AMERICAN FUTURE

The Telegraph reports on the British Treasury’s “contingency plans” in case the euro disintegrates:

The preparations are being made only for a worst-case scenario and would run alongside similar limited capital controls across Europe, imposed to reduce the economic fall-out of a break-up and to ease the transition to new currencies.

Officials fear that if one member state left the euro, investors in both that country and other vulnerable eurozone nations would transfer their funds to safe havens abroad. Capital flight from weak euro nations to countries such as the UK would drive up sterling, dealing a devastating blow to the Government’s plans to rebalance the economy towards exports.

Britain’s top four banks have about £170bn of exposure to the troubled periphery of Greece, Ireland, Italy, Portugal and Spain through loans to companies, households, rival banks and holdings of sovereign debt. For Barclays and Royal Bank of Scotland, the loans equate to more than their entire equity capital buffer.

The plans include more than just capital controls:

Borders are expected to be closed and the Foreign Office is preparing to evacuate thousands of British expatriates and holidaymakers from stricken countries.

The Ministry of Defence has been consulted about organising a mass evacuation if Britons are trapped in countries which close their borders, prevent bank withdrawals and ground flights.

In the aftermath of the 2008 financial collapse, not a single American banker has been charged with a criminal or civil crime; if memory serves me correctly, there aren’t even any active investigations into whether charges should be brought.

Considering the consequences of the collapse for millions of mostly innocent Americans, this seems outrageous.

Earlier this week, the U.K.’s Financial Services Authority (the equivalent of our SEC) issued a report on “The failure of the Royal Bank of Scotland.” The Chairman’s Forward to the report deals with the following questions:

• If RBS management errors led to failure, why has no-one been punished?
• Why has the FSA not taken enforcement action?
• Should the rules be changed for the future?
• Why were regulation and the supervisory approach deficient?
• Have changes been sufficiently radical?

While the circumstances surrounding the collapse of RBS (the closest analogy might be Bank of America’s takeover of Countrywide Financial) and the regulatory authority of the FSA aren’t identical to those of the failed American financial institutions and the mandate of the SEC, I think  the answers to these five questions shed some light on the situation in the U.S.

Continue reading ‘Why Haven’t the Bankers Been Punished?’ »

Round 2 of Reactions to the EU Summit (and some other stuff)

The consensus:

The title of the FT’s editorial — “Europe fails to reach summit” — says it all:

It should have been the climax to Europe’s thriller, a summit that would kill off the sovereign debt crisis with a salvo of confidence-restoring measures. But, apart from Britain’sdramatic exit, last week’s European summit was entirely predictable in its inconclusiveness.

To be fair, it is good news that even modest steps were taken towards closer fiscal integration. But the real, comprehensive fiscal union needed to restore faith in the euro, as opposed to a few new rules, remains elusive.

More urgently, the deal that was struck does nothing to resolve the immediate crisis. Moves to bolster the International Monetary Fund and hints of more support next year for Europe’s two bail-out vehicles are neither big enough nor fast enough to deal with the titanic task of funding peripheral countries’ debt until confidence returns.

Hopes in the existence of a big bazooka proved misplaced. Mario Draghi, European Central Bank president, on Thursday quashed hopes that he would launch an unlimited bond-buying programme to help indebted sovereigns, as European rules do not allow this.

Now there is the suggestion that the ECB has a cunning plan to give the bazooka to Europe’s banks, which will be lent bags of cheap money, with which to buy their own countries’ debt.

The argument is tempting. Friday’s summit declared that there will be no more haircuts on sovereign debt. So if banks can get three-year ECB money at 1 per cent and buy Italian bonds at 6 per cent, this could help cut debt costs while bringing seemingly risk-free returns. This is not contrary to European rules and it could be in both parties’ interests. If the sovereigns go, Europe’s banks are front line victims.

However, there are many reasons to be wary of such a solution, not least because it fools no one. The ECB would in effect be funding sovereign debt through Europe’s banks. This is hardly in the spirit of the European treaty. Second, shareholders might rightly question why banks, which have been shedding periphery bonds despite having had the arbitrage opportunity for some time now, were suddenly scooping them up. Most importantly, if the current crisis was sparked by the link between sovereign and bank risk, does it make sense to intensify that link? Right now there may be no alternative to save the euro. But it amounts to little more than sleight of hand in a crisis where clarity and resolve would do much more to restore confidence.

Unsurprisingly, the FT’s Wolfgang Munchau agrees:

. . . the decision to set up a fiscal union outside the European treaties will do nothing whatsoever to resolve the eurozone crisis . . . this is not something you would wish to do outside European treaties. The existing treaties form the legal basis for all policy co-ordination of monetary union. It gets very messy when you try to circumvent them.

[...] A fiscal union set up outside the European treaty would face severe legal and practical limitations. Unless a trick is found, it cannot make recourse to the resources and institutions of the EU. Nor can it issue eurozone bonds. The only conceivable counterparty for a eurozone bond is the EU itself.

More important even, a fiscal union created through a legal trapdoor would not help solve the crisis. The eurozone is facing a generalised loss of confidence. Investors no longer trust its crisis management, the solidarity of its citizens, even the ability to conduct sensible economic policies. The EU is not going to restore confidence through legal gimmickry that will face numerous court challenges.

Leaders should have admitted on Friday that the summit had simply failed, or perhaps have given it a few more days. Negotiations might have produced a compromise. With the fake pretence of another treaty, that is no longer possible.

Remember what everybody said a week ago? To solve the crisis, the eurozone requires, in the long run, a fiscal union with a prospect of a eurozone bond and, in the short run, unlimited sovereign bond market support by the European Central Bank. What we now have is no treaty change, no eurozone bond and no increase either in the rescue fund or in ECB support.

Policy changes the ECB announced last week will help banks directly and governments indirectly. But the EU fell short on every element of a comprehensive deal. On Friday, investors reacted positively to what was sold to them as a “fiscal compact”. But once the implications of a separate treaty are understood, I fear disillusionment will set in.

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The rating agencies are equally unimpressed.

In its Weekly Credit Outlook, Moody’s says that “Pressure Remains on Euro Area Sovereigns in Absence of Decisive Initiatives” and “European Bank Recapitalization Plan Is Credit Positive, but Encourages Deleveraging”:

Pressure Remains . . .

. . . the [EU summit] communiqué reflects the continuing tension between euro area leaders’ recognition of the need to increase support for fiscally weaker countries and the significant opposition within stronger countries to doing so. Amid the increasing pressure on euro area authorities to act quickly to restore credit market confidence, the constraints they face are also rising. The longer that remains the case, the greater the risk of adverse economic conditions that would add to the already sizeable challenges facing the authorities’ coordination and debt reduction efforts.

As a result, the communiqué does not change our view that the crisis is in a critical, and volatile, stage, with sovereign and bank debt markets prone to acute dislocation which policymakers will find increasingly hard to contain. While our central scenario remains that the euro area will be preserved without further widespread defaults, shocks likely to materialise even under this ‘positive’ scenario carry negative credit and rating implications in the coming months. And the longer the incremental approach to policy persists, the greater the likelihood of more severe scenarios, including those involving multiple defaults by euro area countries and those additionally involving exits from the euro area.The credit implications of these and further measures likely to be announced in coming weeks require careful consideration against the backdrop of decelerating regional economic activity, fragile banking systems, partly dysfunctional credit markets, and the varying degree of success of country-specific measures aimed at structural change and fiscal consolidation. But in the absence of credit market conditions stabilising, the system remains prone to further shocks which would likely lead to selective rating changes. More broadly, in the absence of any decisive policy initiatives that stabilise credit market conditions effectively, our intention as announced in November is to revisit the level and dispersion of ratings during the first quarter of 2012.

European Bank Recapitalization . . .

Additional capital is credit positive as it enables banks to cope with increased stress. However, there is a risk that tighter capital requirements will encourage further deleveraging, thereby increasing the risk of a credit crunch and additional impairments.

The establishment of a sovereign exposure buffer follows criticism that the EBA’s stress test earlier this year inadequately reflected the true value of, and impairments in, banks’ sovereign exposures. Disclosures in banks’ interim statements also point to inadequate evaluation and provisioning and, in some cases, a failure to comply with international accounting standards.

[...] Supervisors are not simply seeking to achieve higher capital ratios, but also higher capital. Nevertheless, the incentive for banks to deleverage remains high and will only be exacerbated by higher capital requirements. More fundamentally, higher capital buffers cannot address the underlying cause of the disruption to the funding markets which is the sovereign debt crisis.

Fitch says that the “Summit Does Little To Ease Pressure on Eurozone Sovereign Debt”:

After the latest EU crisis meeting it is clear that politicians are responding to the eurozone sovereign debt crisis through incremental improvements. It seems that a “comprehensive solution” to the current crisis is not on offer.

This Summit demonstrated strong political support for the euro, and that its members are putting in place the institutional and policy framework for a more viable eurozone and ultimately greater fiscal union. But taking the gradualist approach imposes additional economic and financial costs compared with an immediate comprehensive solution. It means the crisis will continue at varying levels of intensity throughout 2012 and probably beyond, until the region is able to sustain broad economic recovery.

In the short term we predict a significant economic downturn across the region. The eurozone faces intense market pressure, which is triggering loss of business and consumer confidence, and weak industrial activity and retail sales. Our forecast of 0.4% eurozone GDP growth next year and 1.2% in 2013 would be significantly higher if there was a comprehensive solution to the crisis. The lack of a comprehensive solution has increased short-term pressure on eurozone sovereign credit profiles and ratings.

The latest EU Summit, like others before it, has resulted in some positive developments. There is an extra EUR200bn of funding for the IMF, the ESM has been brought forward, and there has been policy change on private-sector involvement in any future sovereign crisis. As with all Summits there is execution risk.

The extra resources for the IMF are welcome but it is not clear how and under what circumstances they would be deployed. The move away from requiring private-sector involvement (PSI) as a condition for ESM programmes is clearly positive for bondholders. The European Commission said it will “strictly adhere to the well established IMF principles and practices.” PSI has been a feature of past IMF programmes, but the Fund sets out to attract private capital to sovereigns and can be expected to use PSI as a last rather than a first resort.

Separately, the ECB also announced changes to its repo schemes that will aid bank liquidity, such as three-year liquidity lines and looser collateral requirements for structured finance. This could be positive for eurozone sovereigns if it eases pressure on them to introduce or re-activate bank debt guarantee schemes.

The Summit’s conclusions show a longer-term desire to move towards some form of fiscal integration in return for enforced fiscal prudence. We believe that most of the vulnerable eurozone countries are already implementing aggressive austerity programmes, and some are already changing their national constitutions. It is too early to judge how effective the fiscal compact will be due to the uncertainty regarding how it will be implemented.

We still believe the ECB, either directly through its sovereign bond purchase programme or indirectly by allowing the EFSF/ESM to access its balance sheet, is the only truly credible “firewall” against liquidity and even solvency crises in Europe.

Hopes that the ECB would step up its actions in support of its sovereign shareholders as a quid pro quo for institutional and legal changes that gave the ECB greater confidence in the long-run commitment of eurozone governments to fiscal discipline appear to have been misplaced.

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Lurking in the background, according to the Wall Street Journal, is an old nemesis: credit default swaps, which have been used in copious quantities by European banks:

Dozens of banks across Europe have sold large quantities of insurance to other banks and investors that protects against the risk of ailing countries defaulting on their debts, the latest illustration of the extensive financial entanglements among the continent’s banks and governments.

New data released last week by European banking regulators suggest the risks of banks suffering losses tied to European government bonds could be higher and more widespread than previously realized.

The numbers show European banks have sold a total of €178 billion ($238 billion) worth of insurance policies, in the form of financial derivatives known as credit-default swaps, on bonds issued by the financially struggling Greek, Irish, Italian, Portuguese and Spanish governments. If those bonds default, as some investors fear they might, banks could be on the hook for making large payments to the holders of the swaps.

The banks have at least partly insulated themselves from such potential losses by buying large quantities—roughly €169 billion worth—of credit-default swaps tied to the same bonds, apparently in large part from other European banks, according to European Banking Authority data.

Some analysts and investors say they had assumed that sovereign credit-default swaps, known as CDS, were primarily sold by giant global investment banks in the U.K., France and Germany, as well as in the U.S. Those banks sell the swaps to big corporate clients and other banks and institutions.

But the new EBA data show a surprising breadth of large and small European banks—at least 38 of them—have sold instruments that protect against potential losses on Greek, Irish, Italian, Portuguese and Spanish government bonds.

Of the total protection that European banks have written on government bonds in Europe’s five most-stressed countries, nearly one-third originated from German banks.

The diverse array of banks in the sovereign CDS market means that risks can spread more quickly through the financial system. It also means it is harder to predict how losses would ricochet among institutions and countries, analysts say.

The banks and some analysts argue that the industry’s actual exposure is far less than the €178 billion of swaps they have sold because the banks have purchased €169 billion in similar protection from other sources, which can offset the exposure. Many of Deutsche Bank’s purchases and sales of CDSs, for example, are with the same counterparties, with whom the German bank has legally enforceable netting agreements in place.

But some experts say it is risky to assume that all banks’ CDS transactions neatly cancel each other out.

“Netting is all very well provided that you trust your counterparty,” said Jon Peace, a Nomura Securities banking analyst. But in a crisis situation, “what you thought was net could tend toward your gross exposures” because certain sellers of the default insurance could themselves go bust.

For example, two of Italy’s biggest banks, UniCredit SpA and Banca Monte dei Paschi di Siena SpA, have sold a total of about €5.3 billion of protection against the risk of an Italian sovereign default, according to the new EBA data. The problem is that, in a default scenario, both banks likely would be in trouble themselves due to their huge holdings of Italian government bonds and the fact that their businesses are largely concentrated in Italy.

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While the Organisation for Economic Co-operation and Development (OECD) hasn’t issued a statement setting forth its view of the results of the EU summit, the Financial Times reports that it “will warn in its latest borrowing outlook, due to be published this month, that financial stresses are likely to continue with the “animal spirits” of the markets – their unpredictable nature – a threat to the stability of many governments that need to refinance debt.”

For the foreseeable future it will be a “great challenge” for a wide range of OECD countries to raise large volumes in the private markets, with so-called rollover risk a big problem for the stability of many governments and economies.

Rollover risk is the threat of a country not being able to refinance or rollover its debt, forcing it either to turn to the European Central Bank in the case of eurozone countries or to seek emergency bail-outs, which happened to Greece, Ireland and Portugal. The OECD says the gross borrowing needs of OECD governments is expected to reach $10.4tr in 2011 and will increase to $10.5tr next year – a $1tr increase on 2007 and almost twice as much as in 2005. This highlights the risks for even the most advanced economies that in many cases, such as Italy and Spain, are close to being shut out of the private markets.

While borrowing was higher in 2009 and 2010, the risks are greater than ever because of rising borrowing costs in turbulent, unpredictable markets.

The OECD says that the share of short-term debt issuance in the OECD area remains at 44 per cent, much higher than before the global financial crisis in 2007. This, according to some investors, is a problem as it means governments have to refinance, sometimes as often as every month, rather than being able to lock in more debt for the longer term that helps stabilise public finances.

The OECD also warns that a big problem is the loss of the so-called risk-free status of many sovereigns, such as Italy and Spain, and possibly even France and Austria. The latter two have triple A credit ratings but investors no longer consider them risk-free.

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Contagion from the eurozone crisis appears to be spreading to emerging markets: Indian industrial production dropped by 5.1 percent in October. From the Financial Times:

“The data are way worse than we were expecting,” said A Prasanna, economist at ICICI securities in Mumbai. “Usually output is lower during the months of October and November as there are fewer working days due to the festival season but a 5.1 per cent drop is significantly more than we predicted,” he added.

Manufacturing output, which represents about 76 per cent of industrial production, dropped 6 per cent in October, compared with a year ago and capital goods production, which is considered to be a key barometer of investment sentiment in the country, fell 25.5 per cent. Meanwhile, mining production was down 7.2 per cent, as a series of scandals in the sector and continued uncertainty over the outcome of a long-awaited mining bill hurt the industry.

Reactions to the Results of the EU Summit Meeting

This is an extremely long post with complete articles from the Financial Times, the Economist, the Guardian, Spiegel Online, and the Centre for European Reform (a British think tank). So as to avoid inserting my own slant on the outcome of the summit meeting, I decided not to post shortened, edited versions.

The articles are below the fold.

Continue reading ‘Opinions and News on the Eurozone Crisis, No. 46’ »

The British prime minister defends his position in a video interview with the Telegraph:

From the BBC at 00:45 EST

Attempts to get all 27 EU states to agree changes to the bloc’s treaties to tackle the eurozone crisis have failed.

Speaking after long talks in Brussels, French President Nicolas Sarkozy said the 17 eurozone states and others would work on a separate pact instead.

France and Germany are pushing for tough new budgetary rules to be enshrined in the accord.

But UK Prime Minister David Cameron said an EU-wide deal “isn’t in Britain’s interests”.

After nearly 10 hours of talks between EU leaders, Mr Sarkozy said he would have preferred a new treaty involving all 27 member states.

But he said Mr Cameron had proposed a protocol to be written in the deal allowing London to opt-out on proposed change on financial services.

“We could not accept this,” Mr Sarkozy said.

Mr Sarkozy added that Hungary also decided to remain outside the proposed treaty, while the Czech Republic and Sweden wanted first to consult with their parliaments.

“All the others have wished to join the inter-governmental treaty,” the French leader said.

He denied suggestions that the new treaty would lead to a two-speed EU.

Speaking at a news conference shortly afterwards, Mr Cameron said he had made “a tough decision, but the right one”.

“What’s on offer isn’t in Britain’s interests,” he said, adding that he would not put the proposed deal before British parliament as it was an accord outside EU structures.

In 1914, an economically healthy Europe was divided into armed camps. In the 1930s, an economically destitute Europe was divided into armed camps. Now, an economically unhealthy Europe is again divided into camps. This time, a military confrontation is thankfully not in the cards, but the handwriting is on the wall for economic and financial warfare. Every time Europeans leaders get together, hope soon gives way to despair. The lesson is that no matter how bad things are, they find a way to make things worse. Who would have thought that this time it would be the Brits who, fearful that agreements brokered by the Germans and French would weaken The City (London’s Wall Street), would escalate the crisis to a new and more dangerous level?

From Reuters at 10:08 EST:

The European Union failed to secure backing from all 27 countries to change the EU treaty at a summit Friday, meaning any deal will now likely involve the 17 euro zone countries plus any others that want to join, three EU diplomats said.

An agreement at 27 fell through after British Prime Minister David Cameron demanded concessions that Germany and France were not willing to give, one of the officials said.

During nearly 10 hours of talks that lasted into the night, EU leaders did manage to reach agreement on a ceiling for the size of the euro zone’s permanent bailout fund, the ESM, saying it would be capped at 500 billion euros.

That figure will be reviewed in July next year, when the ESM is due to come into force, the diplomats said.

The leaders also agreed to explore the idea of providing bilateral loans to the International Monetary Fund totalling 200 billion euros, with 150 billion of that coming from the euro zone , to bolster IMF resources to tackle Europe’s debt crisis.

If market participants ignore this development, I’ll be forced to conclude that they’ve taken leave of their senses.

[An earlier report providing background from The Guardian]

I’ve almost completely ignored the goings-on in Britain, which — fortunately for its people — isn’t part of the eurozone. On Tuesday, the Chancellor of the Exchequer will deliver his budget message to Parliament. This opinion piece by Michael Portillo, a former Conservative Party cabinet minister, does a good job of setting the stage:

Britain is not Italy, Greece or Spain. George Osborne will want us to cling to that thought when on Tuesday the chancellor of the exchequer gives parliament his assessment of the economy. Whereas those countries are paying about 7 per cent for new debt, the UK borrows at about 2 per cent. While some of our continental neighbours contemplate economic ruin, we have no difficulty in funding our deficit.

The chancellor claims that this happy position owes everything to the government’s commitment to reduce the structural deficit. There is evidence to support him. When the 2010 general election produced a hung parliament, senior civil servants pleaded with the party leaders to form a government quickly, for fear that Britain would be unable to sell its gilts and would lose its triple A credit rating.

The argument convinced Nick Clegg, who within a few hours accepted that the Conservatives had been right to argue for reducing our borrowings faster. He committed himself to the coalition and an austerity programme. The government’s determination impressed the markets. Gilts have sold smoothly, our credit rating is intact and sterling has been steady.

For the Labour party, Ed Balls argues that cutting public spending and raising tax depress growth. Well, of course they do. But, as the coalition would retort, without such severe measures, the markets would rank us alongside the Mediterranean countries and like them we would be contemplating the abyss.

However, the government hardly feels comfortable with our economic progress. Spending cuts and tax rises were designed to calm the market and to shrink the state, leaving light and air for the private sector. Mr Osborne always knew that in themselves those measures were insufficient to tackle the deficit. For that we needed growth.

If this were a standard post-war recession, the economy would by now be racing to recover lost ground. We could expect several years of growth above trend. The unemployed would return to jobs, pay would boom, and the Treasury’s coffers would swell with tax receipts. But this depression is shaped like that of the 1930s, when for most of the decade growth was below trend.

So, the government is realising that throughout the parliament gross domestic product may remain flat. Over these five years many will lose their jobs. Pensions will be cut. Benefits and pay settlements will fall behind prices. The nation will endure all that, and at the end, the deficit will still tower over the economy. It’s not a cheerful prospect for the Conservatives and Liberal Democrats, whether seeking re-election together or separately.

They have two hopes. First, the country seems to have decided that Ed Miliband is not prime ministerial, and from the evidence of Neil Kinnock, William Hague and Michael Howard, leaders of the opposition find the electorate’s opinion, once formed, hard to alter. Second, the coalition leaders may hope that, like Margaret Thatcher, they will be credited with having done the difficult but right thing, and be re-elected despite their unpopularity. They can take inspiration from Meryl Streep’s performance in The Iron Lady, which certainly reminded me of what true grit looks like.

Paradoxically, the low rate of interest that Britain pays on its sovereign debt throws up a political problem for the government. For not everyone agrees that it results from the coalition’s impressive austerity. It is pointed out that the US, without a convincing deficit reduction programme, can also borrow cheaply. Conversely, a state strongly committed to tough measures – Spain – is paying 7 per cent. The key may be that money is readily on offer to a sovereign state that has its own currency. The exchange rate will adjust to economic reality, allowing a country to trade out of its difficulties, even if its deficit is large. In which case, why shouldn’t Britain indulge in a little fiscal stimulus?

Mr Osborne has to weigh up whether our felicitous standing in the markets is a prize won at enormous cost that it would be folly to sacrifice, or whether lenders are pleading with him to borrow more and stoke recovery.

The signs are that he will not waver. Ministers may be nervous, but the government looks steady. It was impressive that during the Liberal Democrat conference, despite pressure from the membership to put distance between the two parties, Mr Clegg and Danny Alexander, the chief secretary, maintained a robust defence of the austerity package.

It must cross ministers’ minds that the grim prospect of five years without growth should now be regarded as the most optimistic scenario. It takes no account of what may happen if the euro falls apart in disorder. So it may seem logical that the government’s policy is to wish the single currency well and urge the eurozone to use all measures to save it, such as requiring the European Central Bank to act as lender of last resort and accelerating moves towards fiscal union. But now that it is clear that countries such as Spain are paying crippling interest rates precisely because they are shackled to the euro, it is at best perverse to will the currency to survive, and at worst immoral, given the impact on unemployment and other human miseries. Moreover, how exactly a continental fiscal union dominated by Germany could be in Britain’s foreign policy interests eludes me.

If we weather these prolonged economic doldrums, Britain will find itself at the start of a process. The recession affecting the west – but not the east – surely indicates that the old industrialised world now fails to compete with the new. China’s sovereign wealth fund told the Group of 20 summit that it was disinclined to invest in Europe because welfare systems are out of kilter, encouraging indolence and sloth.

Britain will have to reduce welfare and public sector employment dramatically. The state will need to step back from education and health where it simply doesn’t do a good enough job. Such changes may be too draconian for a coalition, yet the public may find them too radical to accept from a single-party government. The only question, however, is whether we will tackle those big issues soon, or merely ensure prolonged stagnation by postponing the inevitable.

The Economist says that the growing troubles in the euro zone mean Britain is set for another recession:

PREPARE for some bad news. The prime minister, David Cameron, told an audience of business leaders on November 21st that shrinking the budget deficit was “proving harder than anyone envisaged.” His comments laid the ground for the chancellor, George Osborne, who makes his autumn statement on the economy and public finances on November 29th. The chancellor’s message is likely to be grim: a downgrade to official growth forecasts for next year and beyond seems certain. The coalition government’s hopes of eliminating the “structural” part of the deficit (the bit that cannot be blamed on temporary slack in the economy) and of capping public debt by the end of the current parliament are in serious doubt.

Bond markets are likely to be forgiving, given the scale of troubles elsewhere. But a failure to hit its fiscal targets would harm the coalition government’s credibility. And there is a more pressing worry. Britain’s strong links with the wretched euro zone mean that its economy is being dragged into continent-wide recession. Some Conservative politicians seem to believe that Britain stands apart from the euro disaster because it has its own currency. In fact, the economy is increasingly dependent on exports, two-fifths of which are shipped to the euro zone. There is little spending power at home: consumers are still carrying a lot of debt while struggling with weak wage growth and high inflation; public spending is shrinking; and business investment has been sluggish.

Worse still, Britain’s banks have lent heavily to the euro area’s biggest trouble spots. Loans extended by British banks to Ireland, Spain, Italy, Portugal and Greece stood at $350 billion (£220 billion) at the end of June, equivalent to 15% of GDP. Most of this was direct lending to businesses and banks but about 10% was to governments. They are indirectly exposed, too: a further $210 billion of banks’ assets in June were loans to French and German banks, who are in turn lenders to Italy and Spain.

Growing anxiety about public finances in Europe has sapped confidence in banks which are big holders of government bonds. And the rush by European banks to sell bonds of the least creditworthy sovereigns has made things worse. European banks are finding it harder to refinance their own debts at reasonable interest rates, and funding costs are rising for British banks too. That will eventually feed through to higher interest rates on loans to companies and consumers. Banks nervous about euro-zone assets turning sour and keen to preserve scarce capital will be cautious about making new loans, which will only add to the recessionary forces.

Businesses will soon be caught up in this spiral of ever-diminishing confidence. Firms know that credit lines cannot be relied upon when banks and financial markets shun all but the safest investments. There are already reports that firms are postponing purchases and trimming their stocks of supplies to conserve cash. Cuts to discretionary spending, such as capital projects or advertising, will become more common as the euro crisis intensifies and uncertainty and anxiety increase.

How far might the economy fall? The central case of the Bank of England’s monetary-policy committee is that output will be broadly flat in the current quarter and in the first half of 2012, though it thinks a worse outcome is more likely than a better one. Its forecast excludes the possibility of a big euro-zone blow-up, not because this is improbable but because there is “no meaningful way” to calculate its impact. Fear that the euro zone will disintegrate will itself weigh on the economy.

Absent a complete meltdown, the second dip of a “double-dip” recession ought to be smaller than the first, because there are fewer excesses to correct. Britain’s current-account deficit is closer to balance. The household savings rate is a healthy 7.2%, which means consumers have a bigger cushion between their income and spending than they did when recession first struck in 2008. There is less capital spending to cut back on: companies are already sitting on piles of cash. And the flow of capital seeking a haven from the euro crisis will sustain demand for British government bonds, for fancy houses, and for other assets deemed to be safer than euro-zone banks or bonds. Real household income is likely to rise modestly in 2012 after falling sharply this year because of high inflation and tax increases, notes Kevin Daly of Goldman Sachs.

Yet the likely recession will strain public finances. Figures for the first seven months of the financial year suggest that the government is roughly on track to meet its borrowing target of £122 billion (around 8% of GDP) for 2011-12. Yet the number of people claiming unemployment benefit has risen each month since March. Many economists believe the Office for Budget Responsibility, the independent fiscal watchdog, will take a dimmer view of the economy’s medium-term prospects. That would imply less of the budget deficit will be eroded as the economy expands to its full potential, and that more of it is therefore structural.

This leaves Mr Osborne in an uncomfortable position as he prepares his autumn statement. He has made it clear that he does not regard it as a “fiscal event” where spending and tax changes are announced; that will be saved for the budget in March. But it is a political set-piece all the same. So the chancellor will try to knit together a variety of small, fairly cheap policy strands, such as measures to help small businesses with credit, into a coherent growth strategy. Given the unfolding catastrophe on Britain’s doorstep, it is likely to look threadbare.

An editorial on the state of the U.K. economy from the Financial Times:

It is now clear that curbing Britain’s public debt is going to be much harder than the coalition government originally predicted. While David Cameron admitted as much earlier this week, official confirmation will come next week with the publication of the Office of Budget Responsibility’s report on the state of the UK’s public finances. While disappointing, this does not undermine what still appears to be a sensible plan.

The problem for the government is that weaker actual and potential growth has made the task of reining in the deficit much harder than forecast. Chancellor George Osborne’s hopes of eliminating the current structural deficit by 2014-5 now look impossible. Meeting this target in the fallback year of 2015-6 also looks improbable. Most likely, the target will be reached only in 2016-7.

The Labour opposition will argue that these delays undermine Mr Osborne’s strategy. Yet it is worth remembering that the government’s plans for fiscal consolidation have allowed Britain to regain the confidence of investors at a time when all too many countries have forfeited it. That 10-year gilts fell earlier this month to the lowest level since they were introduced in the 1950s is powerful ammunition for the plans.

Considering the chaotic state of fiscal planning in the eurozone and the US, Britain’s status as a safe haven is unlikely to be put at risk by the OBR’s latest figures. Therefore, the chancellor has no need to press the panic button. Yet he should refrain from making any more immediate cuts. His concern should be to stick to the spending path he has staked out. Since the global outlook is so uncertain, there is a strong economic case for staying put.

That said, the chancellor may want to consider a range of small adjustments within the framework of his overall plan. To foster growth, it may make sense to front-load some capital spending planned for 2013-4. The government should also consider cutting current spending and investing more, although that may prove to be politically difficult.

There is only so much that the government can do about the biggest drag on growth – the slowdown in the eurozone. But at home, the challenge is to restore business confidence, particularly among smaller firms. The lack of access to credit and excessive regulation is holding back corporate investment. The government should push harder on the banks to lend, ease planning laws where possible, and stay the course.

An editorial from the Telegraph:

The pressure is therefore on George Osborne to come up with measures that will promote growth – and rightly so. We understand that the Chancellor will probably freeze fuel duty, abandoning the increases that were planned for January and August 2012, and that he will allow rail companies to increase their fares by a maximum of six rather than eight per cent. Those measures will certainly be of help to the “squeezed middle” – but no one is pretending that they are more than a sticking-plaster solution.

Is there scope for the Chancellor to do more? Our poll today indicates that many wish he would. At the same time, the public’s great fear is that the squeeze on disposable income will increase. One of the fastest ways for the Government to jack up inflation would be to abandon its strategy for reducing the deficit, and cover the gap between expenditure and revenue by printing money. Heeding the calls of the deficit deniers, and increasing spending, would shake the confidence of the bond markets, provoking a significant increase in interest rates that would choke off whatever chance there is of recovery.

The Chancellor’s options are, therefore, extremely limited. Set against that background, we are surprised by the idea that Chris Huhne is set to announce that around £1 billion will be devoted to helping African nations deal with the effects of climate change over the next four years. While we appreciate the need to help the world’s poorest people, and admire the moral zeal behind the Coalition’s commitment to international development, it is not easy to endorse spending taxpayers’ money in this way at this of all times. There are, after all, more than a million young Britons without jobs, and it appears that the economic situation will only deteriorate. The politics of this gesture are also difficult to understand. Hard-working families naturally, and rightly, believe that their Government’s first duty is to protect their interests. While it is true that, ultimately, we all live on the same planet, few taxpayers expect, or want, their Government to spend their money on a project whose effects are very uncertain – save that they will not, in the short term, benefit anyone in Britain.

We also understand that the Chancellor will announce that companies employing fewer than 50 people will be exempted from automatically enrolling their workers in a pension scheme. This measure may encourage growth: many small businesses had complained that they will not be able to afford to contribute to their employees’ new pensions. But it will come at a very significant cost. Automatic enrolment was the Government’s response to a looming disaster: the fact that 14 million people in Britain are not saving for any form of pension. The Government appears now to have given up on a large part of its strategy to diminish the scale of that disaster. The benefits from automatic enrolment would not be felt for 15 or 20 years: perhaps that is why the Government thinks the scheme can be put on the back burner. But it does mean that the problems of pensioner poverty are going to be far harder to tackle a few years down the line.

In a way, this episode is a microcosm of many of the problems that the Government faces: it must do as much as possible to promote growth in the short term, while minimising any damage to the country’s prospects in the more distant future. Yet if it can make such a tough decision on pensions, why not make an equally hard-headed choice over aid spending, or carbon tariffs? Such proposals aside, the Chancellor’s freedom of manoeuvre is ferociously constrained – and the crisis in the eurozone beyond his capacity to resolve. The economy has been grievously injured, and from what we have seen, the Autumn Statement will do as much as is within Mr Osborne’s power to bandage the wounds. But these days, miracle cures are in short supply.

An editorial from the Guardian:

Whatever else George Osborne announces in his autumn statement on Tuesday, one thing is clear: plan A has been binned. The chancellor began the year claiming “there is no plan B”, but that is exactly what ministers are now scrambling for as the economic outlook gets ever worse. So what voters can expect next week is a tacit admission that plan A hasn’t worked, as forecast after forecast is pushed down yet again, followed by a raft of fresh proposals. The big question is whether Mr Osborne has faced up to economic reality, and whether his new measures go far enough to help stave off a second recession. The portents are gloomy.

Strip out the numbers and plan A boils down to a simple precept: the government embarks on a historic programme of public spending cuts on the premise that private spending fills the gap and powers Britain to a sustained recovery. This was not only the coalition’s belief: for the past year, the independent Office for Budget Responsibility has been counting on a private investment boom, Britain exporting more than ever before and for private-sector jobs offsetting the loss of jobs in the public sector.

Put bluntly, it hasn’t happened. To take one example: 111,000 jobs were shed by the public sector in the three months to June; only 41,000 were created in the private sector. The chancellor wants to blame this on the euro’s crisis, but the slowdown predates that as these figures for spring indicate. What ministers have learned the hard way is what many warned long ago: that if you suck public spending out of a recession-hit economy where the state is a major driver of activity, a massive slump will result.

Which is why policy-makers have spent the past few months in a panic, fumbling around for new levers to pull. In his party conference speech, the chancellor promised something called “credit easing”, to extend loans to smaller firms. This could prove important, but it all depends on the details which officials have been scrambling to sort out ever since the sudden announcement. In October, the Bank of England announced another £75bn of quantitative easing – money injected into the markets. And in the past few days all sorts of kites have been flown: underwriting of mortgages, apprenticeship schemes and the leak of a plan to bring forward spending on infrastructure, even while cutting day-to-day outgoings (a trick few government departments manage).

Many proposals carry the distinct burnt-rubber smell of the U-turn. The new quantitative easing was welcomed by the same Mr Osborne who had only two years ago described it as “the last resort of desperate governments when all other policies have failed”. Credit easing marks a recognition that February’s Project Merlin agreement has failed to get the banks lending enough. And yesterday’s strategy to help the million young jobless looks like a cut-price version of the Future Jobs Fund introduced by Gordon Brown – and scrapped by David Cameron. The impression is of an administration that has put nearly all of its policy chips on the wrong number – and is now scattering the remainder all over the roulette wheel.

Next week the various strands will be tied up into a growth strategy. It may have a magic ingredient missing from either the growth review of last November or the growth plan from this March – but one wouldn’t bet too many drachmas on that. Some measures do sound interesting, but few will be help much right now. The best, credit easing, will take a long time to introduce without the aid of Mervyn King – which doesn’t look to be forthcoming. Inveigling pension funds into investing in infrastructure and pumping-up the housing market both look like lengthy processes. The chancellor will need more than this in his autumn statement. If he doesn’t provide it, the only numbers to cut through on Tuesday will be the yet-lower forecasts from the OBR, outlining just what a bleak few years Britain faces.

From the Inflation Report:

• Overview – The prospects for the UK economy have worsened. Global demand slowed. And concerns about the solvency of several euro-area governments intensified, increasing strains in banking and somesovereign funding markets. Household and business confidence fell, both at home and abroad. These factors, along with the fiscal consolidation and squeeze on households’ real incomes, are likely to weigh heavily on UK growth in the near term. Thereafter, the recovery should gain traction,supported by continued monetary stimulus and a gentle recovery in real incomes. Implementation of a credible and effective policy response in the euro area would help to reduce uncertainty and so support UK growth, but its absence poses the single biggest risk to the domestic recovery.
• Money and Asset Prices – Since early August, sovereign debt concerns have intensified, the global outlook has deteriorated and investors’ risk appetite has waned. The prices of riskier assets fell sharply around the time of the August Report. Although prices subsequently recovered somewhat during October, they have continued to be sensitive to developments in the euro area. Bank funding markets have been impaired, reflecting the perceived vulnerabilities of banks to euro-area developments. Lending to businesses and households remained weak in 2011 Q3, as did annual broad money growth. In October, the MPC voted to increase the scale of its asset purchases financed by the issuance of central bank reserves to £275billion and to maintain Bank Rate at 0.5%.
• Demand – The pace of global expansion slowed and confidence fell. Concerns about the solvency of several euro-area countries intensified. Demand for UK exports weakened as global growth prospects deteriorated. The rise in uncertainty and the likelihood of tighter credit conditions, along with the fiscal consolidation and continuing squeeze on households’ real incomes, are likely to restrain spending by UK households and businesses in the near term. But the highly stimulative stance ofmonetary policy should provide some support to spending.
• Output and Supply – Output was estimated to have risen by 0.5% in Q3, but underlying growth was probably weaker. Business surveys suggest that output is likely to be broadly flat in Q4. Employment fell sharply in the public sector in Q2, and private sector employment growth appears to have weakened. Unemployment remained elevated. Business surveys suggest that the margin of spare capacity within companies widened a little in Q3.
• Costs and Prices – CPI inflation rose to 5.2% in September 2011. The elevated rate of inflation reflected increases inVAT, energy and import prices. The impact of those factors will dissipate during 2012, so inflation should fall back. Domestically generated inflation appears subdued and is likely to remain weak given the margin of slack in the economy and the outlook for demand. Companies’ profit margins appear to have recovered somewhat over the past year, but remain below their pre-recession levels. Nominal wage growth continued to be weak, although it has picked up a little this year. Indicators of inflation expectations remained mixed.
• Prospects for Inflation — The outlook for the UK economy has worsened. Global growth has slowed. And increased concerns about the solvency of some euro-area countries have been accompanied by heightened strains in bank and some sovereign funding markets, and by falls in household and business confidence. Together with continuing headwinds from fiscal consolidation and weak real income growth, these factors are likely to mean that UK growth remains subdued in the near term, before picking up further ahead. CPI inflation is likely to be around its peak at present, and should fall sharply next year as the contributions of VAT, energy and import prices decline, while a continuing margin of economic slack weighs on wages and prices. How fast and how far inflation will fall are uncertain, but, under the assumptions that BankRate moves in line with market interest rates and the stock of purchased assets remains at £275 billion, inflation is judged more likely to be below the target than above it at the forecast horizon.

Excerpts from the press conference with the BoE Governor Mervyn King:

Q: Governor, the new ECB President, Mario Draghi, said that Europe is facing a mild recession. Is the UK facing one too?

A: What’s happened since August has been very pronounced. We’ve seen a significant weakening of indicators of confidence and growth in the euro area that’s bound to affect our net trade position. Over the past year we’ve benefited from exports to the euro area; that’s not going to be true to the same extent, we would expect, over the next year.

We’ve seen that this has also caused problems in the financial sector in general. Our banking system is in a much healthier state than many of the banking systems on the Continent, but nevertheless – like all large banks - our banks are inextricably involved with developments in Europe. And if there were to be a sharp downturn in the euro area, then our banks would be affected by it. And that has meant that their funding costs have gone up. So we had hoped that by now we’d be seeing a compression of bank funding costs – the price which banks have to pay to borrow money relative to Bank Rate. That hasn’t happened; if anything it’s got worse in the last few months. So those higher credit spreads clearly will not help growth in the United Kingdom.

Q: Governor, you’ve always said that in the medium term Britain is the master of its own destiny. I make this about the 17th consecutive Inflation Report in which you’ve come here and had to say that the level of GDP is going to be lower than you previously thought it would be in the future. What does this persistent now sort of habit of coming back and telling us thisabout the economy being worse than we previously thought, tell you about both the UK economy and monetary policy?

A: I think it tells you a great deal about the severity of what’s happened in the world in the last four years. I think from autumn 2007 onwards, we’ve been in the middle of an extraordinary worldfinancial and resulting economic crisis. I think many people felt that after the downturn that was very severe between 2008 in the autumn and the spring of 2009, that we were going to come out of it; but in fact what we’ve seen is that the financial sector has not come out of it, that the interest rates which banks – our banks -can borrow, have not fallen significantly relative to Bank Rate. And that has continued to mean a squeeze on the finance available for business lending.

And we’ve seen in the last couple of years some factors which have led to a very sharp squeeze in real incomes, hence in consumption. And it’s consumption which has been the most important component of demand, which has really led to weak growth over the past year.

Q: . . . a quote from yourcounter part from France, Christian Noyer, who is obviously on the ECB Board, “We’re paying the price for our virtue and our refusal to liquefy our debt through massive monetisation of our fiscal deficits,” before referencing that Britain had bought 51% of total debt issued in 2009. I say this in the context that we’re told the Prime Minister is going to Berlin on Friday to try and coax Angela Merkel into telling the ECB – to get the ECB to do something. Areyou saying you disagree with that? You said you had sympathy with the ECB?

A: I have great sympathy for the position of the ECB, in not going around and buying all sorts of assets. The question really is one about transfers. And in order to finance the current account deficits, someone has got to finance that. The private sector has dropped out of that in the past three or four months; other euro area governments will have to do it.

Now there are various mechanisms that can be put forward. I was interested to see in the Financial Times this morning that they too have come round to the view that it’s wrong to put pressure on the ECB to do it, as such. But there may be mechanisms under which a fund, or even the ECB, could act as an agent for the governments that would take decisions and bear the risk.

But ultimately it is a question of real resources. Central banks don’t have real resources; they create money. And to the extent that governments feel that they have to take the burden of transferring real resources from one country to another in order to sustain a current account deficit for a period, that’s a decision that can be taken only by governments.

Q: Was the Prime Minister wrong to reference the ECB?

A: Well, I’ve not seen what he said, and all I would say is that I think that the people who put pressure on the ECB misunderstand the nature of the challenge that the ECB faces, which is that this is a problem for governments. Now there may be circumstances inwhich the ECB can play its role as an agent for those governments. What it can’t do is to pretend that, in its role as a central bank, that its role is to transfer resources from one countryto another. That is not part of the remit of the ECB.

Mervyn King is the Governor of the Bank of England. Earlier today, he delivered a speech that, in my estimation, is far more somber in tone than any words spoken by Fed Chairman Bernanke. Perhaps this is a reflection of the more precarious financial position of the U.K., whose economy is even more dependent on the health of the financial services sector than is ours.

Whatever the reason, Governor King’s speech is worth a close look.

“It is surely time,” he says, “to accept that the underlying problem is one of solvency not liquidity – solvency of banks and solvency of countries. The provision of additional liquidity by central banks has bought valuable time, but “that time will prove valuable only if it is used to tackle the underlying problem.”

Following the onset of the financial crisis in August, 2007, it took a year for governments in Europe and the U.S. to be persuaded that the problems of their banking sectors stemmed from massively over-leveraged balance sheets, not from a liquidity shortage. In October 2008, banks were recapitalized. However, says the Governor, the recapitalizations were inadequate, especially in continental Europe. As a result, “the underlying problems of excessive debt have not gone away,” and “markets are now posing new questions about the solvency of banks, and indeed of governments themselves.”

As have numerous others, Mr. King attributes the “unsustainable” debt build-up to “the continuing imbalance between those economies running large current account surpluses and those running large current account deficits.” He expects that the burden of debt “will go on rising” in advanced economies unless and until the imbalances have been resolved.

Due to short-term versus the long-term conundrum, he’s deeply pessimistic regarding the depth and duration of the necessary rebalancing:

When the crisis hit, the starting point was the need for a substantial rebalancing of demand and a repaymentof debt. In the deficit economies, there was an inevitable tension between the short run need to stimulatedemand to prevent rising unemployment and falling inflation, and the long run need to rebalance demandand reduce indebtedness. In January 2009, I described this as “the paradox of policy … almost any policymeasure that is desirable now appears diametrically opposite to the direction in which we need to go in thelong term”. The almost intractable challenge facing policy-makers is how to balance those short-run and long-run considerations. There is a long journey ahead before the world economy returns to a sustainable equilibrium, involving rebalancing and a reduction of debt burdens. For the time being, a significant degree of policy stimulus is appropriate to support demand. But that will delay and exacerbate the size of the adjustment ultimately required. [My emphasis]

The time that was bought through liquidity injections hasn’t been put to good use. Coordinated international action by the G20 countries is now far more difficult to come by than it was in 2008-2009, when, faced by a collapse in world trade, countries “needed no persuasion” of the necessity of policy stimulus.

But it has proved much harder to form a consensus on how to tackle the underlying problems. So, three years later, the imbalances in demand remain. Around the world, short-run stimulus packages of various kinds, and unsustainably low interest rates, have bought time. So far that time has not been used to deal with the underlying imbalances, or the weaknesses in bank and sovereign balance sheets. Four years after the financial crisis began, the foreign exchange reserve holdings of China are substantially larger than at theonset of the crisis. Markets now realise that before the crisis banks were seriously undercapitalised and so react in a volatile way to any news about the health of the banking system. And the indebtedness of governments around the world is certainly greater. Time is running out. [My emphasis]

The reason that time is running out is the “crisis of confidence in some banks and sovereigns.”

Since the summer, there have been renewed concerns aboutthe adequacy of the capital of banks in the euro area to absorb likely future losses, thus jeopardising theirability to raise funds. Wholesale funding dried up for many banks over the summer, and share prices ofEuropean banks are around 35% lower today than at the start of July. A transparent recognition of lossesand a substantial injection of additional capital are necessary to restore market confidence. On its own,however, such a policy will raise difficult political questions about the capacity of the weaker sovereigns to pay for any recapitalisation of their banks. Bank and sovereign solvency concerns are inextricably intertwined. [My emphasis]

At this point, Governor King focuses on the prospects for the U.K. economy. Here, too, he’s pessimistic:

The main impediment to the strategy of rebalancing our economy is markedly slower growth in our major export markets, especially in the rest of Europe. That is why we are treading a fine line between stimulus to demand in the short run, and a rebalancing away from private and public consumption towards exports and import substitution in the longer run. Without monetary stimulus – low interest rates and large asset purchases – there is a risk that growth will stall and inflation fall below our symmetric 2% target. But easy monetary policy, by bringing forward spending from the future to the present, means that the ultimate adjustment of borrowing and spending will be even greater. That is our dilemma, and that of other deficit countries . . . in the absence of rebalancing, globally and especially in the euro area, we could be facing a recovery that is not merely reluctant but recalcitrant. [My emphasis]