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DONE BY: YASHVI CHITALIA
I would like to express my gratitude towards Mumbai University for giving me this opportunity to work on this particular topic and helping me expand my knowledge and views about it. Also I would like to thank my Professor in charge who not only guided me throughout the course of the project but also helped me understand every minute detail. Last, but not the least my course coordinator for providing us her support.
GLOBAL DEBT CRISIS: INTRODUCTION
A debt crisis deals with countries and their ability to repay borrowed funds. Therefore, it deals with national economies, international loans and national budgeting. The definitions of "debt crisis" have varied over time, with major institutions such as Standard and Poor's or the International Monetary Fund (IMF) offering their own views on the matter. The most basic definition that all agree on is that a debt crisis is when a national government cannot pay the debt it owes and seeks, as a result, some form of assistance. 1. The Bond Market
Standard and Poor's rates economic entities in terms of their credit worthiness. Credit worthiness internationally can be measured, among other ways, by following the divergence between long-term and short-term bond prices adhering to a specific country. Standard and Poor's defines debt crisis formally as the divergence between long- and short-term bonds of 1000 base points or more. Ten base points equal a 1 percent rate increase. Therefore, if the interest rate on long-term bonds is 10 percent above short-term bonds, the country is in a debt crisis. Less formally, this means that investors in international bonds see a country as failing economically. Therefore, the long-term prospects of the relevant national economy are bleak, meaning that the rate for long-term bonds rises quickly.
Default and Rescheduling
The International Monetary Fund, in its substantial literature on debt, rejects the concept of default as an important part of a debt crisis. This is because since Ecuador's default in 1999, there have been few of these. Banks are interested primarily in avoiding default, which would mean the total write off of the loan. Instead, banks want to see at least a portion of their money returned. Therefore, the IMF sees debt rescheduling as the main ingredient in debt crises. More formally, if a debt is renegotiated --- or rescheduled --- at terms
less advantageous than the original loan, then the country is formally in a debt crisis. Write Downs
Another useful measure of debt crisis is the writing down --- or writing off --- a loan amount. This means that the creditors of a specific national economy have largely given up on the ability of the country to pay its debts, and therefore, renegotiate the loan such that the principle amount is lower. This will lower the country's credit rating substantially, but it will provide some debt relief.
The loss of some national sovereignty is a more specifically political -- and less formal --- part of the debt crisis experience. The IMF states that coercive restructuring of a country's finances is a clear marker of a debt crisis. Banks and the national governments that protect them want to see their money returned, if not now, then some time in the future. Therefore, the World Bank, the IMF or even other countries can begin the process of forcibly restructuring a country's economy so as to produce more tax revenue, profit or whatever will lead to eventual repayment. The IMF, when assisting a country, only does so on the condition that the country radically revamps its financial and economic system. Therefore, the connection between receiving assistance from the IMF and forcible restructuring is a variable that points to a debt crisis that has reached a critical point.
Growth of the debt and leverage before the Crisis
Most analysis has focused on the cause of the crisis on the roles played by US mortgage lending and financial sector leverage. However, a large part in the picture is missing. Enabled by globalization of the banking sector and a period of unusually low interest rates and risks spread debt grew mostly after the year 2000 in most mature economies. By 2008, most mature economies such as UK, Spain, South Korea and France had higher level of debt as a percentage of the GDP than the US. Also, most of the debt was not in the financial sector but rather in household, business and some government sectors. Borrowing accelerated in most developed countries: The total debt relative to GDP in 10 mature economies has increased from 200%of GDP in 1995 to over 300% in 2008. Rise of debt mainly occurred in the Real Economy particularly in the real estate: Attention is focused mainly on the financial sector borrowing as a prime contributor to the crisis. Financial Institutions issued debt-rather short term debtrather on the deposits to fund lending in the years before the crisis. This source of funding dried up when the credit markets seized up in the fall of 2008, wreaking havoc in the bank operations and contributing to the severity of the crisis. However in the mature economies, the increases in the financial sector borrowing were dwarfed by the collective growth in the debts of the households, corporations and government. Out of the total debt of about $40 trillions, almost 11 trillion accounted for financial institutions and the remaining $29 trillion were divided among the households, non-financial business and the government-the so called real economy. Real Estate played an important role in the growth of leverage across countries. Rising real estate were both a cause and consequence of the increased borrowing : as property prices rose, buyers borrowed more thereby pushing prices up even more. By 2007, bank lending for residential mortgages was equal to 81% of the GDP in the UK and 73% in the US. In comparision, bank lending to businesses was
UK and Swiss households had even larger amounts of debts at 102% and 121% of their GDP respectively. mortgage lending is lower but however across western Europe. Canadian households also reached higher levels of debt to GDP in recent years. It was these borrowers in each of the sectors that got into trouble and caused most of the credit losses in the crisis. In summary the breadth of the housing bubble was greater than its understood and should be monitored closely. Although US household debt grew significantly to 96% of their GDP by 2008. Household leverage increased significantly in many economies: Households in almost all mature economies boosted their borrowing significantly relative to their GDP since the year 2000. it accounted for majority of growth in lending. However total debt is rarely spread evenly within the sectors and that average levels of sector leverage mask pockets of highly leveraged borrowers. Using more granular measures. In European countries. BUSINESS AND GOVERNMENT SECTORS: The aggregate measure of debt relative to GDP is not the only indicator of GDP. one observes that households became significantly more leveraged in many countries. DEBT AND LEVERAGE WITHIN HOUSEHOLDS.equal to 46% of GDP in UK and 36% in the US. Exceptions were the households in Japan and Germany which had declining levels of debt relative to their GDP. while most of the corporations and the governments entered the crisis within stable or even declining levels of leverage. 6 .
were stable or declining in most countries in the years prior to the crisis. Most borrowers who did not qualify for the prime mortgage categorywere in fact the middle income and the high income households with poor credit histories. the greatest increase in leverage occurred among the middle incomed households. In Spain by contrast. measured as debt to book equity. In the United States. However 2 exceptions stand out. or no down payments or poor documentation of income – not low income households buying a house for the first time. there are some pockets of very highly leveraged borrowers. as businesses enjoyed higher profits and booming equity markets .commercial real estate and companies acquired in the recent years through leveraged buy outs. The commercial real estate sector.Within the household sector. not the poorest. with its preponderance of fixed assets. contrary to conventional wisdom. with 2 exceptions: Leverage ratio of nonfinancial business. 7 . This increased to even higher levels before the crisis as underwriting standards were relaxed. leverage increased mostly among the poorer households. commercial properties rose rapidly and interest rates remained low. has traditionally employed more leverage than the rest of the corporate sector. The Corporate Sector entered the crisis with stable or declining levels of leverage.
for example. Companies brought through leverage buy-outs are another exception to the pattern of stable leverage in the overall corporate sector. it is fortunate that most entered the crisis with ample room to expand public spending. Finally real estate developers have an asymmetric pay-off due to limited liability. factors which emerged over a number of years. In the US. commercial real estate lending takes place with only limited disclosure available on the businesses of real estate developers. While governments could have done more to reduce debt during booming years. Government debt relative to GDP also slightly fell in countries like Italy. most of which are private companies. Spain and Switzerland and rose slightly in Canada. Germany and the UK. as they have done since.Rapid appreciation in the prices of commercial property. borrowers 8 . As private equity industry attracted new investors. Third. In addition. has been the heart of many financial crises. First is the positive feedback between asset values and credit availability through mechanisms such as loan-to-value ratios. just like residential property. The Government Sector entered the crisis with steady levels of leverage: Most mature economies’ government debt relative to GDP did not change much from 2000 through 2008. strong economic growth during the period caused the ratio of government debt to GDP fall by about 2% a year. even with extra borrowing to pay for wars in Iraq and Afghanistan. France. the number and the size of buyout deals rose as did the leveraged employed in the deals. Causes proposed include the inability of homeowners to make their mortgage payments (due primarily to adjustable-rate mortgages resetting. Several factors account for this empirical regularity. with large potential profits if the project succeeds with losses in case are borne by borne by banks and other investors. There is a definite relation between real estate booms and banking crises. long lead times in real estate can result in big price shifts when there is a change in demand. Causes The crisis can be attributed to a number of factors pervasive in both housing and credit markets.
were sustainable. predatory lending. and speculation). in the form of various financial models used to evaluate credit risk. and prolonged stability earlier this decade. high personal and corporate debt levels. and 5) Stronger regulation of the shadow banking system and derivatives markets was not needed. international trade imbalances. market participants sought higher yields without an adequate appreciation of the risks and failed to exercise proper due diligence.overextending. keep pace with financial innovation. directing funds to the most profitable and productive uses. weak underwriting standards. and inappropriate government regulation. 3) Concepts embedded in mathematics and physics could be directly adapted to markets. 9 . bad monetary and housing policies. unsound risk management practices. financial products that distributed and perhaps concealed the risk of mortgage default. growing capital flows. and consequent excessive leverage combined to create vulnerabilities in the system. At the same time. such as large trade deficits and low savings rates indicative of over-consumption. Policymakers. overbuilding during the boom period." dated 15 November 2008. 4) Economic imbalances. risky mortgage products. In its "Declaration of the Summit on Financial Markets and the World Economy.S. During May 2010. in some advanced countries. 2) Free and open financial markets supported by sophisticated financial engineering would most effectively support market efficiency and stability. These assumptions included: 1) Housing prices would not fall dramatically. or take into account the systemic ramifications of domestic regulatory actions. regulators and supervisors. did not adequately appreciate and address the risks building up in financial markets. Warren Buffett and Paul Volcker separately described questionable assumptions or judgments underlying the U. financial and economic system that contributed to the crisis. increasingly complex and opaque financial products. leaders of the Group of 20 cited the following causes: During a period of strong global growth.
respectively. which caused investment sales to fall much faster than the primary market. B) Homeowner speculation: Speculative borrowing in residential real estate has been cited as a contributing factor to the subprime mortgage crisis. Subprime lending was a major contributor to this increase in home ownership rates and in the overall demand for housing.Causes of the Debt Crisis: 1) In the US: A) Boom and bust in the housing market: Low interest rates and large inflows of foreign funds created easy credit conditions for a number of years prior to the crisis. 22% of homes purchased (1. $160 billion (13%) in 1999. with an additional 14% (1. During 2005. and $600 billion (20%) in 2006. which drove prices higher. including undocumented immigrants. these figures were 28% and 12%. the behavior of lenders changed dramatically. a record level of nearly 40% of homes purchases were not intended as primary residences. In other words. 10 . David Lereah. Subprime mortgages amounted to $35 billion (5% of total originations) in 1994. During 2006." C) High-risk mortgage loans and lending/borrowing practices In the years before the crisis.2% in 2004. Lenders offered more and more loans to higher-risk borrowers. The USA home ownership rate increased from 64% in 1994 (about where it had been since 1980) to an all-time high of 69. NAR's chief economist at the time. 9% in 1996.07 million units) purchased as vacation homes.65 million units) were for investment purposes. fueling a housing market boom and encouraging debt-financed consumption. stated that the 2006 decline in investment buying was expected: "Speculators left the market in 2006.
such as the housing bubble and dot-com bubble. 11 . as they were paid by investment banks and other firms that organize and sell structured securities to investors. a cycle that can be broken only by canceling the debt.D) Inaccurate Credit Ratings: Critics allege that the rating agencies suffered from conflicts of interest. This process is designed to perpetuate itself thanks to a diabolical mechanism whereby debt replicates itself on an ever greater scale. B) Odious Debt Many poor countries today have started their independent status with heavy debt burdens imposed by the former colonial occupiers. South Africa as another example. They have some authority over commercial banks and possibly other financial institutions. Central banks have generally chosen to react after such bubbles burst so as to minimize collateral damage to the economy. E) Policies of central banks: Central banks manage monetary policy and may target the rate of inflation. They are less concerned with avoiding asset price bubbles. has found it now has to pay for its own past repression: the debts incurred during the apartheid era are now to be repaid by the new South Africa. rather than trying to prevent or stop the bubble itself 2) IN THE THIRD WORLD COUNTRIES: A) A Continuing Legacy of Colonialism: The history of third world debt is the history of a massive siphoning-off by international finance of the resources of the most deprived peoples.
g.C) Mismanaged Lending Most loans to the third world have to be paid back in hard currencies (which do not usually change too much in value. Structural adjustment advice in the past from the IMF and others. that include preferential exports etc. Many loans also come with conditions. This 12 . Debt crises can also occur just by the value of the developing country’s money going down. the American Dollar. education. This has implied a downward spiral and further poverty. Paying off loans implies earning foreign exchange in hard currencies. the Japanese Yen. in order to help repay loans. which can be due to a variety of other inter-related factors. In effect then. These moneys are often placed in foreign banks (and used to loan back to the developing countries).) Poor countries have soft currencies (values which can fluctuate). D) The World’s Poor Are Subsidizing The Rich: Another cause for large scale debt has been the corruption and embezzlement of money by the elite in developing countries (who were often placed in power by the powerful countries themselves). debts become even harder to pay off. e. has led to the cut back on important spending such as health. more money comes out of the developing countries than is given in. etc. Combined with falling export prices for many poor countries. Refinancing loans implies taking on new debts to service the old ones.
13 . treaties and institutions by the wealthy and powerful nations also help form the backbone of today’s globalization. The policies of those who have the power and influence have been successful to help raise standards for some in their own nations. but often the wealthier and more powerful ones are able to use various means to avoid getting into the dilemmas and problems the poor nations get into.depresses wages even further due to the spiraling circle downwards to ensure that enough exports are produced. That such immense wealth and prosperity for some have come at a time when most nations in the world have steeped into further poverty and debt is no coincidence. Rich nations as well as poor incur debts. but at a terrible cost. E) Backbone To Globalization: The economic decisions and influence in various international agreements.
5% of euro-area GDP. Portugal’s recent capitulation to EU authority has awakened fears that the debt contagion could spread to Spain.3%. The accessibility to easy credit led to an overreliance on external credit sources to fund domestic debt.” The European Union (EU) has rescued Greece and Ireland. All three countries.3% OF GDP IN 2009. the United States and the rest of the world. These preceding events and the scope of Spain’s own debt have raised shiver and panic in markets. This policy brief will attempt to ascertain the origins of the crisis.2%. and most recently Portugal has admitted its need for a similar rescue loan. ACCORDING TO THE ECONOMIST. ITALY 5.THE EUROPEAN SOVEREIGN DEBT CRISIS: “THE ADVENT OF THE GLOBAL FINANCIAL CRISIS COUPLED WITH GREECE’S PUBLIC DEBT ADMISSIONIN OCTOBER 2009 SPARKED DISMAY THROUGHGLOBAL MARKETS AS THE FULL EXTENT OF EUROZONE DEBT LEVELS WERE UNVEILED. Origins of Crisis The global financial crisis led to the deterioration of government budgets and finances as nations utilized public expenditures to provide stability and stimulus. GREECE’S BUDGET DEFICIT REACHED 15. Perhaps other wrecked countries will need to be helped at a later date.3% AND PORTUGAL AT 9. “Greece the biggest. Greece.4%. makes up only around 2. draw attention to possible alternatives to implemented policies.IRELAND’S WAS 14. making the debt crisis far more serious. Ireland and Portugal are economically small. Additionally. the commercial and financial interdependence Europe developed with foreign nations made it more vulnerable 14 . SPAIN 11. I.” However. Reacting in a similar manner. Eurozone nations faced their own strand of fiscal distress due to heavy borrowing practices. enumerate European and international responses. property bubbles and living above their means. and finally explore the broader implications for Europe.
and tax evasion. compared to a Eurozone average of 2% and its current account deficits averaged 9% per year. a reevaluation of Greece’s balance sheets in the latter part of 2009 revealed Greece’s budget deficit was in reality closer to 15. Greece’s budget deficit was estimated to have been 13. When pressed on where Greece had gone wrong. government misreporting. Greece borrowed heavily from abroad to fund its large budget and current account deficit. cronyism. a lot of money was wasted basically through these types of practices. The roots of Greece’s fiscal calamity lie in prolonged deficit spending. the EU established the Stability and Growth Pact in 1997 that set a budget deficit ceiling of 3% of GDP and external debt ceiling of 60% of GDP. economic mismanagement. Greece Before the spread of the global financial crisis. Ireland 15 . However. Prime Minister George Papandreou answered: “Corruption. Acknowledging the inherent hazards and risks of crises emerging due to the common currency. the pact required greater coordination of monetary and economic policies from members of the monetary union. The pact sought to ensure member states maintained budget discipline in order to diminish systemic risk and encourage monetary stability.6% of GDP. In addition.to economic volatility.” Beginning with the adoption of the Euro in 2001. Soon afterwards Greece committed itself to a drastic austerity program in order to avoid a default but later accepted €110 billion ($155 billion) in financial assistance from the EU and IMF in May of 2010. clientalistic politics. In 2009. compared to a Eurozone average of 1%. Greece’s budget deficit averaged 5% per year until 2008. lowering a degree of national sovereignty and clout for certain member states. resulting in a domino effect when crisis occurs in other parts of the world.4% of GDP.
banks and the government. this reliance on the construction and financial sectors coupled with the arrival of the global financial crisis caused a deflation in its domestic property bubble and hurt households. speculation quickly arose that Portugal would require a bailout as it shared some of the symptoms of Greece and Ireland. Ireland’s fiscal shortfall was incurred due to the escalating cost of propping up its undercapitalized banks. Yet. Portugal’s prime minister admitted that his country needed a rescue loan from the EU.” Ireland’s economy performed exceptionally well due to a successful financial services industry and robust property market. the Irish government implemented a series of consolidation measures to help contain the deficit below 12% in 2010. Markets responded by slashing Portugal’s credit rating to near-junk status on March 29th. The government’s repeated fiscal adjustments became increasingly difficult as they were met with strong political opposition. Ireland’s new budget is a four-year plan that slashes $20 billion via spending cuts and new taxes. and agreed to an €80 billion bailout that required the drafting of a new budget. The global financial crisis worsened these pre-existing and homegrown problems. The Irish republic became the first Eurozone country to fall into recession in 2008. Unlike Greece. these cuts include extensive unemployment benefits and welfare payment deductions. general government deficit was estimated at 14. The government has yet defined the amount or conditions of 16 . and unemployment increased from 4. Ireland formally sought support from the IMF and EU. Moreover. On April 6th. Portugal’s Prime Minister Jose Socrates resigned after failing to win support for the fourth austerity package in a year. Portugal Portugal’s adoption of the euro originally resulted in an economic boom. In late November of 2010. Over 2008-2009 its output decreased by 10%. yet increased its susceptibility to the banking system’s volatile performance.5% percent of GDP. When the crisis hit in 2009.Once hailed as the “Celtic Tiger. In response. 2011 while ten-year bond yields rose above 8%.5% in 2007 to nearly 13% in March 2010. After Ireland’s bailout. on March 23rd.
Italy Confidence. Spanish bond yields are narrowing. The country’s unemployment rate continues to be the lowest among the PIIGS nations. Its output fell sharply driven by sharp declines in investment. The overall public debt increased to about 122. Portugal’s public debt levels are significantly lower than Greece. exports. Portugal now joins Greece and Ireland in the Eurozone’s sovereign-debt crisis. Rescue funds are enough to cope with Portugal’s situation. 17 . and its banking industry is comparatively more stable than that of Ireland. and private consumption. trade and credit were quickly shaken due to the global financial crisis in Italy and a global reduction in demand reduced Italy’s exports. Spain was hit hard by the global financial crisis. “due to the large stimulus and evaporating cyclical and one-off revenues. The government deficit declined from a surplus of 2 % of GDP in 2007 to a deficit of 11.14% of GDP by 2010.this aid.2% of GDP in 2009. Moreover. the fear however is that confidence in neighboring Spain will be shaken. and output. while weaker imports and rising government demand provided some offset. The country has lost its competitiveness. and are continuing to fall as of April 6th 2011. Spain’s unemployment rate skyrocketed. contracting Italy’s private consumption.” Spain shares several of the weaknesses of the three fallen economies. reaching 20%. fear of unfavorable market reactions has limited Italy’s ability to use fiscal policy to stimulate its economy. Spain After 15 years of strong growth led by a housing boom. Prime Minister Jose Luis Rodriguez Zapatero’s recent decision not to seek re-election will likely add greater uncertainty to Spain’s already dubious fiscal future. However. and it has large current account deficit similar to Greece and Portugal.
brewing for a while. influential and inconsiderate of others’ viewpoints and concerns. other weaknesses in the global financial system have surfaced. really started to show its effects in the middle of 2007 and into 2008. large financial institutions have collapsed or been bought out. A Crisis So Severe. Around the world stock markets have fallen. Furthermore. 18 . and governments in even the wealthiest nations have had to come up with rescue packages to bail out their financial systems. trust in the whole system started to fail. A collapse of the US sub-prime mortgage market and the reversal of the housing boom in other industrialized economies have had a ripple effect around the world.IMPACT OF THE GLOBAL FINANCIAL CRISIS: The global financial crisis. a global financial meltdown will affect the livelihoods of almost everyone in an increasingly inter-connected world. The problem could have been avoided. The World Financial System Is Affected Following a period of economic boom. if ideologues supporting the current economics models weren’t so vocal. that as things start to unravel. a financial bubble—global in scope—has now burst. Some financial products and instruments have become so complex and twisted. On the one hand many people are concerned that those responsible for the financial problems are the ones being bailed out. while on the other hand.
rating agencies were paid to rate these products (risking a conflict of interest) and invariably got good ratings. especially in the US. the riskier loans.) As BBC’s former economic editor and presenter. For example. but they are tied up for decades. Banks borrowed even more money to lend out so they could create more securitization. bad loans would be the problem of whoever bought the securities. Securitization was seen as perhaps the greatest financial innovation in the 20th century. Starting in Wall Street. With soaring profits. Some banks didn’t need to rely on savers as much then. banks turned to the poor. The security buyer gets regular payments from all those mortgages. others followed quickly. even if it went beyond their area of expertise. buying them in order to securitize them and then sell them on. millions can be made in money-earning loans. as long as they could borrow from other banks and sell those loans on as securities. Some banks loaned even more to have an excuse to securitize those loans. (For banks. Subprime and “selfcertified” loans (sometimes dubbed “liar’s loans”) became popular.Securitization And The Subprime Crisis The subprime crisis came about in large part because of financial instruments such as securitization where banks would pool their various loans into sellable assets. encouraging people to take them up. Some banks evens started to buy securities from others. the banker off loads the risk. thus off-loading risky loans onto others. the subprime. bad loans meant repossessing high-valued property. Running out of who to loan to. Some investment banks like Lehman Brothers got into mortgages. 19 . 2008). all wanted in. So they were turned into securities. Evan Davies noted in a documentary called The City Uncovered with Evan Davis: Banks and How to Break Them (January 14. Rising house prices led lenders to think it wasn’t too risky.
The problem was so large. But some investment banks had little in deposits. so they had to turn to governments for bail out. no-one wanted bad news. New capital was injected into banks to. in effect. banks even with large capital reserves ran out. (even more complex forms of securitization) spread the risk but were very complicated and often hid the bad loans. Investment banks. etc without the right controls and management. so some collapsed quickly and dramatically. in some cases ceased for a while and even now. allowthem to lose more money without going bust. buying. selling and trading risk. Side Note» High street banks got into a form of investment banking. selling and trading risk. Some investment banks were sitting on the riskiest loans that other investors did not want. or insure against problems.) Shrinking banks suck money out of the economy as they try to build their capital and are nervous about loaning. When people did eventually start to see problems. Assets were plummeting in value so lenders wanted to take their money back. that a financial instrument to reduce risk and help lend more—securities—would backfire so much. or CDOs. confidence fell quickly. no secure retail funding. Meanwhile businesses and individuals that rely on credit find it harder to get. Collateralized Debt Obligations. there is a crisis of confidence. Perhaps it was ironic. as Evan Davies observed. While things were good. not content with buying. Lending slowed. banks had somehow taken what seemed to be a magic bullet of securitization and fired it on themselves. mortgages. There have been a number of attempts to mitigate risk. Many banks were taking on huge risks increasing their exposure to problems. (Some think it may take years for confidence to return. While these are legitimate 20 . A spiral of problems result. As Evan Davies described it. Creating More Risk By Trying To Manage Risk Securitization was an attempt at managing risk. That still wasn’t enough and confidence was not restored. got into home loans.
It was a result of a system heavily grounded in bad theories. As they initially made more money taking more risks. economists came up with options. greed. a derivative that gives you the right to buy something in the future at a price agreed now.things to do. or insure against. it all went wrong. the instruments that allowed this to happen helped cause the current problems. misunderstanding of probability and. 21 . and a drop of 50% in the US stock market made businesses look harder for ways to manage risk and insure themselves more effectively. This was a hit. Davis interviewed Naseem Taleb. credit default swaps. and related instruments came out of the turmoil from the 1970s. they reinforced their own view that they had it figured out. ultimately. too. risk actually led to the rise of instruments that accelerated problems: Derivatives. who argued that many hedge fund managers and bankers fool themselves into thinking they are safe and on high ground. The finance industry flourished as more people started looking into how to insure against the downsides when investing in something. the Black-Scholes model. The oil shock. once options could be priced. Combined with the growth of telecoms and computing. bad statistics. the double-digit inflation in the US. once an options trader himself. A whole new market in risk was born. it became easier to trade. a look for way to manage. They thought they had spread all their risks effectively and yet when it really went wrong. the derivatives market exploded making buying and selling of risk on the open market possible in ways never seen before. what had happened was that banks. In a follow-up documentary. he said What allowed this to happen? As Davis explained. financial futures. Mathematical and economic geniuses believed they had come up with a formula of how to price an option. hedge funds and others had become over-confident as they all thought they had figured out how to take on risk and make money more effectively. In essence. To find out how to price this insurance.
A lot of exposure with little regulation. which were encouraging borrowing beyond people’s means. Any problem.As people became successful quickly. In the recent crisis they were criticized for shorting on banks. exceeding the entire world economic output of $50 trillion by summer 2008. much like gambling. and so did AIG. but the problem came about when the market became more speculative in nature. Derivatives caused the destruction of that bank. Or gambling. As Nick Leeson (of the famous Barings Bank collapse) explained in the same documentary. Some countries temporarily banned shorting on banks. they used derivatives not to reduce their risk. Businesses started to go into areas that was not necessarily part of their underlying business. such as risk or actual 22 . Greed started to kick in. people were making more bets — speculating. On the other hand the more it continued the more they could profit. Hedge funds have received a lot of criticism for betting on things going badly. The trade in these swaps created a whole web of interlinked dependencies. Furthermore. credit default swaps. Some institutions were paying for risk on margin so you didn’t have to lay down the actual full values in advance. allowing people to make big profits (and big losses) with little capital. Hedge funds. for example. In effect. was enormous. hedge funds may have been signaling an underlying weakness with banks. driving down their prices. which of course went downhill. a chain only as strong as the weakest link. many of AIGs credit default swaps were on mortgages. The market for credit default swaps market (a derivative on insurance on when a business defaults). AIG alone had credit default swaps of around $400 billion at that time. In some regards. but to take on more risk to make more money. each loss resulted in more betting and more risk taking hoping to recoup the earlier losses. can be legitimate instruments when trying to insure against whether someone will default or not. The world’s largest insurance and financial services company. It was also poorly regulated.
Others have been bought out by their competition at low prices and in other cases. such as confirmation bias (always looking for facts that support your view. Despite the benefits of a market system. US taxpayers alone will spend some $9. Derivatives revolutionized the financial markets and will likely be here to stay because there is such a demand for insurance and mitigating risk. as all have admitted for many years. or better than the average and can make good decisions all the time). because of the interlinked investments. Derivatives didn’t cause this financial meltdown but they did accelerate it once the subprime mortgage collapsed. according to Bloomberg. Davis summarized. $14. The total amounts that governments have spent on bailouts have skyrocketed. rather than just facts) and superiority bias (the belief that one is better than the others. More is expected.7 trillion in bailout packages and plans.5 trillion. The Scale Of The Crisis: Trillions In Taxpayer Bailouts The extent of the problems has been so severe that some of the world’s largest financial institutions have collapsed. the governments of the wealthiest nations in the world have resorted to extensive bail-out and rescue packages for the remaining large banks and financial institutions. it is far from perfect. Trying to reign in these facets of human nature seems like a tall order and in the meanwhile the costs are skyrocketing. This will be very hard to do. The challenge now. The UK and other European countries have also spent some $2 trillion on rescues and bailout packages. Hence the eventual bailout (now some $150bn) of AIG by the US government to prevent them failing. or 33%. From a world credit loss of $2. is to reign in the wilder excesses of derivatives to avoid those incredibly expensive disasters and prevent more AIGs happening. Amongst other things. experts such as economists and psychologists say that markets suffer from a few human frailties.8 trillion in October 2009. of the value of the world’s companies has been wiped out by this crisis.significant loss could spread quickly. 23 .
A Crisis So Severe. but potentially everyone. The Rest Suffer Too Because of the critical role banks play in the current market system. 24 . it is not just the wealthy that suffer. when the larger banks show signs of crisis. a credit crunch can ripple through the entire (real) economy very quickly turning a global financial crisis into a global economic crisis. With a globalized system.
institutions and ideologues that pushed for the policies that caused the problems are found. this “credit crunch” and higher costs of borrowing will affect many sectors. an entire banking system that lacks confidence in lending as it faces massive losses will try to shore up reserves and may reduce access to credit. but with add-ons to the bill to get the additional congressmen and women to accept the plan. This bailout package was controversial because it was unpopular with the public. In the wider economy. sending shock waves around the world. starting with Britain. People may find their mortgages harder to pay. or make it more difficult and expensive to obtain. or part-nationalize. some failing banks to try and restore confidence. 25 . seen as a bailout for the culprits while the ordinary person would be left to pay for their folly. The Financial Crisis And Wealthy Countries Many blame the greed of Wall Street for causing the problem in the first place because it is in the US that the most influential banks. The crisis became so severe that after the failure and buyouts of major institutions. the US capitulated and the Bush Administration announced that the US government would buy shares in troubled banks. It took a second attempt to pass the plan. In Europe. The US House of Representatives initial rejected the package as a result. more businesses will struggle to survive leading to further further job losses. as it goes against the rigid free market view the US has taken for a few decades now. a number of nations decided to nationalize. The US resisted this approach at first. leading to job cuts. the value of their homes are likely to fall in value leaving them in negative equity. As people cut back on consumption to try and weather this economic storm. Eventually. For any recent home buyers. or remortgaging could become expensive. the Bush Administration offered a $700 billion bailout plan for the US financial system.For example.
Paul Craig Roberts also argues that the bailout should have been to help people with failing mortgages. By February 2009. according to the government. About $600bn is marked to buy up mortgage-backed securities while $200bn will be aimed at unfreezing the consumer credit market. Perhaps fearing an ideological backlash. banks have still been reluctant to lend. the total US bailout is $9. This led to the US Fed announcing another $800 billion stimulus package at the end of November. others echo Stiglitz’s concern above. not banks: “The problem. So there’s no connection between the government’s explanation of the crisis and its solution to the crisis. which could be part of a deeper root cause of the problem). For example. is the defaulting mortgages. Europe And The Financial Crisis In Europe. a number of major financial institutions failed. Enough to pay off more than 90 percent of America’s home mortgages (although this bailout barely helps homeowners). according to Bloomberg. And that would restore the value of the mortgage-backed securities that are threatening the financial institutions *and+ the crisis would be over. This also reflects how the crisis has spread from the financial markets to the “real economy” and consumer spending.7 trillion. Others needed rescuing.” Despite the large $700 billion US plan.This illustrates how serious this problem is for such an ardent follower of free market ideology to do this (although free market theories were not originally intended to be applied to finance. but to preserve it. so the money should be directed at refinancing the mortgages and paying off the foreclosed ones.” While the US move was eventually welcomed by many. Bush was quick to say that buying stakes in banks “is not intended to take over the free market. former Assistant Secretary of the Treasury Department in the Reagan administration and a former associate editor of the Wall Street Journal. 26 .
A number of European countries have attempted different measures (as they seemed to have failed to come up with a united response). public dissatisfaction at the way the government was handling the crisis meant the Iceland government fell. where the economy was very dependent on the finance sector. was a reason for a recent boom. soaring commodity prices together with fears of global recession are worrying many developing country analysts. High fuel costs. and promoting green technologies.In Iceland. especially on developing countries that are dependent on commodities for import or export: 27 . economic problems have hit them hard. For example. Russia’a economy is contracting sharply with many more feared to slide into poverty. oil. the rise in food prices as well as the knock-on effects from the financial instability and uncertainty in industrialized nations are having a compounding effect. Summarizing a United Nations Conference on Trade and Development report. The Financial Crisis And The Developing World For the developing world. getting the banks lending again. some nations have stepped in to nationalize or in some way attempt to provide assurance for people. The EU is also considering spending increases and tax cuts said to be worth €200bn over two years. This may include guaranteeing 100% of people’s savings or helping broker deals between large banks to ensure there isn’t a failure. One of Russia’s key exports. The banking system virtually collapsed and the government had to borrow from the IMF and other neighbors to try and rescue the economy. In the end. The plan is supposed to help restore consumer and business confidence. shore up employment. the Third World Network notes the impacts the crisis could have around the world. but falling prices have had a big impact and investors are withdrawing from the country.
Many believed Asia was sufficiently decoupled from the Western financial systems. mostly from the West. coupled with doubts about the direction of monetary policy in some major developed countries. there was increased foreign investment in Asia. even that has not been enough to shield it from the effect of the global financial crisis. From 2007 to 2008 India’s economy grew by a whopping 9%. India and China are the among the world’s fastest growing nations and after Japan. for example. are contributing to a gloomy outlook for the world economy and could present considerable risks for the developing world. Many Asian nations have witnessed rapid growth and wealth creation in recent years. this crisis has shown that in an increasingly inter-connected world means there are always knock-on effects and as a result. are the largest economies in Asia. the UN Conference on Trade and Development (UNCTAD) reports. Asia has had more exposure to problems stemming from the West. and a slowdown in wealthy countries means increased chances of a slowdown in Asia and the risk of job losses and associated problems such as social unrest. currency and commodity markets.Uncertainty and instability in international financial. Asia And The Financial Crisis Countries in Asia are increasingly worried about what is happening in the West. In addition. This lead to enormous investment in Western countries. as that would have a knock-on effect of reassuring foreign investors and helping ease concerns in other parts of the world. Asian products and services are also global. However. Asia has not had a subprime mortgage crisis like many nations in the West have. However. A number of nations urged the US to provide meaningful assurances and bailout packages for the US economy. … Commodity-dependent economies are exposed to considerable external shocks stemming from price booms and busts in international commodity markets. and it is expected that in data will show that by March 2009 that India’s 28 . Many Asian countries have seen their stock markets suffer and currency values going on a downward trend. Much of it is fueled by its domestic market.
In recent years. Although this is a very impressive growth figure even in good times. hoping it will reduce the upward pressure on its currency.growth will have slowed quickly to 7. China also has a growing crisis of unrest over job losses. the International Monetary Fund (IMF) warned that Africa’s economic growth will plummet because of the world economic downturn. With China concerned about its economy.1%. Japan. it has been trying to encourage its companies to invest more overseas. predicting growth in sub-Saharan Africa will slow to 1. In May 2009. unfortunately. may face some problems. however. may be short lived. These earlier hopes for Africa. Africa may yet enjoy increased trade for a while. Africa’s generally weak integration with the rest of the global economy may mean that many African countries will not be affected from the crisis. Japan’s industrial production fell by 10%. Both have poured billions into recovery packages. The wealthier ones who do have some exposure to the rest of the world. which has suffered its own crisis in the 1990s also faces trouble now. the biggest monthly drop since their records began. at least not initially. below the rate of 29 . However. China.5% in 2009. Japan is so exposed that in January alone. the Yuan. As the financial crisis is hitting the Western nations the hardest. While their banks seem more secure compared to their Western counterparts. as suggested by Reuters in September 2008. the speed at which it has dropped—the sharp slowdown—is what is concerning. Africa And The Financial Crisis Perhaps ironically. above. similarly has also experienced a sharp slowdown and its growth is expected to slow down to 8% (still a good growth figure in normal conditions). it is very dependent on exports. there has been more interest in Africa from Asian countries such as China.
alone. has entered into recession for the first time since 1992. Due to its proximity to the US and its close relationship via the NAFTA and other agreements. Many will likely remain skeptical of IMF loans given this past. Africa’s largest economy. as Stiglitz and others have already voiced concerns about (see further below). importantly with looser conditions.9%. which is important for a number of African countries. compared to a downgraded forecast of 3% for the rest of the region. (Effectiveness of aid is a separate issue which the previous link details.25% growth due to the the slump in commodity prices and the credit squeeze). for example). foreign aid. In the long run. is likely to diminish. due to a sharp decline in the key manufacturing and mining sectors. South Africa. As such Latin America will also feel the effect of the US financial crisis and slower growth in Latin America is expected.) Latin America And The Financial Crisis Much of Latin America depends on trade with the United States (which absorbs half of Latin America’s exports. it can be expected that foreign investment in Africa will reduce as the credit squeeze takes hold. Mexico is expected to have one of the lowest growth rates for the region next year at 1.population growth (revising downward a March 2009 prediction of 3. Furthermore. The IMF has promised more aid to the region. which in the past have been very detrimental to Africa. 30 .
many people. This includes the US. education. Borrowing at a time of recession seems risky. hopefully affording people a better chance to weather the economic storm. but the idea is that this should be complimented with paying back during times of growth. when banks need to build up their capital reserves. etc. reducing interest rates sounds like there would be less incentive for people to save money. Often. the Eurozone. Standard macroeconomic policy includes policies to Increase borrowing. Reduce interest rates. Reduce taxes. and many others. Likewise. At such times governments attempt to stimulate the economy. is palatable. because higher taxes during downturns means more hardship for more people. 31 . However. Tax reduction is something that most people favor. under free market ideals. Finally it is at this time that public infrastructure work. or are in it. However. increased borrowing is supposed to offset the reduction in taxes. which can potentially employ many. reduced interest rates is an attempt to encourage people to take part in the economy. as the real economy starts to feel the pinch. would be at risk. and yet during times of economic downturn it would seem that a reduction in tax would result in reduced government revenues just when they need it and then spending on health.GOVERNMENT MEASURES TAKEN TO CURB RECESSION: Dealing With Recession Most economic regions are now facing recession. and Spend on public works such as infrastructure.
various European countries. South Korea reduced its interest rates. infrastructure investments may not need to be as direct from government and private enterprise may be able to contribute. pragmatic and sensible adoption of market systems means governments can guide development and progress as required. 32 . However. taxes should increase again to offset the reduction in borrowing. For example. While these might be reasonably standard things to do. China. and most politically sensitive of all. most states realize that markets are not always able to function on their own (the current financial crisis. Many have looked to borrow billions or in some way come up with stimulus packages to try and kick-start ailing economies.government involvement in such activities is supposed to be minimal. UK and elsewhere was that interest rates were too low during good times). many governments have started to contemplate these kinds of measures. starting in the US. it requires that during economic good times. Even the other forms of “interference” is usually frowned upon. a reversal of some of these policies are required. being the prime example). Nonetheless. interest rates may need to increase (one reason for the housing booms in the US. and many others. England. borrowing should be reduced and debts should start to be repaid. as has Japan.
it is also higher as a percentage of GDP than Spain. At 11. schadenfreude and fear around the world. In the financial year just ended. he drama playing out in Greece has been watched with a mix of curiosity.5%. Some portray the UK as a country in fiscal crisis. Portugal and all other European Union countries except Greece and Ireland. have warned that the City is grossly underestimating the chance of a downgrade from the UK's current top-notch AAA status. The UK does not share all of Greece's economic challenges: above all. unable to decide what it wants out of the polls and headed for the debt downgrade spiral that has plunged Greece into street fighting and strikes.4bn. But fears around the so-called "peripheral" European nations have still raised the alarm over Britain's fiscal position – which by one measure at least is almost as bad as that of Greece. two London-based economists at BNP Paribas.THE UK DEBT CRISIS: Britain has a high deficit and is facing the prospect of a hung parliament. it has the benefit of its own currency and an independent central bank. limiting the rise in joblessness. the scrutiny of a nearby nation in dire straits has been particularly intense. as the markets brace for an indecisive election result and the country grapples with the biggest deficit in decades. But there are many differences between it and the crisis-hit southern European countries. public sector net borrowing – the gap between the exchequer's tax take and its spending – stood at £163. Others believe parallels with Athens are misguided: they point to Britain's long history of honouring its debts and previous success at swift deficit reduction measures such as in 1981 and the mid-1990s. In the UK. That was less than the government had feared but still the highest since the end of the second world war. Many economists warn that failure at this week's election to produce an outright winner will delay action to get Britain out of that troubled group. They warn that an 33 . excluding the cost of interventions to support the financial sector. Also working in its favour is the fact that it has a flexible economy. Alan Clarke and Paul Mortimer-Lee. as proven by employers' ability to tweak working hours and pay in the recession.
But they do not share fears of a downgrade spiral. they say.216." says Clarke.000. The Debt owed is more than £900 billion to investors at home and abroad. That is £1. That.000. could cost the taxpayer at least £10bn because of higher interest costs on government borrowing. Britain has grown accustomed to living beyond their means. Q: Why is Britain in so much debt? The UK's budget deficit As a country.000. "Many countries several notches below us are going along fine.undecided Britain is heading towards a coalition government that would create distractions from repairing the public finances – something that would raise the chance of a downgrade to almost 50%.800 in tax which is not a joke as it will cost and land up burning a hole in the pockets of the common man. To pay this year's £43 billion interest bill. This unprecedented level of public debt in peacetime has huge implications for Britain's economy and their future. National debt: The UK national debt clock is still ticking fast.043 billion by April 2011 and will hit £1. The money they can't 34 . every household will stump up more than£1.2 trillion just one year later. compared with a consensus estimate of 10% risk . The UK's national debt has become so astronomical that it's hard to make sense of it anymore. But in this economic climate it's never been more important to understand how the politicians spend their money and why they're running up huge debts on the behalf of the public. The Government's tax revenues are rarely enough to fulfill its generous spending promises. so every year Britain runs a large budget deficit. The Government says their debt hit £1. But it does mean we [would be] spending £10bn on interest payments that could otherwise be spent on schools and hospitals.
By the end of 2009-10 the annual deficit had ballooned to £170. Every year. the public finances had finally been brought under control.9 billion this year. the politicians have chosen to go on an unprecedented spending splurge. it would have long been declared bankrupt. even in the good times. 35 . the Government borrowed a monumental £170. If a company were run like this. the general public are the guarantee on the loan. we're set to borrow another £167. this budget deficit is added to the national debt.8 billion. Public finances out of control At the very time tax revenues were declining and a debt crisis is ravaging the global economy. To fund it. the budget was barely in surplus for more than a few years. Britain’s been maxing out a new credit card almost every year. This graph shows how the UK's budget deficit has fluctuated as a percentage of the country's economic output (GDP): As the graph shows. But after four years in office Gordon Brown took out the country's credit card and let rip.raise from taxation needs to be borrowed.8 billion last year. If all goes well. In 1997 Labour inherited a budget that was actually in balance. After a painful and turbulent decade under the Tories. and as taxpayers.
The term gilt is short for 'gilt-edged security' and is a reference to their perceived safety as an investment. These bonds are sold at regular auctions held by the UK Debt Management Office (DMO). The Government has never failed to make a repayment on a gilt. government deficit financing is similar to an illegal Ponzi scheme. Whom do they owe the money to??? The DMO publishes a quarterly report that shows who currently owns the UK's debt. known as 'gilts'. the Government guarantees to pay the holder a fixed interest payment every six months until the maturity date. summarized in the pie chart below: 36 . On average. on behalf of Her Majesty's Treasury. Q: Who do they borrow all this money from? The role of the bond market The British Government borrows money by selling bonds. The proceeds from a gilt sale are then spent by the Government and the value of the gilt is added to our national debt. the bonds that make up the national debt need to be repaid within 15 years. When run on this basis. at which point the full value of the bond is repaid. When a gilt is sold. interest on the national debt will cost over £42 billion this year. Currently Britain can only afford to make repayments by selling even more gilts. With government spending so far out of control.This kind of deficit is far greater than during the recessions of the 80s and early 90s and even higher than when Britain went cap in hand to the IMF in 1976.
Britain’s relying on the confidence of foreign investors to keep our own country afloat. printing money via the Bank of England's Quantitative Easing programme. or more recently. Currently just over 35% of their national debt is owed to foreign governments and investors. "How is national debt measured?" Measuring the national debt The precise term 'National Debt' refers to an older definition of public debt that excludes too many liabilities to be meaningful nowadays. The official government measure of what is commonly known as the national debt is Public Sector Net Debt. In their words. So it's not just Third World nations in hock to the rest of the world. In this context. such as bank deposits. 37 . Measuring Public Sector Net Debt (PSND) is the joint responsibility of the Office of National Statistics and HM Treasury. PSND "records most financial liabilities issued by the public sector less its holdings of liquid financial assets. public sector refers to central government." The debt is financed by the sale of government bonds. it's worth noting that the amounts held overseas have risen sharply since 2003. local government and publicly-owned corporations.Although the majority of gilts are held by British institutions.
As taxpayers. "What are they spending the money on?" Public spending in the UK today In 2009-10 the Government spent £671. Northern Rock and Bradford & Bingley account for £123 billion. Since taking office in 1997.Bank bailouts The Treasury have made some provision in their forecasts for the losses they are likely to make on the bank bailouts.5 billion of the national debt. Britain has pledged £781.2 billion in capital injections. That's the problem. If this wasn't bad enough. unrealised losses from financial sector interventions account for £134. the national debt will top 79% of GDP by 2014. the picture is going to get considerably worse. right there. PFI The Private Finance Initiative (PFI) is a form of commercial partnership between government and private companies to build and maintain public projects. The Office of National Statistics has classified the Royal Bank of Scotland and Lloyds as public corporations but hasn't yet included their liabilities in the national debt. PFI currently accounts for some £5 billion of net debt. The last time they borrowed this much money the freedom of the entire world was at stake in World War Two. we're on the hook for any losses. The spending is given as follows in billions of pounds: 38 . expect the results to be ugly. liability guarantees and liquidity support to the banking system. with a further £9 billion going to compensate depositors with the Dunfermline Building Society.4 billion of the money. Under current spending plans. although it is argued the true liabilities amount to significantly more. despite tax revenues of only £496.1 billion. Labour has made extensive use of PFI to fund infrastructure programmes. When they finally crunch the numbers. According to EU figures. As of April 2009.
6 5.5 127.4 2010-11 202.4 701.7 39 .2 125.2 42.5 99.7 30.4 5.6 13.4 27.7 30.1 25.2 38.4 6.6 14 9.(£ billions) Benefits and Pensions Health Education Debt interest Defence Local government Scotland Law and Order Wales Northern Ireland EU contributions Transport International aid Other departments Total government spending 2009-10 195.8 26.9 7.9 66.6 9.9 671.1 19.4 19.9 36.6 6.9 6.6 104 69.
reaching £42. especially when it fails to deliver improvements. Public spending is set to rise by £119 billion between 2008 and 2011. In other words. it's gone and can only be repaid with higher taxes. In his own terms. railways. where a nation's wealth is created. it confiscates its money from people in the form of tax. Investment in capital infrastructure like this is commonly associated with higher economic growth and output.9 billion.6 billion to maintain this year. When the cash is spent. Just 6% of this is associated with capital investment. child support and other benefits. plus unemployment. like any person or business. Instead. In 2010-11. The welfare budget includes pensions and tax credits. 40 . governments borrow and spend for two principal reasons: either to produce or to consume. The bottom line is that borrowing to fund this kind of expenditure won't pay for itself. It can help to facilitate trade and promote economic activity in the private sector. we're now failing on a scale never seen before. when government spends money productively it invests in things like roads. housing. The state doesn't earn anything. "Does it matter how government spends the money?" The impact of fiscal policy Politicians consider fiscal policy as if it were a business strategy for the country. Spending on health and education can also consume money. energy generation and communication networks. But Britain is doing just the opposite. However. Gordon Brown used to call escalating social security and debt interest payments the costs of failure. But government is nothing like a business. The most obvious form of government consumption is when the state transfers money to people in the form of pensions and benefits. When in opposition. council tax. Public investment Alternatively. which will cost the UK some£202. sickness. interest payments on the national debt will be the fourth biggest line in the budget. borrowing to produce can pay for itself.The public finances are dominated by the welfare state.
driving up the cost of borrowing in the process. This leaves the remaining 56%. the less they have to pay down debt or invest for the future.Another 38% is a result of higher social security bills during recession and the dead money of debt interest. High on debt and intoxicated by power. Last year national debt interest cost the taxpayer £27. There is now a long-term structural imbalance between what the government spends and how much money it raises in tax. This harms the ability of the private sector to create the wealth and jobs needed to get us out of recession. The more they borrow. Stifling of business Government borrowing increases the total demand for credit in the economy. "How will national debt affect the future?" The consequences of national debt The British Government has been on a decade-long borrowing binge. In 2010-11 that figure soars to a jawdropping £42. they have to borrow more just to stay afloat which is the reason the national debt is getting out of control. the bigger their interest payments get. stock and other capital goods in the private sector. the government needs to sell its bonds at attractive interest rates to entice investors away from alternatives.2 billion. Borrowing to consume means that once the money is spent. British government bonds pay interest for 15 years. A grip on public spending should be kept. This policy of never-ending budget deficit is unsustainable. To make matters worse. That interest is dead money. Higher taxes and spending cuts On average. which means higher taxes for years to come. This is known as the 41 . it's not showing any signs of stopping.9 billion. Higher borrowing costs make it more expensive to finance investment in equipment. The more they spend on interest. which the Government is willfully borrowing to fund yet more unproductive consumption.
we would be forced to make savage spending cuts to balance our budget. 42 . If a gilt auction fails Britain would be plunged into a full-blown economic crisis. On the other hand. If the market for gilts weakens. If we fail to get a grip on spending at that point and print even more money to cover the shortfall in gilt sales. their price also declines as a result. This means we pay more in interest for every penny we borrow. we may find ourselves in trouble much more quickly. we can always print money to buy our own bonds. gilt yields start to rise. the consequences for our country could be devastating. Economic and social breakdown could conceivably follow. If investors see their holdings devalued they'll be reluctant to buy gilts and may even start to sell. Overnight. meaning the major rating agencies believe we're still a good bet. Currency collapse Many of our biggest customers are pension funds and foreign central banks that only invest in the safest 'Triple-A' bonds. For the time-being Britain retains its AAA status.'crowding out' of private capital and means even less investment in business and real jobs. This gradual debauching of sterling raises the spectre of high inflation once the economy begins to recover. Everything from trade finance to mortgage payments would get more expensive. which is what the Bank of England is already doing with its so-called Quantitative Easing programme. High interest rates The Government relies on investors continuing to buy UK gilts to fund its spending habit. But if we lose their seal of approval and the big investors that come with it. If the bond market gets nervous about our excessive borrowing and the demand for gilts falls. suffocating our deeply unhealthy economy even further. extreme inflation and a potentially fatal sterling crisis would ensue. Because they now cost less to buy. sterling would plummet and we'd need an IMF bailout to stave off complete bankruptcy. sending interest rates spiraling upwards.
in sharp contrast to the Treasury's prediction of 1. or Gross Domestic Product (GDP). This allows for factors like inflation and also reflects a nation's ability to repay the money it owes. taxation and the country's economic performance. namely government spending plans. Many independent forecasters believe the Government's own economic predictions are far too rosy. Independent forecasters 43 . What's more.4% in 2010. If recession is more severe or lasts longer than anticipated. if the Government's GDP forecasts are wrong. The IMF forecasts the UK economy will shrink by another 0.25% growth. the national debt-to-GDP ratio rises. This graph shows the projected rise in Public Sector Net Debt as a percentage of GDP: Future national debt levels depend on the state of the public finances. Any spending that can't be supported by taxation needs to be funded through borrowing."Is the problem getting better or worse?" Forecasting national debt National debt is usually analyzed as a proportion of a country's economic output. their national debt forecasts are wrong too. tax revenues decline and we run up more debt to cover the shortfall. Therefore. if the economy performs more poorly than expected.
That might sound obvious.surveyed by the Treasury believe that by 2011 the UK's economy will be 3% smaller than the Government predicts. from 40% of GDP in 1997 to 80% in 2014. 2. Start being honest about what services the state can no longer afford to deliver. repayment is the solution. 3. New Labour will forever be remembered as the government that doubled the national debt. Stop demonising anyone who speaks out against our addiction to spending and waste. but our politicians haven't grasped it yet. The consequences of excess debt are misery and dishonour. so cutting it is the only sensible course of action. 44 . "What can one do to prevent a debt crisis?" Averting a debt crisis in Britain As complex as the national debt problem may be. If debt is the problem. These are just some of the simple steps Britain can take to maintain economic and social stability: 1. Ultimately this all boils down to one thing: the national debt is probably going to get a lot bigger than we think. Take back the moral high ground. the solutions call for nothing more than basic common sense. The Government needs to stop borrowing and spend less. 4. Public spending cannot be sustained at current levels. Get the public finances under control and balance the budget.
"There is not enough money. The chancellor said further steps would be taken to boost growth in his autumn statement next month." George Osborne agreed to King's request to be able to expand the asset purchase scheme under which the Bank buys government bonds from commercial banks. after Threadneedle Street responded to growing evidence of a looming double-dip recession and the deepening crisis in the eurozone with a four-month programme of electronic money creation. Dismissing concerns that the action risked adding to inflationary pressure. King said Britain was now facing a different problem from the days when too much money flowing round the economy pushed up the annual cost of living. if not ever. the Treasury is 45 . "Given evidence of continued impairment in the flow of credit to some parts of the real economy.CURRENT SCENARIO: Britain in grip of worst ever financial crisis. notably small and medium-sized businesses." he told Sky News. Shares rose strongly in the City. "But that's because this is the most serious financial crisis at least since the 1930s. The Bank's governor said the UK was suffering from a 1930s-style shortage of money and needed a second dose of quantitative easing to boost demand and prevent inflation falling too low. posting a rise of almost 200 points. That may seem unfamiliar to people. Bank of England governor fears (AS ON 6TH OCT 2011 as per the Guardian): £75bn more quantitative easing announced by Sir Mervyn King to boost demand in economy: Sir Mervyn King expressed fears that Britain is in the grip of the world's worst ever financial crisis after the Bank of England announced it was injecting £75bn into the ailing economy.
46 . but the mood has changed in response to poor domestic news and concerns that Europe's sovereign debt crisis risks a repeat of the mayhem three years ago following the bankruptcy of the US investment bank Lehman Brothers." Britain's first dose of quantitative easing. the shadow chancellor. had in part been caused by temporary factors. also known as QE1. These tensions in the world economy threaten the UK recovery." Some in the City were caught unawares by the scale and the timing of the Bank's move. especially in the United Kingdom's main export markets." The MPC said the slowdown in the UK economy. with £200bn being injected into the economy." Osborne said in a letter to the governor. voted for more QE. "The pace of global expansion has slackened. was in 2009/10. "Such interventions should complement the monetary policy committee's [MPC] asset purchases. But rather than change course the government has spent the last week urging the Bank of England to step in and essentially print more money. but added that there was also evidence that the underlying pace of activity had weakened. which saw no growth in the nine months to mid-2011. Last month. "Vulnerabilities associated with the indebtedness of some euro-area sovereigns and banks have resulted in severe strains in bank funding markets and financial markets more generally. Labour said the launch of QE2 was an admission that the government's economic policy had failed. Adam Posen. It said the squeeze on real incomes caused by inflation running well ahead of wage increases and the impact of Osborne's austerity programme were "likely to continue to weigh on domestic spending". said: "With our economy stagnated since last autumn David Cameron and George Osborne are now betting on a bailout from the Bank of England. only one of the nine members of the MPC.exploring further policy options. Ed Balls. The government's reckless policy of cutting spending and raising taxes too far and too fast is demonstrably not working." the MPC said in a statement explaining its decision.
said the decision to expand QE was the right one. quantitative easing is no economic magic wand. but thankfully it hasn't made the same mistake twice. Michael Saunders." 47 . with gross domestic product dropping by 7. said the deteriorating outlook for the economy would require the Bank to "do QE on a very big scale". Brendan Barber. the Bank will have bought a total of £275bn in assets from banks. He added: "We expect the cumulative total of QE (now heading to £275bn) will eventually reach £500bn or so.King admitted that inflation could breach 5% next month but said that would be the peak." Business leaders welcomed the move. It could be argued that the Bank of England was slow to introduce QE the first time." By the end of the four-month programme.1% in the biggest recession since the second world war. It may go even higher than that. but Threadneedle Street left the door ajar for a further expansion of QE2 should the economy not respond. Graeme Leach. but added: "While it is better than not doing anything. The TUC's general secretary. The news prompted alarm in Britain's pension funds. The flatlining of the economy since last autumn has left activity still 4. "We worry that it does more to help the finance sector than the rest of the economy and could fuel further inflation at a time when living standards are already being squeezed. UK economist at Citi. chief economist at the Institute of Directors. which are concerned that QE pushes down interest rates and reduces the return on their investments. said: "Near-zero GDP and money supply growth made a compelling case and the Bank of England was right to launch QE2. Analysts said the Bank was now clearly more concerned about the risks of recession than about the possibility of a rise in inflation. Figures released by the Office for National Statistics this week showed that the downturn of 2008/09 was even deeper than originally believed.4 percentage points below its 2008 peak. around 20% of GDP.
The Bank decided to restart its programme of quantitative easing in the face of growing fears of a double-dip recession exacerbated by the eurozone debt crisis. with retail prices predicted to hit 5 per cent within weeks. he pumps £75bn into economy Move seen as last-ditch bid to stave off new recession Interest rates held at record low of 0.5% Bank considered shock drop in interest rates to 0. The Bank’s governor pumped £75billion of new money into the flatlining economy. Hammer savers. Sir Mervyn expressed sympathy for savers but insisted he would not ‘push Britain into a recession’ just to help them. 48 . Further reduce annuity rates for pensioners. But Sir Mervyn King admitted there could be a severe price to pay.25% Household expenditure falls rapidly The fragile finances of families. saying the worst financial crisis in modern history demanded it. savers and pensioners suffered a huge blow yesterday when the Bank of England launched a desperate new bid to stave off recession. The move could: Force another spike in inflation.The Daily Mail reported as on 7th October 2011: A triple blow to squeezed middle: As Bank chief warns of worst-ever crisis. offering them little hope of a return on their investments.
‘I have enormous sympathy with the predicament that savers.945.’ Critics branded yesterday’s decision to print money ‘a Titanic disaster’ which will deepen the squeeze on those already hit by low savings returns. That is because this is the most serious financial crisis we have seen at least since the 1930s. currently 4. cannot easily get out of it. inflation.’ To add to the crisis.’ he added. The equivalent figure now would be £5. Annuity rates are woefully low. is set to climb higher. on its own. ‘But this is a situation where Britain. ‘We are doing it because there is not enough money in the economy.Had you cashed in a £100. Joanne Segars. if not ever. Now that may seem unfamiliar to people but it is unfamiliar. They are suffering from the consequences of an economic crisis which they did not cause or are responsible for. more than double the Government’s 2 per cent target. The only way to return to a situation with full employment.3 per cent this year.‘I would desperately like to get back to a world as soon as possible with normal levels of interest rates we need to encourage people to save. of the National Association of Pension Funds. face. said: ‘This is another kick in the ribs for many people who have worked all their lives and are trying to retire. up 14. steady growth and a balanced economy is to make sure other countries expand their spending. and particularly those who are retired.000 pension pot in 1990.5 per cent. you would have received an annual income of £16.’ The Bank blamed the crippling rise in energy bills. in our view. The Bank’s decision to pump more money into the economy is also almost guaranteed to drive annuity rates below even their current historic lows. is the peak and it will then start falling and. 49 . Sir Mervyn said: ‘In two weeks we will get another inflation number which may well go above 5 per cent but that.000. in the first few months of next year will fall quite rapidly so that the underlying inflationary pressures will disappear over the course of the next year.
has powered away from its target rate of 2 per cent and stood at 4. when the world faced global financial meltdown. 50 . used the phrase last year. could be described as a 'deflation nutter'. have made a significant contribution to price pressure. is the extreme view. CPI. has hovered around 5 per cent for the past two years – and the consumer prices index (CPI) measure has been close behind. at least. much to the annoyance of savers who have seen the real value of a £10. So what next? While the evidence is not conclusive. Today. The so-called ‘inflation nutters’ believe uncontrollable price pressure has already been unleashed.What next for inflation? The experts who fear a return of spiraling prices By ANDREW OXLADE The Bank of England’s obsession with stimulating the economy has set in motion a price rise spiral that will end in hyperinflation and wipe out British wealth. Posen. given his persistent attempts to persuade other MPC members to hold off on rate rises and vote for more stimulus. Inflation. That. it would be wise to assume that the Bank’s efforts to save the economy in 2009.1 per cent in September 2009.5 per cent in August. a member of the rate-setting monetary policy committee (MPC).000 cash fall to a little more than £9. as measured by the retail prices index (RPI). which hit a low of 1.000 in the past two years. Adam Posen. his wish came true with the committee voting to pump another £75billion of electronically created money into the system. in contrast.
Dr Sentance believes the MPC consensus is now ‘dominated’ by Sir Mervyn: ‘The MPC is no longer acting in line with keeping the 2 per cent target. There has been a global influence as fast-rising demand for raw materials in emerging markets has pushed up prices around the world. I’m sure they will come good eventually".’ Dr Sentance believes the Governor underwent a huge shift during the financial crisis. Then. This electronic form of money printing saw £200billion spent on buying government bonds. and the letter of response. has descended into ‘farce’. with desperation creeping in to policymaking. or gilts.The UK bank rate was pushed down and down between October 2008 and March 2009. a programme of quantitative easing was begun. until it reached 0.5 per cent. and cannot be persuaded to adapt his opinion even in the face of high inflation. Britain’s inflation problem is not entirely homegrown. He says the letter of explanation the Bank Governor Sir Mervyn King is compelled to send the Chancellor each time the target is breached. Another £75billion is now on the way . fearing long-term hardship for the economy with deflation as the biggest threat.the impact is unknown. by early 2010. 51 .' Speaking at the M&G Inflation Conference earlier this week. ‘The Chancellor’s response is basically "Even though your forecasts have been woefully wrong *on inflation+ over the last two years. It has used its discretion to redefine the inflation target framework. Dr Andrew Sentance. who left the MPC in May having failed to win the argument to raise rates to control inflation. accepts that argument but is concerned that the Bank has given up on its mandate of keeping CPI below 2 per cent.
has seen the biggest decline – of 25 per cent – since 'coming off the gold standard in the 1920s'. during the crisis.CPI and RPI (Source: Treasury) 52 . He would like to see the committee have more confidence in the economy. he does not forecast anything like the ‘horrors’ of 1920s Germany.He also blames the committee for ‘benign neglect’ of the pound which. While Dr Sentance says people should be concerned about inflation. Inflation projections for 2012 .
co.html#ixzz1a4Mq9o1F 54 .thisismoney.BIBLIOGRAPHY: http://www.org/wiki/Subprime_mortgage_crisis#Causes http://thecyberdaily.uk/business/2011/oct/06/britain-financial-crisisquantitative-easing http://www.com/news/mongolia-news/the-european-sovereigndebt-crisis-responses-to-the-financial-crisis-5382/ http://www.guardian.globalissues.pdf http://en.org/wiki/European_sovereign_debt_crisis#Causes http://www.com/2011/08/us-debt-crisis-2011-causes-panic/ http://en.com/uk-national-debt.uk/money/news/article-2045977/What-inflation-Theexperts-fear-hyperinflation.mckinsey.wikipedia.debtbombshell.org/article/768/global-financial-crisis http://www.mad-mongolia.co.wikipedia.html#ixzz1a4KW0q9L http://www.com/mgi/reports/freepass_pdfs/debt_and_deleveraging/d ebt_and_deleveraging_full_report.dailymail.co.htm http://www.uk/news/article-2045974/Debt-crisis-Bank-Englandinjects-75bn-economy-kick-start-recovery.
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