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Colin Lawson University of Bath

Prepared for the conference FINANCE AND RISK, University of Economics in Bratislava, Faculty of National Economy, Finance Department, November 24 th – 25th 2008.

SUMMARY: The thesis of this paper is that the Credit Crisis has led to a major and profound expansion in the scale of public finance, and in its risks and uncertainties, across the developed market economies, and probably beyond. While it is too early to give a definitive answer to the size of this change, it may well come to be seen as a defining characteristic of early 21st Century market systems. The paper outlines the causes and consequences of these changes, and suggests some possible remedies to deal with the dramatic growth in risk facing the public finances and ultimately all taxpayers and citizens. The growth in risk is centred on the loans and guarantees – both explicit and implicit – made as a consequence of the Credit Crisis. But the increases in uncertainty and risk go much further than these loans and guarantees, to encompass the need for new national and regulatory systems, and for overhauls of tax policy and the way incentives are structured in financial services. The EU`s role is also called into question, and an accelerated admission to the euro area may be advisable for those EU members still outside it, to help reduce risk.


INTRODUCTION: The Credit Crisis began in August 2007, when interbank lending markets in the US, UK and Europe began to seize up. These markets had rarely received much public attention, and it was not immediately obvious why this should have happened. But loans on interbank markets, from overnight to several months, were not just important in keeping the flow of credit circulating amongst banks, and hence amongst almost all economic agents in a market system, they were made without collateral being necessary, and were increasingly important to the banking model developing across market economies. That model relied to an increasing extent on wholesale markets for supplies of capital, rather than on the deposits of individuals or companies. At the same time the degree of leveraging on capital was also increasing. So with larger supplies of credit and greater leveraging higher profits were possible. As were higher risks, as banks sought out increasing rates of return to satisfy their shareholders and those of their employees whose wages and bonuses were linked to levels of business or profits. But the increasing levels of risk seemed manageable by the device of securitisation, which appeared to allow the securitising bank to simultaneously sell on the risk and replenish its capital. When a rapidly deflating housing market bubble in the USA exposed weaknesses in this banking model, and similar bubbles in Ireland, the UK, Australia and Spain also began deflating, doubts about the location and value of securitised assets led eventually to an evaporation of trust between first banks, and then other financial and non-financial companies.

By the autumn of 2008 the lack of trust in the financial sector was sufficiently great to almost completely seize up credit flows and threaten the stability of the world financial system. The financial system was in effect broken, and by October 2008 a coordinated action by large numbers of central banks and countries was needed to stabilise it. This involved giving widespread promises of state protection to depositors, large injections of capital to banks, vast liquidity supplies to gummed-up financial market and increasing guarantees for all sorts of short term bond issues. Most recently the Crisis moved into the realm of sovereign default, as countries such Hungary and Ukraine struggle to refinance foreign currency loans, bringing in

3 international agencies such as the IMF and the World Bank to provide assistance. At the same time the Credit Crisis has spawned an international economic downturn, and in some cases recession, the depth and severity of which cannot at the moment be estimated. All of these responses have public finance consequences – tax revenues and expenditures – and risk and uncertainty consequences that are still growing and evolving. Here we sketch out some of the outlines of this crisis in public finance and some possible remedies.

Fiscal Risks from the Credit Crisis: The increased fiscal risks come from the actual or potential increases in expenditure that responses to the crisis have or will require. As the crisis is in its early stages it is impossible to estimate the size of the required funds, or the losses that may result from these commitments. In its October 2008 sixmonthly Global Financial Stability Review the IMF estimates that the losses to the US banking system are around $1.4trillion (IMF, 2008). Others think the eventual loss will be double that, and if anything the damage to European banking will be greater. Certainly up to the autumn European banks had written off slightly more capital than US banks. As the IMF, whose damage estimates are clearly conservative, had estimated US bank costs at only $945billion as recently as August, the cost estimates should be treaded as “to date” rather than “provisional”. As much of the damage comes from defaulting mortgage loans, reasonably accurate final cost estimates are not likely to emerge until the various housing markets have stabilised – which is very unlikely before 2010.

Like the estimates of private costs the need for public funding is growing rapidly. By October 2008 the USA had committed $1.5trillion in loans and investments to its banking sector. It had also guaranteed another $3.6trillion investments and deposits, not including $620billion in currency swaps with other central banks, or a 21 st October offer to buy $540billion in short term debt from money market mutual funds to provide a key area of the US financial system with liquidity. In Europe by mid October the total public money committed in loans and investments, and credit lines was around $2.5trillion. In addition there were extensive new guarantees on bank deposits throughout most European countries, some extending to companies and

4 wholesale deposits. These additional guarantees were precipitated by Ireland`s comprehensive savings deposits scheme announced at the end of September. Other European states, fearing a loss of deposits to Irish banks, quickly and separately increased guarantees, having just agreed to act together not separately. It was the low point in EU solidarity, triggered by Germany`s failure to keep the agreement for even a day.

The loans from public funds will mostly be repaid, generally at reasonably high interest rates. The capital injections will mostly be recoverable, perhaps at good rates of return. Most of the guarantees will not be needed, and the insurances should be more than self-financing. But there are risks. The state will have to borrow substantial sums additional to its usual requirements, possibly for long periods, probably at a higher rate than usual. Lenders are increasingly sceptical about some sovereign debt, and there is currently relatively little to borrow. In the last few weeks alone Belgium, Denmark and Austria have had to pull government bond issues that were clearly not going to succeed: but may do so on more attractive terms.

The Credit Crisis comes in part as the culmination of a 20 year ideological experiment with minimal regulation and maximum freedom for private business to pursue profit unhindered by law or apparently by social convention. In financial markets this ideology is associated with Alan Greenspan, whose desire to encourage unregulated off balance sheet derivatives led directly to the toxic mortgage derivatives that have destroyed perhaps $3trillion of bank capital across the world. It is clear that in most advanced market systems financial regulation requires a thorough overhaul – one that advocates of deregulation were incapable of delivering. This will cost money – the seven US Federal financial regulators have a total budget of over $4billion - but more importantly for public finances, such a tightening of regulation may easily overshoot the necessary correction, and in being too tight may reduce lending and financial innovation and so hinder growth and hence limit increases in tax revenue.

The latest phase of the Credit Crisis is the failure of certain sovereign governments to be able to refinance foreign loans or current trade imbalances without drastic currency devaluations or depreciations. Iceland, Hungary and Ukraine have consequently had to approach the IMF, and many other countries may soon find themselves in the same

5 position. In November the IMF authorised a $16.4 billion for Ukraine, and $15.7 billion for Hungary, as part of a larger package of credit facilities including $8.4 billion from the EU and $1.36 billion from the World Bank.

Credit default swap rates on many countries debts have risen significantly in recent months. This signals that the market`s assessment of sovereign default has risen, and so will their borrowing costs, if indeed they can borrow at all. Even those countries with excellent credit records and relatively low public debt may soon find further large borrowings expensively elusive.

The next problem area requiring some public funding or guarantees will likely be private pension companies and insurance funds, where the collapse on equity prices over the last year will have impaired their capital cushions to the point where they cannot write new business or, in the case of pension funds, safely deliver their pension promises.

In all of these areas it is not that public funds have never before been used, though in some cases this is true, but it is the sheer scale and unpredictability of calls on public funds that generates the increased risks. For example it will not be easy to roll back the promises on deposit protection, and now this issue is in the public political domain, it may be electorally damaging to try to do so. How such extended promises are to be funded is also important. If the promise is funded by public finances then public risks rise. If it funded partly by public funds, partly by private funds, then risks are split. In either case taxpayers, by acting as insurers of last resort, will want to know what they are to receive in return. Governments will have to make a clear case that the advantages to society of such guarantees will outweigh the costs: and part of the governments` case will have to be a convincing story that they have dealt with the extra moral hazard that such a promise entails.

Part of the answer will have to be more effective regulation, and part of that extra effort will have to go into resolving to improve bank governance and incentive structures. In particular it is obvious that a large part of the blame attaches to banks with sales driven incentives schemes that did not sufficiently distinguish between boosting short run business and longer run reputational damage. However Alan

6 Greenspan`s limited mea culpa - that he had assumed that bankers` desire for short term bonuses linked to product sales that might sour in the longer run would be restrained by their desire to protect the reputation of their banks – is sadly fantastical, ignoring as it does the history of banking crises. The motives and incentives that led to the current crisis are as old as banking. Only some of the financial products and processes were new. The risks of such systemic failure are, and always have been, and always will be inherent in the activity of private banking. Everyone knows this. They also know that every generation or two it is forgotten in moments of greed-fuelled financial exuberance, generally driven by the invention of some new financial products or processes whose inventors claim allow the constraints of sensible banking to be expanded. This time the claim was that advances in financial risk analysis modelling and the consequent growth in increasingly complex financial derivatives could allow the system to handle much more risk more effectively. This was true, but not to the extent that its advocates and customers believed. It is a task of regulation and public policy to ensure that financial innovation is encouraged, but not to the extent that the system is damaged, or in this case collapses.

There is a lot of the aspect of a public good about a well functioning financial system: which is why massive public expenditure is justified to save it from its own failings. Private bankers are lucky that in most market systems the public allows them to make handsome profits by supplying financial products some of which have strong elements of public necessities. This is a moment when taxpayers, voters, politicians and bankers should reflect on this privilege, and decide whether we have the balance right between public and private provision. Public provision has such well known drawbacks that we are prone to dismiss it as feasible solution. But if the alternative is a private system that is incapable of self-governance to the point of destruction the alternative needs to be contemplated.

Fiscal risks from the recession: The credit crisis has caused a recession. A recession raises risks for public finance. These increased risks come through greater mandatory expenditure on unemployment and related social needs, mostly housing and health, and more law enforcement activity. At the same time tax revenues fall more than proportionately to output as fiscal drag goes into reverse. Budget deficits widen,

7 public debt increases as a proportion of GDP, and sovereign credit default swap spreads may widen.

This sequence is for a normal recession. The present crisis looks to be abnormal in extent, and perhaps in depth and duration. Therefore states from China to the UK have announced large additional expenditure programmes to replace falls in aggregate demand. If funded these programmes raise debt levels and the interest rates paid on debt. If unfunded there is a risk they will lead to inflation.

For some countries the risks are greater, as the increased exceptional expenditure damages their reputation for fiscal probity. For example the UK government has been operating a fiscal golden rule scheme since 1997. In essence this requires the government to balance expenditure and income over the business cycle. Expenditure above this level is within the rule only if it is clearly intended for public investment purposes. Along with the 1997 limited operational independence granted to the Bank of England the fiscal rule played a significant role in building credibility for the UK government and lowering the rates at which they could borrow. In November 2008 the government signalled it is abandoning the fiscal rule, and the Bank of England in effect admitted it grossly underestimated the risk of deflation. Although the intention is to re-establish a similar self-limitation on borrowing when the worst recession risks are past, it remains to be seen what lasting damage has been inflicted on their reputation, as signalled by increased borrowing rates. Whether having specific expenditure rules or inflation targets is sensible should be debated. Personally I think they invite trouble because events will sometimes drive the optimal policy solutions away from the rules and either require governments to stick with sub-optimal policies, or risk damaging their credibility by waiving the rules while pretending to observe them. The last seems to have been the UK government`s policy even before the credit crisis.

Conclusions: We have argued that the Credit Crisis has led to unprecedented government involvement in the financial systems of the advanced market economies, and that this poses significantly increased risks to public finances. Further risks come from the costs of the resulting world recession. While the twin crises create the

8 preconditions for an overdue reform of both national and international financial and public finance regimes, the costs will very high and cannot yet be estimated. Reference: International Monetary Fund “Global Financial Stability Report: October 2008”. Washington, IMF.

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