust. The financial plague will be cured, once and for all.

Interview with Larry Kotlikoff Author of "Jimmy Stewart Is Dead" from Daniela Guernica on Vimeo.

To bring back economic optimism we must build a new, more stable foundation for economic activity. This foundation can be created with a new financial system like the one proposed by Professor Kotlikoff, who is quite optimistic about the likelihood that his ideas will ultimately be implemented. It may take one more financial crisis and bailout of the banks to get the public and politicians on board with this type of reform, but I agree with Professor Kotlikoff that something along the lines of the reforms he's outlined will happen eventually.

In Greece, Locals Rule

Harvard Professor Dani Rodrik clearly spells out the bottom line on Greece:

History suggests...when the demands of financial markets and foreign creditors clash with those of domestic workers, pensioners, and the middle class, it is usually the locals who have the last say.

Rodrik's full post here, and video you won't see on most main stream media below.

Mervyn is the Man

Anyone following the ongoing financial crisis (yes, it's not over yet) closely these past few years has probably noted the markedly different rhetoric coming from two central banks on opposites sides of the Atlantic.

BoE Governor Mervyn King

Governor Mervyn King is Ben Bernanke's equivalent at the Bank of England. This weekend he again excoriated Too Big to Fail banks, which predictably led to HSBC threatening to leave town (again).

Is Mervyn out of his mind? I mean, however will London's economy and the U.K.'s tax receipts survive if megabanks like HSBC relocate to Singapore?

The oft-repeated threat by Too 'Bigger' to Fail megabanks that they'll leave town for lax regulatory and lower tax enclaves in Switzerland, Asia, etc. shouldn't scare anyone. If in fact they do carry through on this threat I for one would be at the airport to wave them off goodbye.

For starters, many megabanks don't pay much in the way of local taxes. But that's not the main reason we should call the Too Bigger to Fail bankers' bluff.

With respect to megabanks' threatening to leave town, author Michael Lewis recently made the following analogy:

Your local utility is found to be poisoning the community's water supply, which is making people sick. However, in order to continue providing electricity the utility says that it has to be allowed to poison the water. If the community doesn't allow it to keep poisoning the water then it will leave town for another location which is ok with this. 

The obvious response to this lunacy is to tell the utility to take a hike -- our community can find someone else to provide non-polluting electricity!

Banks are like utilities. They both fulfill important functions. However, Too Big to Fail megabanks are not the only firms capable of providing banking services. If Too Big to Fail firms leave town then other smaller banks, which don't poison the local water, would gladly step into their place. There is nothing so special that Too Big to Fail banks do that can't be easily and quickly replaced. In fact, they are much, much easier to replace than an electricity utility.

Megabanks pose a risk to the health of the economy, just like the water-poisoning utility poses a risk to the well being of the community. When something goes wrong at the Too Big to Fail banks, like it did in 2007-2008, everyone suffers in the form of bigger deficits, higher taxes and lost jobs.

Meanwhile, it looks to be another record setting year for banker bonuses.

Between Governor King and the Independent Banking Commission's Sir John Vickers it would appear that the U.K., unlike the U.S., has the right people in the right place at the right time.

Bravo, Mervyn! Keep up the good fight!

P.S. Interestingly, Mervyn in his pre-BoE life was Michael Lewis' tutor at the London School of Economics.

The Biggest Loser (Besides the Irish) in Ireland's Ongoing Debt Crisis

Noted economic historian Barry Eichengreen has written perhaps the most scathing damnation of this week's Irish bailout. I strongly encourage reading the full piece.

Professor Eichengreen takes aim at Germany in particular. In the below passage he compares the Irish bailout to Germany's own hopelessly burdensome WWI war reparations, which played a key role in the rise of the Nazis and perhaps the Great Depression:

"Ireland will be transferring nearly 10 per cent of its national income as reparations to the bondholders, year after painful year.This is not politically sustainable, as anyone who remembers Germany’s own experience with World War I reparations should know. A populist backlash is inevitable. The Commission, the ECB and the German Government have set the stage for a situation where Ireland’s new government, once formed early next year, rejects the budget negotiated by its predecessor. Do Mr. Trichet and Mrs. Merkel have a contingency plan for this?"

The short answer to Barry's question is, of course, no.

Irish Bailout Rejection Fallout

European sovereign bailouts may wind up becoming a lot like Department of Defense contracts in that the only thing contract signing signifies is the beginning (rather than the end) of negotiations. For example, if the new Irish government rejects its bailout as expected there may be an attempt to stem the ensuing crisis by negotiating down the hopelessly high bailout interest rate of 5.8% (or 7.25% depending on how it's calculated). And Ireland's controversial low corporate tax rate of 12.5%, rumored during the height of the drama  to be on the table for european 'harmonization', may also be revisited.

Any such renegotiations should be viewed as window dressing aimed at delaying the final reckoning. The fundamental problem is that Ireland is insolvent. No amount of additional liquidity or tax rate bargaining alters this inescapable fact. Faced with this prospect, Europe's current leaders are struggling to determine who will take the biggest hit from Ireland's inevitable default.

Who Will Be the Biggest Loser?

Arguably the key issue to keep an eye on is whether senior Irish bank debt holders will be forced to take losses. If in fact Eichengreen's suggestion of 100% haircuts on insolvent Irish bank debt is adopted the ramifications for Europe's banking system would be difficult to overstate.

The below chart is helpful to understanding the implications of an Irish bailout rejection/and or default.

(click to enlarge)

The U.K. is Ireland's largest creditor with approximately $220 billion in exposure, so any Irish bailout rejection and/or default will weigh heaviest on Britain. Royal Bank of Scotland (RBS) and Lloyds TSB, which were previously placed on government life support, are particularly threatened.

An Irish rejection of the bailout will put substantial pressure on the still fragile British banking system, which post-bailout consolidation is now home to three of the world's five largest banks (including #1 RBS).

(click to enlarge)

In spite of the current austerity push in the U.K., the government participated in the Irish bailout and pledged approximately $10M to "a friend in need". An Irish Times editorial, reflecting the long and conflicted relationship between these two nations, greeted British 'kindness' with a degree of skepticism.

It's would appear that the U.K. (an EU member which never adopted the euro currency) helped bailout Ireland because rescuing a neighbor is politically more palatable than what would have been necessary if Ireland's debt situation had further deteriorated: recapitalizing the British banking sector (again).

A Lonely Lady

But if at some point an Irish default is inevitable, and the Eurozone nations align to protect their euro based banking system, Britain may well find itself the odd man out. And since further bank bailouts by parliament are politically DOA, Mervyn King and the Old Lady of Threadneedle Street may be left to step into the breach to recapitalize British banks. Any such Bank of England support would be coming on top of calls from the Cameron government for further quantitative easing to reduce the effects of government budget cuts and nagging inflation. In other words, sterling would be forced to do even more at a time when the currency is already stretched thin.

It is worth briefly reviewing the history of pound sterling in the 20th century. In the 1920s one pound fetched almost $5. The country was forced off the gold standard during the September 1931 Sterling Crisis, resulting in a sharp devaluation. Following the massive accumulation of debt during WWII, the pound was devalued again in 1948. This was followed by a further 15% devaluation in 1967. Following a severe recession in the early 1980s, the pound has traded as low as $1.03 in March 1985. Overall, there is well established history of devaluation when the going gets tricky.

While the recent plunge in the euro has provided a relative respite in what had been a steady weakening trend in the pound, Britain will bear the foreign brunt of any Irish bailout rejection and/or default. Further compounding this problem is China's curious financial support to Europe's 'Club Med' nations, but not Ireland, and Britain's total debt position which stands at a whopping 5x GDP (the world's largest total debt/GDP ratio). Based on these and other factors one can make a very good argument that over the medium-to-longer term the pound will continue its long drift downwards. Several ETFs are available to hedge against this risk.