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

David T Llewellyn

Loughborough UniversityVienna University of Economics and Business

CASS Business SchoolVice Chair, Banking Stakeholder Group, European Banking Authority

Consultant Economist, ICAP plc

CIPFA Scottish Treasury Management Forum23rd February, 2012

TOO MANY PROBLEMS1. Cyclical2. Structural aspect of recession: crises and the economy3. Debt Overhang: Public and Private sectors4. Austerity Trap5. Global financial imbalances6. Unsustainable standard of living: pay-back time7. Euro and sovereign debt crisis8. Recession in Europe9. Euro fault-lines10. Banking fragility: crisis?11. Negative feed-back loop12. Structural shift in the world economy13. Too few instruments: Tinbergen Principle14. Erosion of political authority: global economy and finance with national politics

33

ADJUSTMENTS NEEDED

* Cyclical

* Structural

* Global

* Sustainability

44

BANK OF ENGLAND GDP GROWTH PROJECTION*

* Based on market rate expectations & £325bn QE

55

BANK OF ENGLAND INFLATION PROJECTION*

* Based on market rate expectations & £325bn QE

66

POWERFUL HEADWINDS

• Personal sector squeeze)

• Debt overhang legacy

• Ricardian equivalence

• Consumer confidence

• Bank fragility

77

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

ALTERNATIVE SCENARIOS

1. Full recovery: no permanent impact of recession

2. Permanent loss of output and capacity

3. 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

EXCESS DEBT

• Unprecedented borrowing by households

• Structural deficit prior to crisis

• Recession

• Bank rescues

1212

FISCAL STRATEGY

Fiscal Pragmatists(early / substantial / quick)

V

Fiscal Retrenchers(smaller / later /.longer / conditional)

Risks in both!

1313

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

1414

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

1515

PUBLIC SECTOR NET BORROWING

1616

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

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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

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A MEDIUM TERM FISCAL STRATEGY

Short-term support and long-term adjustment

- medium term balance

- path could be economy-dependent

1919

DILEMMA

(1) Overwhelming problem of excess debt

(2) De-leveraging without growth?

(3) Vicious circle: Austerity Trap

2020

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

212121

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

2222

MASSIVE SQUEEZE IN LIVING STANDARDS

(1) Pay-back time: reversal of unsustainable trends

(2) Rise in prices (partly EGI) relative to wages

232323

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

24

LOANS TO EURO-AREA CREDIT INSTITUTIONS*

* By ECB & countries’ central banks – sources ECB & BoE

2525

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

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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

SERIOUS CONCERNS ABOUT EUROPEAN BANKING

(1) Unprecedented combination of pressures

(2) Parallels with 2008

(3) Implications of fragility

(4) Regulatory concerns

(5) Conflicts in objectives

PRESSURES ON EUROPEAN BANKING(1) BALANCE SHEET

- capital- funding

- liquidity

(2) MACRO ECONOMY

(3) 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

PARALLELS WITH 2008

Uncertainty v. RiskDependency 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

IMPLICATIONS

• Fragility

• Vulnerability to shocks

• NFBL

• Dependency on ECB

• Unsustainability

• Conflict- stable banking system via E/A- no pro-cyclicality

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

CONFLICT OF OBJECTIVES

1. Need for a rise in E/A

2. Not via de-leveraging

3. Problems with new equity: cost and availability

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BANK RATE PROJECTION*

* Bank of England projections using Overnight Index Swap Rates

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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

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QUARTERLY CHANGES IN GILT HOLDINGS – BY SECTOR

3636

BUT THERE ARE RISKS

• Correction at some stage