The Great Debate UK

Should a country always stand behind its banks?

Ever since the financial crisis broke in 2008 some of the world’s major banks have their governments to thank for their survival. The fates of Royal Bank of Scotland or Citibank would have been much worse without large injections of capital from the UK and U.S. authorities. The UK government pumped more than £37 billion into its largest banks in the immediate aftermath of the Lehman Brothers crisis. Ireland took that a step further when it guaranteed all of its banks’ deposits and liabilities. This was affordable, the Irish government said at the time.

However, this policy failed spectacularly. Ireland’s bailout of its banking sector brought the country to the edge of bankruptcy and forced it to accept a 82 billion euro bailout loan from the IMF/ECB and the European Union. More than 30 billion euros of this loan is to re-capitalise the Irish banking sector and the rest is to shore up the state’s finances. The conditions of the loan mean that Ireland will have to implement harsh austerity measures for many years to come that will inevitably hurt growth.

So should governments always stand behind their banks? There are some success stories. Back in 2008, when the global financial sector teetered on the brink of collapse, it was necessary for the world’s major central banks and governments to offer unlimited support to their banks. The chief reason for this was to ensure that credit flowed through the economy to foster growth. In truth however, a mixture of stringent capital rules caused banks to shrink their balance sheets in the teeth of the recession, which didn’t help the overall economy but did boost their balance sheets. In the first six months of 2010 the UK’s four largest banks: Lloyds Banking Group, Royal Bank of Scotland, Barclays and HSBC (the latter two did not receive bailouts) made combined profits of £13.6 billion. This is a far cry from the £22.3 billion they lost in 2008.

The U.S. banking sector has also seen earnings recover sharply. The Federal Deposit Insurance Corporation (FDIC) announced that the earnings for U.S. banks rose by $14.5 billio in the third quarter of 2010. Now that the banking sector is back on its feet again one can hope that credit conditions will also become more supportive of economic growth. And strong earnings also increase the chances that taxpayers will profit from the capital injections at some point.

So why did things go so wrong for the Irish? There are two reasons. Firstly, the government’s guarantee to cover banks liabilities was too hasty. It didn’t inject capital, instead it promised to write an unlimited number of blank cheques. Secondly, there was a mis-match between the size of the banks’ liabilities and the size of the state. Ireland’s economy was 210 billion euros in 2008, the cost to bailout Anglo Irish Bank alone is at least 30 billion euros, and by some estimates it could be 50 billion. This makes the $40 billion plu capital injection (which then turned into equity) into Citibank look like small change for a $14 trillion economy like the U.S.

The trick is for governments not to bite off more than they can chew, and make sure they have conducted a rigorous analysis of a bank’ liabilities before underwriting its future losses. If you don’t do this then the punishment can be harsh, as Ireland has found out.

On paper Ireland’s banks guarantee doesn’t look like such a good idea, but a bank is also part of a country’s social fabric. Its citizens trust the banks to look after their deposits and expect 24-hour access to their money to fund their living costs – paying for a mortgages, school fees, clothing and food. If customers can’t access their money this hits confidence in the central plank of capitalism – the banks. The US has the FDIC to protect deposits of up to $250,000; Ireland didn’t have an equivalent institution so in October 2008 it had to offer a government guarantee for deposits. This was the right thing to do; however, it should have stopped there. A government should protect the hard-earned savings of its citizens, but it is learning how expensive it can be to essentially take on the risk for banks’ bondholders as well.

Thank you, Gordon Brown

–Laurence Copeland is a professor of finance at Cardiff University Business School. The opinions expressed are his own.–

If the economics profession has sunk in public estimation in the last two or three years, it would hardly be surprising. Our failure to predict the crisis is something which cannot be simply brushed aside lightly, as some of my colleagues would love to do.

To ordinary folk, claiming to be quite good at explaining and even forecasting events in normal conditions, but admitting we simply can’t handle crises makes us about as much use as a doctor who knows how to treat ingrowing toenails and flatulence, but hasn’t a clue about how to deal with heart attacks or cancer.

Nor is that the only charge which could be levelled at the British profession. One could forgive any politician who felt bewildered by the sheer fluidity of the positions taken by the hordes of macro-economists offering advice, solicited and unsolicited, on the direction policy should take. After all, the overwhelming majority of the profession appears to be in favour of expansionary monetary policy (aka QE2) with an eye on keeping sterling weak against the euro and, if possible, the dollar (hence also against the yuan). Yet most of the same people were enthusiastic advocates of Britain joining the euro zone, in spite of the fact that the option of driving down our exchange rate in the way they advise is only open to us because we have stayed out of the single currency.

Likewise, many colleagues are equally confident in opposing too rapid a reduction of our budget deficit  – “After all, we aren’t Ireland/Greece/Spain/Portugal……” they snort, whenever anyone points to the possible risk of delaying the cuts, as they  would like us to do.

On this point, they are right, of course – we are in a very different situation from Ireland and the sunkissed PIGS. But why are we so different?

It’s certainly not because we have been running a tighter ship – in 2009, our deficit was 11.5% of GDP, compared to 14% in Ireland and Greece, 11% in Spain and a mere 9% in Portugal, and by election time, in May this year, our deficit was estimated to be running at 12% of GDP, compared with only 9% for Greece and less for every other EU member. Moreover, our accumulated debt, although less than many other European countries, still stood at 68% of GDP last year, 4% higher than Ireland, which is under intense pressure these days.

Pound recovers as Osborne outlines fiscal plans

- Mark Bolsom is head of the UK Trading Desk at Travelex Global Business Payments. The opinions expressed are his own. -

As widely expected, Chancellor George Osborne took a tough stance in his first budget and unveiled some “unavoidable” cuts and taxes.

It was slightly more aggressive than I had expected, as he promised to reduce the entire deficit by the end of his parliamentary turn. It was moderate in other areas, however – the bank levy was not as severe as expected, for example, nor was the rise in Capital Gains Tax.

It is risky for Osborne to cut spending and raise taxes when economic recovery remains fragile. Whilst the budget deficit will be cut a lot quicker than it would have been under Darling, the impact on growth is unknown and could be severe.

Politically, however, this was Osborne’s only real opportunity to ramp up cuts and taxes, whilst lambasting the outgoing Labour government for their alleged ‘fiscal negligence’. “

Osborne’s move to raise VAT was somewhat surprising, given the UK’s current rate of inflation (3.4 percent). The new VAT rise will be inflationary and heap pressure on the Bank of England to raise interest rates.

Cable: parity is still a long way off but $1.40 beckons

Since 1982, cable has been contained by the 1985 low of GBP/USD1.0790 and the 2007 high of USD2.0798.  The bulk of this time cable has remained within a narrower 1.40 to 1.80 trading range.

These statistics illustrate how significant it would be if the pound were to slip to parity with the dollar this year.  They have not, however, stopped some commentators speculating about such an event.

The problems affecting the pound are well documented.  The appalling truth is that a combination of low growth expectations for the UK economy and a crippling budget deficit have opened the risks of a funding crisis (if the government does not get the budget in order) or a double dip recession (if too much austerity is introduced too soon).

There may exist a narrow policy path the government could steer that would allow for improved fiscal management and moderate growth but, since the chances of a hung parliament are failing to disperse with just 2 months to go before the favoured election date, it appears likely the new government will lack the backing to take difficult decisions.

The size of the budgetary problems facing the US and UK governments are not vastly different.  According to the Bloomberg survey, economists are forecasting a UK budget deficit at 8.7 percent of GDP in 2009 rising to 11.6 percent in 2010.  The US budget deficit is forecast at 10.20 percent of GDP in 2010 but a fall to 9.4 percent of GDP is forecast for 2011.

The first constraint on budget reform in the UK comes from lacklustre economic activity.  Admittedly Q4 GDP was revised higher to 0.3 percent q/q.

However, this was largely due to government spending, a course which will should go into reverse this year.  The risk that the UK could fall back into double dip recession this year not yet been fully averted and the fragile nature of the UK recovery will make aggressive fiscal reform harder to implement.

Has the Bank of England helped stem economic decline?

-Mark Bolsom is the Head of the UK Trading Desk at Travelex, the world’s largest non-bank FX payments specialist. The opinions expressed are his own.-

The onset of 2009 saw the pound well and truly on the back foot against both the dollar and euro, at one stage hitting a six-year low against the greenback (falling to $1.3751) and an all-time low versus the single currency. In one week in January, the pound fell 4.5 percent against the euro, 5.7 percent against the yen and 6 percent against the dollar.

The pound’s weakness at that stage was clearly a direct consequence of the credit crunch and resulting global economic slowdown. Nevertheless, as the both the government and the Bank of England opted for policies of aggressive fiscal and monetary stimulus, sterling recovered, to a degree, even as the economy slid into the deepest recession for generations. In response, the Bank of England took positive and decisive action, slashing interest rates to a record low of 0.5 pc and pumping 200 billion pounds into the economy through its asset purchasing scheme.

How successful this has been is debatable. House prices have stabilised and have been slowly rising. The threat of deflation also appears to have receded with November’s data showing inflation more or less in line with the Bank’s 2 percent target. Similarly unemployment has not risen by as much as had been feared. However, as 2009 draws to an end, the government has been forced to revise its own growth forecasts for 2009 downwards, now stating that by year end the UK economy will have contracted by 4.75%. Similarly, some commentators have argued that unemployment data is misleading. True, the number of claimants is still below expectations, but many employees have been forced to accept pay cuts and shorter working weeks.

Worryingly, at the time of writing, Britain also remains the only major economy not to have emerged from recession. The final Q3 GDP number revealed that the economy still contracted by 0.2 percent in the three months to September. Furthermore, significant question marks remain over the long-term sustainability of Britain’s debt, as the government and taxpayer now have to cope with the cost of successive bank bailouts.

Therefore, sterling’s prospects for 2010 look decidedly mixed. Given the level of economic uncertainty we certainly expect interest rates to stay at their current level of 0.5 percent – at least until 2011- as both the Bank of England and the government will want to stimulate economic growth. Traditionally, this could be expected to lead to a further weakening of the pound as demand diminishes. Mervyn King, governor of the Bank of England, has consistently argued that this is needed in order to rebalance the economy and stimulate the UK’s export sector, although such a move is likely to be unpalatable to the UK consumer.

Low interest rates could also be expected to lead to a higher rate of inflation as money supply increases and imports, upon which the UK relies heavily, become relatively more expensive. We could very well see consumer price inflation hitting the 3 percent mark early next year.

Pound’s fall a symptom of crisis, not a problem in itself

–Vincent Cable is Deputy Leader of Britain’s Liberal Democrats. He is a former economist who is also the party’s spokesman on economics and finance. The views expressed are his own. –

Most of Britain’s moments of high economic drama in the 20th century centred on sterling: the Gold Standard in the inter war period; the various balance of payments crises of 1949 and 1967; Black Monday and the ERM.  It is perhaps understandable that commentators should reach for these folk memories and attach the word “crisis” to the current fall of sterling against the main trading currencies particularly the Euro.  Understandable; but wrong.

Britain certainly faces very deep and painful economic problems  which may prove as serious as any since the second world war: a sharp contraction in output; high unemployment; perhaps, for the first time since the 1930’s, sustained price deflation; serious depressed asset markets, as for equities and housing; and, not least, a virtual collapse of the banking system.

It may well be that the sharp fall in sterling reflects market perceptions that Britain is exceptionally vulnerable even in a major global recession because of its exposure to financial shocks through the City and an extreme ‘bubble’ in house prices and personal debt preceding the crisis.  Markets can clearly see that the Bank of England has been forced to cut interest rates more aggressively than the Eurozone.  Sterling’s fall is a symptom of this vulnerability rather than a problem in itself.

Since the ejection of Sterling from the ERM, Sterling has been allowed to float.  When the independence of the Bank of England was institutionalised in 1997, with the Monetary Policy Committee setting interest rates, it was made explicit that the exchange rate was not a policy objective.  Interest rates were to be used to meet the inflation target, not an exchange rate objective.

For most of the last decade the consequence of monetary policy has been a strong exchange rate in real effective terms – that is taking account of relative inflation and the exchange rates of different trading partners.  One (apparent) benefit was lower inflation, in sterling for imported goods, enabling the Bank of England to cut interest rates (but helping to fuel the disastrous bubble in house prices).  The cost was a severe squeeze on manufacturing industry which suffered a major loss of competitiveness and shed one and a half million jobs in 10 years.

Few British cheers for euro amid crisis

Paul Taylor is a Reuters columnist. The opinions expressed are his own.

The financial crisis has rallied support for euro adoption in many European countries outside the currency bloc, yet in Britain the discussion is so far confined to a few voices among the policy elite.

The politics of the issue remain as fraught as ever, and Britons appear no more willing to lose monetary sovereignty in a recession than they were in the boom years.

For most of the last decade, as the flexible, finance-driven British economy was roaring ahead of its sluggish continental cousins, the economic and political case for joining the single European currency was hard to make.

A Eurosceptical tabloid press helped scare former Prime Minister Tony Blair out of his initial intention to lead Britain into the euro. The 2003 Iraq war drained the political capital he would have needed to win public support.

But now that Britain faces the deepest recession of any major economy next year, arguments for keeping the pound have become harder to defend.

“The crisis has taken the hubris out of the debate. It’s now possible to mention the euro again in British politics without getting a complete ‘No’,” said Lord Wallace of Saltire, European affairs spokesman of the pro-EU Liberal Democrats.