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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
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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
ADJUSTMENTS NEEDED
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Cyclical
Structural
Global
Sustainability
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BANK OF ENGLAND GDP GROWTH PROJECTION*
* Based on market rate expectations & £325bn QE
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BANK OF ENGLAND INFLATION PROJECTION*
* Based on market rate expectations & £325bn QE
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POWERFUL HEADWINDS
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Personal sector squeeze)
Debt overhang legacy
Ricardian equivalence
Consumer confidence
Bank fragility
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PERSONAL SECTOR SQUEEZE
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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
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ALTERNATIVE SCENARIOS
1. Full recovery: no permanent impact of
recession
2. Permanent loss of output and capacity
3. Widening loss via slower capacity growth
LABOUR PRODUCTIVITY – Whole Economy & Sectors*
* Output per hour – source BoE
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BANK OF ENGLAND GDP PROJECTION*
* Based on market rate expectations & £325bn QE
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EXCESS DEBT
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Unprecedented borrowing by households
Structural deficit prior to crisis
Recession
Bank rescues
FISCAL STRATEGY
Fiscal Pragmatists
(early / substantial / quick)
V
Fiscal Retrenchers
(smaller / later /.longer / conditional)
Risks in both!
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BUDGET DEFICITS AND DEBT
% gdp
Budget deficit
Public debt
US
9.3
104
Japan
Ireland
UK
Greece
France
Portugal
Spain
Iceland
Belgium
Italy
Germany
8.9
8.7
8.7 (4th)
7.0
4.5
4.5
4.4
3.3
3.2
1.6
1.1
219
119
97 (10th)
181
103
122
77
127
102
128
87
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THE FISCAL RETRENHCERS
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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
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PUBLIC SECTOR NET BORROWING
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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
2009/10
2010/11
2011/12
2012/13
2013/14
2014/15
2015/16
600
620
660
670
680
695
715
Gross Capital
71
63
53
50
49
50
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
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DILEMMA
(1) Overwhelming problem of excess debt
(2) De-leveraging without growth?
(3) Vicious circle: Austerity Trap
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GLOBAL FINANCIAL IMBALANCES
$ BILLION
Surpluses
Deficits
China
Japan
Germany
331
191
178
US
Euro area*
India
470
310
53
All others
543
All others
329
* excluding Germany and Netherlands
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UNSUSTAINABLE LIVING STANDARDS
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Growth in excess of productive potential
Credit boom
Wealth effect of housing
Savings ratio
Budget deficit
Over-valued exchange rate
NSO
Financial services
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MASSIVE SQUEEZE IN LIVING
STANDARDS
(1) Pay-back time: reversal of
unsustainable trends
(2) Rise in prices (partly EGI) relative to
wages
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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
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LOANS TO EURO-AREA CREDIT INSTITUTIONS*
* By ECB & countries’ central banks – sources ECB & BoE
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MONETARY UNION
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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
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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
`
(4)
- cost of equity
- availability of equity
- sovereign debt exposure
REGULATION
- pro-cyclicality
- steady-state v. stock-adjustment
- incremental v. cumulative
- Regulation Matrix trade-off
PARALLELS WITH 2008
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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
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
BANK RATE PROJECTION*
* Bank of England projections using Overnight Index Swap Rates
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MODEST RISE IN YIELDS
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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
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BUT THERE ARE RISKS
• Correction at some stage
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