Daily Archives: November 29, 2011

The autumn statement has two objectives in the British budgetary process. It provides an updated economic forecast and it makes a mid-course correction in fiscal policy, if thought necessary in light of the new outlook. George Osborne had a tricky task in front of Parliament on Tuesday. He had to admit to a much gloomier outlook, while justifying his decision to stick to the multi-year deficit reduction plan that he laid out last spring. With some clever footwork, he managed to square this circle.

Previous chancellors had more room to manoeuvre. They could, and did, tilt their forecasts to align with their desired policy outcomes, as Alistair Darling describes in his recent book. Much post-budget commentary used to focus on the credibility of the Chancellor’s forecast. Those days ended with the establishment of the independent Office of Budget Responsibility. It provided a stiff rod for Mr Osborne’s back.

He did not attempt to belittle or explain away the OBR’s starkly downgraded growth forecast. Instead he highlighted their analysis that the expected stagnation for the next two years (less than one per cent growth per year) was due to the eurozone debt crisis, the squeeze on UK households from external rises in fuel and food prices, and lower trend growth. The last is a judgement call that may prove too gloomy, but the Chancellor accepted it for now.

The autumn statement was delivered against the backdrop of extremely febrile conditions in the bond markets, and battered business and consumer confidence at home. Mr Osborne used a two-pronged approach to address these challenges. To reassure the markets, he stressed policy stability in the UK, which contrasts strikingly with the policy uncertainty and political turbulence abroad. The British coalition government is unique among the major economies in having an electoral mandate for deficit reduction and a long election-free future to achieve it. The bond markets have recognised and rewarded this superior political capital, along with Britain’s exchange rate flexibility, with significantly lower interest rates. Mr Osborne noted that even a one per cent rise in the cost of government debt would cost £21bn in higher interest payments – and neighbouring countries have seen rises of five per cent in just a few weeks once credibility is lost. This is an advantage the Chancellor took great pains to retain. It is also a politically useful bit of clear water between the coalition’s fiscal strategy and that of the opposition Labour party.

The task of restoring confidence was addressed by laying out a medium-term growth strategy based on infrastructure investments already identified, mainly for road and rail improvements, and targeted incentives for small and medium businesses. Public sector expenditure is necessarily limited but if the bulk of the investment can be obtained from UK pension funds and external sovereign wealth funds, so much the better for the British taxpayer. This will require firm long-term contracts, which themselves rest on a stable tax and policy environment.

Policy stability means sticking to the announced public spending cuts and pension reforms that will have a big cumulative impact on curbing government debt. It does not mean inaction or callousness in the face of slower growth. The built-in stabilisers, such as unemployment compensation and the pension credit, will continue to provide income support to the vulnerable.

A tight fiscal stance provides the space for the Bank of England to continue with a loose monetary policy. Both will cushion the effects of the downturn. The cap on fare increases by trains and buses will also keep inflation down in the short-term, which will help the Bank’s credibility with the public.

Mr Osborne’s autumn statement, overall, was a strong defense of the coalition’s unchanged fiscal strategy coupled with a set of small, but cleverly targeted, incentives to promote investment and growth. The test of success will rest with the market response over the next week, and the strength of the economic recovery over the rest of this Parliament. But just as Gordon Brown’s watchword while he was chancellor was ‘prudence’, Mr Osborne’s should be ‘stability’. Only time will tell if he lives up to his word better than Mr Brown did.

The writer is chairman of Chatham House and former member of the Monetary Policy Committee of the Bank of England

This is an updated version of this article following the Chancellor’s speech

It is increasingly clear that Italy’s public debt is unsustainable and needs an orderly restructuring to avert a disorderly default. The eurozone’s wish to exclude private sector involvement from the design of the new European Stability Mechanism is pig-headed – and lacks all credibility.

With public debt at 120 per cent of gross domestic product, real interest rates close to 5 per cent and zero growth, Italy would need a primary surplus of 5 per cent of gross domestic product – not the current near-zero – merely to stabilise its debt. Soon real rates will be higher and growth negative. Moreover, the austerity that the European Central Bank and Germany are imposing on Italy will turn recession into depression.

While the technocratic government headed by Mario Monti is much more credible than Silvio Berlusconi’s former government, the constraints it faces are unchanged: debt is unsustainable and the policy to reduce it will make matters worse. That is why markets have shrugged off news of the new government and pushed Italian spreads to yet more unsustainable levels. The government is born wounded and weakened, as Mr Berlusconi can pull the plug on it at any time.

Even if austerity and reforms were eventually to restore debt sustainability, Italy and countries in a similar position would need a lender of last resort to support them and prevent sovereign spreads exploding while they regained market credibility. But Italy’s financing needs for the next twelve months alone are not confined to the €400bn of debt maturing. At this point most investors would dump their entire holdings of Italian debt to any sucker – the ECB, European Financial Stability Facility, IMF or whoever – willing to buy it at current yields. If a lender of last resort appears, Italy’s entire debt stock of €1,900bn will be soon supplied.

So using precious official resources to prevent the unavoidable would simply finance the exit of others. Moreover, there is no official money – some €2,000bn would be needed – to backstop Italy, and soon Spain and possibly Belgium, for the next three years.

Even current attempts to ramp up EFSF resources from the IMF (which is reportedly readying a €400bn-€600bn programme to backstop Italy for the next 12-18 months), and from Brics, sovereign wealth funds and elsewhere, are bound to fail if the eurozone’s core is unwilling to increase its own contributions, and if the ECB is unwilling to play the role of an unlimited lender of last resort.

If, as appears likely, Italy remains stuck in an uncompetitive recession and is unable to regain market access in the next twelve months, then even if such large official resources were mobilised, they would be wasted on financing investors’ exit and thus postponing an inevitable debt restructuring that would then be more disorderly.

So Italy’s public debt needs to be reduced now to at worst 90 per cent of GDP from the current 120 per cent. This could be done by offering investors the choice to exchange their securities either for a par bond – with a longer maturity and a low enough coupon to reduce the net present value by 25 per cent – or for a discount bond that has a face value reduction of 25 per cent. The par bond would suit banks that hold bonds to maturity and don’t mark to market. There should be a credible commitment not to pay investors who hold out against participating in the offer – even if this triggers the payment of credit default swaps.

With appropriate regulatory forbearance, it would allow banks to pretend for a while that no losses had occurred and thus give them more time to raise fresh capital. Since about 40 per cent of Italy’s public debt is held by non-residents, a debt restructuring will also imply some burden sharing with foreign creditors.

Some influential figures in Italy have suggested a capital levy, or wealth tax, could achieve the same reduction in public debt. But a debt restructuring is superior. To reduce the debt ratio to 90 per cent of GDP, a wealth tax would need to raise €450bn (30 per cent of GDP). Even if payment of such a levy were spread over a decade that would imply an increase in taxes equivalent to three per cent of GDP for ten years running; the resulting drop in disposable income and consumption would make Italy’s recession a depression.

To reduce such negative effects one would have to focus the tax on the wealthy – raising the rate to ten per cent of their wealth. Leaving aside the political risks of such a move, a debt restructuring is still preferable, as the burden would be shared with foreign investors. It would therefore hit consumption and growth less. Since Italy is running a small primary surplus, a debt restructuring would be feasible even without significant official external financing.

So debt restructuring is preferable to a plan A that will fail and then cause a bigger, disorderly restructuring or default down the line. Even a debt restructuring would not resolve the problems of lack of growth and outright recession, lack of competitiveness and a large current account deficit. Resolving those requires a real depreciation that may well demand the eventual exit of Italy and other member states from the euro.

But exit can be postponed for a while. Restructuring, however, has to be implemented now. The alternative is much worse.

The writer is chairman of Roubini Global Economics and professor at the Stern School of Business at New York University

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