Small businesses, private equity firms, borrowers and major banks are all on the line
We are already at 10pc. We may soon be at 12pc. And before long we may well hit 15pc or perhaps even a genuinely scary 20pc. We have already seen signs this week that inflation has started to soar out of control, that the Bank of England has lost control of prices, and that the Government is floundering around with little idea how to respond.
Right now, most of the discussion around that is about how ordinary people will cope with the cost of living, and of course that is a huge issue. But there is something else to worry about. Sustained high inflation could trigger a financial crisis as well.
When prices start to gallop ahead at the rate they are right now that will inevitably impact the financial system. Like how? Lots of small business will close, jeopardising the loans banks have made to them; the private equity industry’s mountains of debt will be unaffordable; a slice of the one in five mortgages still on variable rates will default; and bank balance sheets, which have not been tested for such extreme price rises, will be stretched to breaking point.
In the hyper-inflation of the 1970s we had the secondary banking crisis, and in the milder inflationary surge of the early 1990s we saw a wave of financial collapses. We shouldn’t kid ourselves that this time will be any different – and it may well be a whole lot worse.
It may have only been a modest increase, but the 10.1pc inflation rate recorded this week was still psychologically important. We are now into double digit annual price rises. It will be higher still over the next few months. True, with the oil price falling, and wheat prices coming down as shipments from Ukraine start to flow again, inflation may well ease some time in the new year.
It will help a lot when the big jump in oil prices earlier this year drops out of the annualised indices. Even so, we can expect a lot more pain ahead, and with real interest rates still at record lows (UK rates should really be at 12pc by now just to be neutral) we could well be facing an inflationary spiral.
Anyone on a low income will be genuinely struggling, while everyone on average earnings will have to trim their budgets a lot to make ends meet. But it is the impact on financial stability we should really be worrying about. Here’s why.
First, lots of small businesses are going to be in trouble this winter. Everyone is talking about bailing out households, but hardly anyone has mentioned help for the independent shops and restaurants that won’t be able to pay huge electricity and heating bills very soon (and let’s not even think about all the sunbed salons you see on every High Street – those things use up a lot of power).
Many of them didn’t make much money in the first place. They will soon start closing in droves, and the banks will take a huge hit on any money they have lent them.
Next, the private equity industry has built up mountains of debt and dumped it on the companies they now control. Those overstretched businesses are vulnerable not just to rising interest rates – although those are going to hurt – but also to the soaring costs of power and supplies.
They have already been squeezed for every spare penny when times were good. In a downturn, all of them are going to struggle, and a few will default.
Thirdly, while around 80pc of mortgages are on fixed rates – phew! – that still leaves 20pc of borrowers with variable rates. They will have already seen their monthly repayments double over the last few months, and they may well double again before Christmas. Here’s a guess as well.
The people who didn’t fix their mortgage rates probably were not very good at managing their finances. Some of them will be able to cope with that, as well as huge heating bills, but plenty won’t. Mortgage repossessions are already up 39pc in the latest quarter (admittedly from low levels) and will climb a lot higher.
Finally, even the major banks might be in trouble. They have all been stress tested by their regulators. Here’s the catch, however. Those tests didn’t include double-digit inflation for the simple reason that no one thought that was possible. If there is a cascade of losses on small business loans, followed by commercial landlords who don’t have any tenants any more, followed by repossessions of people who can’t pay a variable rate mortgage, and then a ton of private equity debt turns sour as well, then there will be some huge write-downs to take. And that will not be pretty.
In reality, we have been here before. The inflation of the 1970s led to the secondary banking crisis and a wave of bailouts, with the likes of Slater Walker, a high-flying conglomerate turned bank, collapsing. It may be largely forgotten now, but the milder inflationary upsurge of the 1990s was almost as bad.
“The early 1990s witnessed the failure of a large number of small banks in the United Kingdom,” argued a 2016 paper from the Bank reviewing the lessons of the era. “Although these banks were not by themselves systemically important, the episode was serious enough for the Bank of England to provide emergency liquidity assistance to a few of them in order to prevent contagion to larger more systemically important banks.”
It would be crazy to think that can’t happen again. Nor can we have much confidence that an increasingly hapless Governor Andrew Bailey will be on top of the issue. The Bank didn’t see inflation coming down the track, and probably won’t have seen this either. Of course, inflation may be transitory, and come back down over the next year.
But if it runs out of control, the financial markets will be in big trouble – and possibly sooner than anyone imagines.
https://www.telegraph.co.uk/business/2022/08/19/financial-system-will-sorely-tested-economic-meltdown/