Too Many Crises: Is there a Way Out for the UK Economy and the Euro?

1. Too Many Crises: Is there a Way Out for the UK Economy and the Euro? David T Llewellyn Loughborough University Vienna University of Economics and Business CASS Business School Vice Chair, Banking Stakeholder Group, European Banking Authority Consultant Economist, ICAP plc CIPFA Scottish Treasury Management Forum 23rd February, 2012 1

2. TOO MANY PROBLEMS 1. Cyclical 2. Structural aspect of recession: crises and the economy 3. Debt Overhang: Public and Private sectors 4. Austerity Trap 5. Global financial imbalances 6. Unsustainable standard of living: pay-back time 7. Euro and sovereign debt crisis 8. Recession in Europe 9. Euro fault-lines 10. Banking fragility: crisis? 11. Negative feed-back loop 12. Structural shift in the world economy 13. Too few instruments: Tinbergen Principle 14. Erosion of political authority: global economy and finance with national politics

3. ADJUSTMENTS NEEDED * Cyclical * Structural * Global * Sustainability 3

4. BANK OF ENGLAND GDP GROWTH PROJECTION* * Based on market rate expectations & £325bn QE 4

5. BANK OF ENGLAND INFLATION PROJECTION* * Based on market rate expectations & £325bn QE 5

6. POWERFUL HEADWINDS • Personal sector squeeze) • Debt overhang legacy • Ricardian equivalence • Consumer confidence • Bank fragility 6

7. PERSONAL SECTOR SQUEEZE Reversal of trends: “hang-over effect” Key prices: fuel, energy, food, insurance Real wages: prices v. wages Cost of banking crisis: real v. financial Cuts in government spending Cuts in benefits and entitlements Taxes Unemployment and expectations Lower income from savings Pensions 7

8. ALTERNATIVE SCENARIOS • Full recovery: no permanent impact of recession • Permanent loss of output and capacity • Widening loss via slower capacity growth

9. LABOUR PRODUCTIVITY – Whole Economy & Sectors* * Output per hour – source BoE

10. BANK OF ENGLAND GDP PROJECTION* * Based on market rate expectations & £325bn QE

11. EXCESS DEBT • Unprecedented borrowing by households • Structural deficit prior to crisis • Recession • Bank rescues

12. FISCAL STRATEGY Fiscal Pragmatists (early / substantial / quick) V Fiscal Retrenchers (smaller / later /.longer / conditional) Risks in both! 12

13. BUDGET DEFICITS AND DEBT% gdp Budget deficit Public debt US 9.3 104 Japan 8.9 219 Ireland 8.7 119 UK 8.7 (4th) 97 (10th) Greece 7.0 181 France 4.5 103 Portugal 4.5 122 Spain 4.4 77 Iceland 3.3 127 Belgium 3.2 102 Italy 1.6 128 Germany 1.1 87 13

14. THE FISCAL RETRENHCERS • Debt crisis and Debt trap • More debt? • Delay means greater cost • Lower growth if D/y >90 percent: Debt Trap • Debt servicing capacity • Vulnerable to confidence crisis • Bond yields rise if relax • Interest rate effect is non-linear • Rating agencies • Sovereign debt crisis can emerge suddenly 14

15. PUBLIC SECTOR NET BORROWING 15

16. THE FISCAL PRAGMATISTS • Risk of recession and permanent impact on economy • Fiscal policy should balance the economy – not the budget • Fiscal retrenchment and de-leveraging is toxic • Interest rates low: no crisis • Counter-productive: Austerity Trap • Fallacy of Composition • Limited scope for monetary easing • Banks not supportive 16

17. PROJECTED PUBLIC SPENDING£ billion Current Gross Capital 2009/10 600 71 2010/11 620 63 2011/12 660 53 2012/13 670 50 2013/14 680 49 2014/15 695 50 2015/16 715 52 17

18. A MEDIUM TERM FISCAL STRATEGY Short-term support and long-term adjustment - medium term balance - path could be economy-dependent 18

19. DILEMMA • Overwhelming problem of excess debt • De-leveraging without growth? • Vicious circle: Austerity Trap 19

20. GLOBAL FINANCIAL IMBALANCES$ BILLION Surpluses Deficits China 331 US 470 Japan 191 Euro area* 310 Germany 178 India 53 All others 543 All others 329 * excluding Germany and Netherlands 20

21. UNSUSTAINABLE LIVING STANDARDS Growth in excess of productive potential Credit boom Wealth effect of housing Savings ratio Budget deficit Over-valued exchange rate NSO Financial services 21 21

22. MASSIVE SQUEEZE IN LIVING STANDARDS (1) Pay-back time: reversal of unsustainable trends (2) Rise in prices (partly EGI) relative to wages 22

23. DOWNSIDE RISKS Global financial imbalances Fiscal retrenchments De-leveraging: household sector / public sector / banks Fragile banking systems Sovereign exposures Commodity prices and real incomes Euro crisis 23 23

24. LOANS TO EURO-AREA CREDIT INSTITUTIONS* * By ECB & countries’ central banks – sources ECB & BoE

25. MONETARY UNION • Common fiscal policy • Large central budget • Single government debt • Automatic fiscal transfers • Transfer illusion • Strong regional policies • Single monetary policy • High labour mobility 25

26. EURO FAULT LINES • Transnational monetary union without fiscal union • No credible fiscal discipline • Negotiated fiscal transfers • Lack of economic convergence: competitiveness • No common government bonds • Single interest rate for different risks • No crisis resolution mechanism • No single policy entity 26

27. SERIOUS CONCERNS ABOUT EUROPEAN BANKING Unprecedented combination of pressures Parallels with 2008 Implications of fragility Regulatory concerns Conflicts in objectives

28. PRESSURES ON EUROPEAN BANKING BALANCE SHEET - capital - funding - liquidity MACRO ECONOMY MARKET CONTEXT - euro - cost of equity - availability of equity ` - sovereign debt exposure (4) REGULATION - pro-cyclicality - steady-state v. stock-adjustment - incremental v. cumulative - Regulation Matrix trade-off

29. PARALLELS WITH 2008 Uncertainty v. Risk Dependency on wholesale funding Dependent on short-term financing Inter-bank market problems: availability / terms / tiering / maturity Problems beyond 3 months IBM spreads and repo interest rate Euro/dollar basis swaps wider Dependent on ECB Hoarding and enhanced liquidity preference Counterparty risk concerns Global risk aversion OIS spreads widen CDS prices Dispersion of credit-standing Reduced liquidity in markets Bond market volatility Bond market spreads Bank equity prices: Market Value < than Book Value Volatility of bank bond prices

30. IMPLICATIONS Fragility Vulnerability to shocks NFBL Dependency on ECB Unsustainability Conflict - stable banking system via E/A - no pro-cyclicality

31. E/A ADJUSTMENT OPTIONS (1) ADDITIONAL CAPITAL * new equity * profits * convertibles (2) BALANCE SHEET ADJUSTMENTS * reduce lending * asset sales * debt-buybacks at a discount * re-calculate risk weights * reduce dividends * reduce bonuses (3) SECURITISATION (4) STATE CAPITAL INJECTIONS (5) BANK DEBT RE-STRUCTURING

32. CONFLICT OF OBJECTIVES Need for a rise in E/A Not via de-leveraging Problems with new equity: cost and availability

33. BANK RATE PROJECTION* * Bank of England projections using Overnight Index Swap Rates

34. MODEST RISE IN YIELDS • Weak economic growth • Credibility of fiscal strategy • Safe haven effect of gilts • Short-term interest rates • Declining inflation • Demand for gilts: banks • Quantitative Easing • Borrow in own currency 34

35. QUARTERLY CHANGES IN GILT HOLDINGS – BY SECTOR 35

36. BUT THERE ARE RISKS • Correction at some stage 36