1. 11 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 23 rd February, 2012

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

4. 44 BANK OF ENGLAND GDP GROWTH PROJECTION* * Based on market rate expectations & £325bn QE

5. 55 BANK OF ENGLAND INFLATION PROJECTION* * Based on market rate expectations & £325bn QE

6. 66 POWERFUL HEADWINDS Personal sector squeeze) Debt overhang legacy Ricardian equivalence Consumer confidence Bank fragility

7. 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

8. 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. 9 LABOUR PRODUCTIVITY – Whole Economy & Sectors* * Output per hour – source BoE

10. 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. 12 FISCAL STRATEGY Fiscal Pragmatists (early / substantial / quick) V Fiscal Retrenchers (smaller / later /.longer / conditional) Risks in both!

13. 13 BUDGET DEFICITS AND DEBT % gdp Budget deficitPublic debt US9.3 104 Japan8.9 219 Ireland 8.7 119 UK8.7 (4 th ) 97 (10 th ) Greece7.0 181 France 4.5 103 Portugal 4.5 122 Spain4.4 77 Iceland3.3 127 Belgium3.2 102 Italy1.6 128 Germany1.1 87

14. 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

15. 15 PUBLIC SECTOR NET BORROWING

16. 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

17. 17 PROJECTED PUBLIC SPENDING £ billion CurrentGross Capital 2009/10 600 71 2010/11 62063 2011/12 66053 2012/13 67050 2013/14 68049 2014/15 69550 2015/16 71552

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

19. 19 DILEMMA (1)Overwhelming problem of excess debt (2)De-leveraging without growth? (3)Vicious circle: Austerity Trap

20. 20 GLOBAL FINANCIAL IMBALANCES $ BILLION Surpluses Deficits China 331US 470 Japan 191 Euro area*310 Germany 178India 53 All others 543All others329 * excluding Germany and Netherlands

21. 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

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

23. 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

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

25. 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

26. 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

27. 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

28. 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

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 1.Need for a rise in E/A 2.Not via de-leveraging 3.Problems with new equity: cost and availability

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

34. 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

35. 35 QUARTERLY CHANGES IN GILT HOLDINGS – BY SECTOR

36. 36 BUT THERE ARE RISKS Correction at some stage