Key Issues Facing The Key Issues Facing The Global Economy:Global Economy:

Outlook for EuropeOutlook for Europe

INSTITUTE OF INTERNATIONAL FINANCE 2008 INSTITUTE OF INTERNATIONAL FINANCE 2008 Spring Membership Meeting Rio de Janeiro, Brazil Spring Membership Meeting Rio de Janeiro, Brazil

Wednesday, March 5 – Friday, March 7Wednesday, March 5 – Friday, March 7

© Willem H. Buiter 2008© Willem H. Buiter 2008

Willem H. Buiter

London School of Economics and Political Science

10/03/2008

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The Impact of the North-Atlantic The Impact of the North-Atlantic Financial Crisis in EuropeFinancial Crisis in Europe

Causes of the crisis systemic and global; Causes of the crisis systemic and global; subprime just extreme example of widespread problemsubprime just extreme example of widespread problem

Perfect storm – 4 PathologiesPerfect storm – 4 Pathologies1.1. Excessive liquidity creation by central banks post-Excessive liquidity creation by central banks post-

200020002.2. Ex-ante global saving glut from nouveaux riches Ex-ante global saving glut from nouveaux riches

(China, GCC)(China, GCC)3.3. Nouveaux riches until recently biased towards safe Nouveaux riches until recently biased towards safe

assetsassets4.4. Triumph of transactions-based financial capitalism Triumph of transactions-based financial capitalism

over relationships-based financial capitalismover relationships-based financial capitalism

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Relationships-based financial Relationships-based financial capitalismcapitalism

Uses banksUses banks– Originate and hold modelOriginate and hold model– Illiquid/nontradable assetsIlliquid/nontradable assets– Funding mainly through deposits withdrawable on demand & Funding mainly through deposits withdrawable on demand &

subject to ‘sequential service constraint’subject to ‘sequential service constraint’– Vulnerable to ‘runs’ & funding liquidity crisesVulnerable to ‘runs’ & funding liquidity crises– Requires Lender of Last Resort Requires Lender of Last Resort – Regulation is the price for LoLRRegulation is the price for LoLR– Limited scope for risk-tradingLimited scope for risk-trading– Limits flexibility & short-run adaptabilityLimits flexibility & short-run adaptability– Encourages long-termism & commitmentEncourages long-termism & commitment– Encourages originators to gather information on & monitor Encourages originators to gather information on & monitor

performance of ultimate borrowersperformance of ultimate borrowers– Encourages cronyism & barriers to entry; creates insiders and Encourages cronyism & barriers to entry; creates insiders and

outsidersoutsiders

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Transactions-based financial capitalismTransactions-based financial capitalismUses capital markets, i.e. disintermediationUses capital markets, i.e. disintermediation– Originate and distribute modelOriginate and distribute model– SecuritisationSecuritisation– Off-balance sheet vehicles (mainly to avoid regulatory constraints)Off-balance sheet vehicles (mainly to avoid regulatory constraints)

Facilitates risk tradingFacilitates risk tradingGives flexibility & short-run adaptabilityGives flexibility & short-run adaptabilityEncourages opportunistic behaviourEncourages opportunistic behaviourDiscourages long-termism & commitmentDiscourages long-termism & commitmentCreates Principal-Agent problems in gathering & disseminating Creates Principal-Agent problems in gathering & disseminating information and monitoring behaviour of ultimate borrowersinformation and monitoring behaviour of ultimate borrowersFunded mainly through wholesale capital marketsFunded mainly through wholesale capital marketsVulnerable to market illiquidity/instrument illiquidityVulnerable to market illiquidity/instrument illiquidityRequires Market Maker of Last Resort Requires Market Maker of Last Resort

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Consequences of the 4 PathologiesConsequences of the 4 PathologiesExcessively low nominal & real risk-free ratesExcessively low nominal & real risk-free ratesGlobal underpricing of risk and excessive leverage Global underpricing of risk and excessive leverage in in the financial sectorthe financial sector (& in the household sector in the US) (& in the household sector in the US)Huge financial sector bubble & over-expansion: highest Huge financial sector bubble & over-expansion: highest profits generated by financial institutions lending to each profits generated by financial institutions lending to each other & transacting among themselves rather than with other & transacting among themselves rather than with households & non-financial corporationshouseholds & non-financial corporations Ponzi financePonzi finance– within the financial sectorwithin the financial sector– between financial & housing sectors in some countries (US, UK, between financial & housing sectors in some countries (US, UK,

Spain, Ireland, certain CEE countries)Spain, Ireland, certain CEE countries)

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Every real world financial system is a mixture of Every real world financial system is a mixture of the transactions-based & relationships-based the transactions-based & relationships-based models; few achieve the right mixture of models; few achieve the right mixture of flexibility & commitmentflexibility & commitmentIn 1In 1stst decade of 21 decade of 21stst century, transactions-based century, transactions-based financial capitalism triumphant & rampantfinancial capitalism triumphant & rampantRanking i.t.o. highest relative weight given to Ranking i.t.o. highest relative weight given to transactions-based model:transactions-based model:

1.1. USAUSA2.2. UKUK3.3. Euro AreaEuro Area4.4. CEECEE5.5. BRICS & other EMsBRICS & other EMs

The same ranking applies to the severity of the The same ranking applies to the severity of the slowdown that has been/will be experienced as slowdown that has been/will be experienced as a result of the financial crisisa result of the financial crisis

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Sense & non-sense of Sense & non-sense of de-couplingde-coupling

US is 25% of world GDP & world tradeUS is 25% of world GDP & world trade

US is >>25% of global financeUS is >>25% of global financeIf there is an exogenous shock to demand in the US, the rest of the world will feel it and slow down

If there is an exogenous financial blow-out in the US, the rest of the world will feel financial fall-out and slow down

The rest of the world has to experience a financial blow-out of the same intensity as the US and will slow down to the same degree as the US

8

EU & Euro Area: slowing down but still quite robust

Source: Eurostat

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UK: slowing down but still quite robust

Source: Eurostat

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Inflation in the Euro Area is way Inflation in the Euro Area is way outside the ECB’s tolerance limitsoutside the ECB’s tolerance limits

Inflation rate (HICP) Inflation rate (HICP)

                                                                                                                

                          

Source: ECB

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Inflation in the UK is also too high Inflation in the UK is also too high for comfortfor comfort

%

Source: ONS

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•Despite the strength of the euro, intervention is extremely unlikely•Euro plays only indirect role in Euro Area rate setting

Source: ECB

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The bilateral exchange rate with the The bilateral exchange rate with the dollar is not a key economic concerndollar is not a key economic concern

US dollar-euro spot exchange rateSource: ECB

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Financial turbulence continues in Financial turbulence continues in Europe as in the USEurope as in the US

European iTraxx senior financial credit index at European iTraxx senior financial credit index at 123bp, up from 45bp at the start of the year, and 123bp, up from 45bp at the start of the year, and less than 10bp in June 2007 less than 10bp in June 2007

Rising sovereign spreads even among Euro Rising sovereign spreads even among Euro Area membersArea members

Rising spreads between sovereign debt & Rising spreads between sovereign debt & investment-grade private debtinvestment-grade private debt

Continued suspended animation of RMBS & Continued suspended animation of RMBS & other ABS marketsother ABS markets

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The key drivers of activity are The key drivers of activity are weakening but not collapsing; they are weakening but not collapsing; they are

also weakening less than in the USalso weakening less than in the US

EU stock markets have weakened, but not EU stock markets have weakened, but not as much as in the US (certainly if as much as in the US (certainly if measured in a common currency)measured in a common currency)

Consumer confidence has weakened but Consumer confidence has weakened but not as much as in the USnot as much as in the US

Credit growth of non-financial corporates Credit growth of non-financial corporates continues to be strong in the Euro Areacontinues to be strong in the Euro Area

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Long-term Euro Area sovereign interest Long-term Euro Area sovereign interest rates historically low but well above USrates historically low but well above US

10-year Euro Area sovereign bond yield

%

Source: ECB

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Key spreads between interbank rate and Key spreads between interbank rate and OIS rate are widening again somewhat, OIS rate are widening again somewhat, especially in the UKespecially in the UK

OIS (overnight indexed swap rate) - the OIS (overnight indexed swap rate) - the fixed leg of a swap whose variable leg is fixed leg of a swap whose variable leg is the compounded overnight interbank the compounded overnight interbank rate - measures the market’s rate - measures the market’s expectation of the overnight interbank expectation of the overnight interbank rate (≈official policy rate) over the rate (≈official policy rate) over the relevant horizonrelevant horizon

Is this a rising liquidity risk Is this a rising liquidity risk premium or a rising banking sector premium or a rising banking sector default risk premium?default risk premium?–Likely a bit of both (Bank of England Likely a bit of both (Bank of England

Inflation Report February 2008Inflation Report February 2008, : : increase in spread was mainly liquidity-related increase in spread was mainly liquidity-related in early phases of crisis; the smaller but still in early phases of crisis; the smaller but still large spreads today have a larger default risk large spreads today have a larger default risk component (based on CDS data – of course component (based on CDS data – of course CDS market may be affected by liquidity CDS market may be affected by liquidity crunch also…)crunch also…)

19Source: Bundesbank and Bloomberg

20Source: Bank of England and Bloomberg

Chart 1.4 of Bank of England Quarterly Bulletin, February 2008, Decomposition of twelve-month interbank spread

over future expected policy rates(a)

Sources: Bloomberg, British Bankers’ Association, Markit and Bank calculations.

(a) Estimates of credit premia are derived from credit default swaps on banks in the Libor panel. Estimates of non-credit premia are derived by residual. The method for decomposing interbank spreads is described in the box on pages 498–99 of the 2007 Bank of England Quarterly Bulletin, Vol. 47, No. 4.(b) Twelve-month Libor spread over overnight interest rate swaps.

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Key differences between ECB & BoEKey differences between ECB & BoEMandate: Mandate: – Fed triple (maximum employment, stable prices & moderate Fed triple (maximum employment, stable prices & moderate

long-term interest rates); all three notionally equal. In fact only long-term interest rates); all three notionally equal. In fact only first two count (‘dual mandate’) and of these the real economy first two count (‘dual mandate’) and of these the real economy has priorityhas priority

– EU & ECB lexicographic/hierarchical in price stabilityEU & ECB lexicographic/hierarchical in price stability

Independence: Independence: – ECB most independentECB most independent– Fed least independentFed least independent

Fed focuses mainly on core inflation (this is changing); Fed focuses mainly on core inflation (this is changing); ECB & BoE focus on medium-term headline inflationECB & BoE focus on medium-term headline inflationCloseness to financial market; Fed more responsive to Closeness to financial market; Fed more responsive to large & rapid asset price declines than ECB & BoE large & rapid asset price declines than ECB & BoE (Greenspan/Bernanke put)(Greenspan/Bernanke put)

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Key differences between ECB & BoE, Key differences between ECB & BoE, ctndctnd

Unlike Fed, ECB and BoE do not use Unlike Fed, ECB and BoE do not use monetary policy instruments (interest rate monetary policy instruments (interest rate cuts) to address either market liquidity cuts) to address either market liquidity problems or funding liquidity problems, problems or funding liquidity problems, capital adequacy & solvency problems of capital adequacy & solvency problems of banks banks Big differences between ECB & BoE on Big differences between ECB & BoE on collateral policy in OMOs & at discount collateral policy in OMOs & at discount window.window.

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Implications for policy ratesImplications for policy rates

Unlikely to see Fed-like cuts in interest Unlikely to see Fed-like cuts in interest rates in by ECB & BoE unless price rates in by ECB & BoE unless price stability requires it – as they see their stability requires it – as they see their mandatesmandates

Expect 2 cuts of 25bps each by ECB in 2Expect 2 cuts of 25bps each by ECB in 2ndnd half of 2008half of 2008

Expect 3 further cuts of 25 bps each by Expect 3 further cuts of 25 bps each by BoE in 2008, starting in MayBoE in 2008, starting in May

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Where will the pain be felt in Where will the pain be felt in Europe?Europe?

Sectors that have over-expanded:Sectors that have over-expanded:– Financial sector (especially banking and shadow-Financial sector (especially banking and shadow-

banking sector)banking sector)– Construction (residential in Spain, UK, Ireland, CEE; Construction (residential in Spain, UK, Ireland, CEE;

commercial in UK)commercial in UK)

Sectors dependent on external finance from Sectors dependent on external finance from frozen-up capital markets and de-capitalised frozen-up capital markets and de-capitalised banksbanks

Whole economy though wealth & multiplier Whole economy though wealth & multiplier effectseffects

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Mitigating factorsMitigating factors

Little physical excess capacity created during Little physical excess capacity created during boom except in financial & housing sectorsboom except in financial & housing sectorsSovereign wealth funds & other nouveaux richesSovereign wealth funds & other nouveaux richesFinancial sector in less bad shape than in USFinancial sector in less bad shape than in USMore room for manoeuvre by monetary More room for manoeuvre by monetary authorities than in US (level of rates and authorities than in US (level of rates and credibility)credibility)Germany, Spain & some of the smaller Germany, Spain & some of the smaller countries, but not UK, Italy and France, have countries, but not UK, Italy and France, have fiscal elbow roomfiscal elbow room

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Prospects for regulatory Prospects for regulatory changeschanges

Odds on single EU-wide regulator (FSA-style Odds on single EU-wide regulator (FSA-style monolith or market-segment-specific menhirs): monolith or market-segment-specific menhirs): zerozeroOdds on enhanced & intensified EU-wide Odds on enhanced & intensified EU-wide cooperation between national regulators: very cooperation between national regulators: very highhighRevision of Basle 2: Revision of Basle 2: – procyclicalityprocyclicality of capital adequacy requirement of capital adequacy requirement– role of role of rating agenciesrating agencies– role of role of internal modelsinternal models for risk assessment for risk assessment

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Near-certainty of EU-led crackdown on Near-certainty of EU-led crackdown on tax havenstax havens

Issue is Issue is notnot low tax jurisdictions low tax jurisdictionsFocus on Focus on bank secrecy/confidentialitybank secrecy/confidentiality and and secrecy/confidentiality of secrecy/confidentiality of beneficial ownership of beneficial ownership of assets through offshore trustsassets through offshore trusts & similar constructions & similar constructionsNo longer just about withholding tax/information No longer just about withholding tax/information sharing on interest income: target is all assets, interest sharing on interest income: target is all assets, interest income, dividends & capital gainsincome, dividends & capital gainsInfrastructure of tax evasion and tax avoidance to be Infrastructure of tax evasion and tax avoidance to be tackled, not just formal laws, rules & regulations: law tackled, not just formal laws, rules & regulations: law firms, accountants, tax advisors & consultants, firms, accountants, tax advisors & consultants, financial institutions & advisors, beneficial owners financial institutions & advisors, beneficial owners hiding behind legal persons etc.hiding behind legal persons etc.

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The twilight of the tax havens?The twilight of the tax havens?The roughly 50 tax havens in existence today are highly exposed & The roughly 50 tax havens in existence today are highly exposed & vulnerable to external pressurevulnerable to external pressureThe OECD gang: The OECD gang: – 3 ‘unco-operative tax havens’: Andorra, Monaco, Liechtenstein3 ‘unco-operative tax havens’: Andorra, Monaco, Liechtenstein– 35 ‘co-operative tax havens’: 35 ‘co-operative tax havens’: Anguilla, Antigua and Barbuda, Aruba, Bahamas,

Bahrain, Belize, Bermuda, British Virgin Islands, Cayman Islands, Cook Islands, Cyprus, Dominica, Gibraltar, Grenada, Guernsey, Isle of Man, Jersey, Liberia, Malta, Marshall Islands, Mauritius, Montserrat, Nauru, Netherlands Antilles, Niue, Panama, Samoa, San Marino, Seychelles, St. Kitts & Nevis, St. Lucia, St. Vincent and the Grenadines, Turks & Caicos Islands, US Virgin Islands and Vanuatu

Of these:Of these:– 7 Overseas Territories of the United Kingdom7 Overseas Territories of the United Kingdom– 3 dependencies of the British crown3 dependencies of the British crown– 2 belong to the Kingdom of the Netherlands2 belong to the Kingdom of the Netherlands– 2 ‘fully self-governing countries in free association with New Zealand’2 ‘fully self-governing countries in free association with New Zealand’– 1 External Territory of the United States of America1 External Territory of the United States of America

– 3 ‘graduated’ from tax haven status: Barbados, Maldives and Tonga3 ‘graduated’ from tax haven status: Barbados, Maldives and TongaLuxembourg, Austria, Switzerland, Dubai (plus 1 or 2 other GCC states), Luxembourg, Austria, Switzerland, Dubai (plus 1 or 2 other GCC states), Singapore, Hong Kong & MacaoSingapore, Hong Kong & MacaoOECD assignment of countries to tax have categories misleading and too OECD assignment of countries to tax have categories misleading and too soft: de facto all tax havens mentioned are unco-operativsoft: de facto all tax havens mentioned are unco-operativee

Twilight of the tax havens continuedTwilight of the tax havens continued18 of the tax havens are European or in 18 of the tax havens are European or in political union with a dominant EU partnerpolitical union with a dominant EU partner– 4 are EU members4 are EU members– 13 are micro-statelets13 are micro-statelets– then there is Switzerlandthen there is Switzerland

Merkel not alone. In EU, only Luxembourg Merkel not alone. In EU, only Luxembourg and Austria are opposedand Austria are opposedSupport of USA, Canada, Australia, New Support of USA, Canada, Australia, New Zealand & many emerging markets expectedZealand & many emerging markets expectedSure vote winnerSure vote winnerNo longer left-right issue No longer left-right issue

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Between the financial crisis and Between the financial crisis and the looming regulatory reforms the looming regulatory reforms and assault on the tax havens,and assault on the tax havens,

these arethese areinteresting times indeed!interesting times indeed!