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The U.K.

Debt Crisis


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.


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

equal to 46% of GDP in UK and 36% in the US. In European countries, mortgage lending is lower but however across western Europe, it accounted for majority of growth in lending. In summary the breadth of the housing bubble was greater than its understood and should be monitored closely. DEBT AND LEVERAGE WITHIN HOUSEHOLDS, BUSINESS AND GOVERNMENT SECTORS: The aggregate measure of debt relative to GDP is not the only indicator of GDP. Using more granular measures, one observes that households became significantly more leveraged in many countries, while most of the corporations and the governments entered the crisis within stable or even declining levels of leverage. However total debt is rarely spread evenly within the sectors and that average levels of sector leverage mask pockets of highly leveraged borrowers. It was these borrowers in each of the sectors that got into trouble and caused most of the credit losses in the crisis. 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. Although US household debt grew significantly to 96% of their GDP by 2008, UK and Swiss households had even larger amounts of debts at 102% and 121% of their GDP respectively. Canadian households also reached higher levels of debt to GDP in recent years. Exceptions were the households in Japan and Germany which had declining levels of debt relative to their GDP.

Within the household sector, there are some pockets of very highly leveraged borrowers. In the United States, contrary to conventional wisdom, the greatest increase in leverage occurred among the middle incomed households, not the poorest. 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, or no down payments or poor documentation of income not low income households buying a house for the first time. In Spain by contrast, leverage increased mostly among the poorer households. The Corporate Sector entered the crisis with stable or declining levels of leverage, with 2 exceptions: Leverage ratio of nonfinancial business, measured as debt to book equity, were stable or declining in most countries in the years prior to the crisis, as businesses enjoyed higher profits and booming equity markets . However 2 exceptions stand out- commercial real estate and companies acquired in the recent years through leveraged buy outs. The commercial real estate sector, with its preponderance of fixed assets, has traditionally employed more leverage than the rest of the corporate sector. This increased to even higher levels before the crisis as underwriting standards were relaxed, commercial properties rose rapidly and interest rates remained low.

Rapid appreciation in the prices of commercial property, just like residential property, has been the heart of many financial crises. There is a definite relation between real estate booms and banking crises. Several factors account for this empirical regularity. First is the positive feedback between asset values and credit availability through mechanisms such as loan-to-value ratios. In addition, commercial real estate lending takes place with only limited disclosure available on the businesses of real estate developers, most of which are private companies. Third, long lead times in real estate can result in big price shifts when there is a change in demand. Finally real estate developers have an asymmetric pay-off due to limited liability, with large potential profits if the project succeeds with losses in case are borne by borne by banks and other investors. Companies brought through leverage buy-outs are another exception to the pattern of stable leverage in the overall corporate sector. As private equity industry attracted new investors, the number and the size of buyout deals rose as did the leveraged employed in the deals. 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. In the US, for example, even with extra borrowing to pay for wars in Iraq and Afghanistan, strong economic growth during the period caused the ratio of government debt to GDP fall by about 2% a year. Government debt relative to GDP also slightly fell in countries like Italy, Spain and Switzerland and rose slightly in Canada, France, Germany and the UK. While governments could have done more to reduce debt during booming years, it is fortunate that most entered the crisis with ample room to expand public spending, as they have done since. Causes The crisis can be attributed to a number of factors pervasive in both housing and credit markets, factors which emerged over a number of years. Causes proposed include the inability of homeowners to make their mortgage payments (due primarily to adjustable-rate mortgages resetting, borrowers

overextending, predatory lending, and speculation), overbuilding during the boom period, risky mortgage products, high personal and corporate debt levels, financial products that distributed and perhaps concealed the risk of mortgage default, bad monetary and housing policies, international trade imbalances, and inappropriate government regulation. In its "Declaration of the Summit on Financial Markets and the World Economy," dated 15 November 2008, leaders of the Group of 20 cited the following causes: During a period of strong global growth, growing capital flows, and prolonged stability earlier this decade, market participants sought higher yields without an adequate appreciation of the risks and failed to exercise proper due diligence. At the same time, weak underwriting standards, unsound risk management practices, increasingly complex and opaque financial products, and consequent excessive leverage combined to create vulnerabilities in the system. Policymakers, regulators and supervisors, in some advanced countries, did not adequately appreciate and address the risks building up in financial markets, keep pace with financial innovation, or take into account the systemic ramifications of domestic regulatory actions. During May 2010, Warren Buffett and Paul Volcker separately described questionable assumptions or judgments underlying the U.S. financial and economic system that contributed to the crisis. These assumptions included: 1) Housing prices would not fall dramatically; 2) Free and open financial markets supported by sophisticated financial engineering would most effectively support market efficiency and stability, directing funds to the most profitable and productive uses; 3) Concepts embedded in mathematics and physics could be directly adapted to markets, in the form of various financial models used to evaluate credit risk; 4) Economic imbalances, such as large trade deficits and low savings rates indicative of over-consumption, were sustainable; and 5) Stronger regulation of the shadow banking system and derivatives markets was not needed.

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, fueling a housing market boom and encouraging debt-financed consumption.[46] The USA home ownership rate increased from 64% in 1994 (about where it had been since 1980) to an all-time high of 69.2% in 2004.[47] Subprime lending was a major contributor to this increase in home ownership rates and in the overall demand for housing, which drove prices higher. B) Homeowner speculation: Speculative borrowing in residential real estate has been cited as a contributing factor to the subprime mortgage crisis. During 2006, 22% of homes purchased (1.65 million units) were for investment purposes, with an additional 14% (1.07 million units) purchased as vacation homes. During 2005, these figures were 28% and 12%, respectively. In other words, a record level of nearly 40% of homes purchases were not intended as primary residences. David Lereah, NAR's chief economist at the time, stated that the 2006 decline in investment buying was expected: "Speculators left the market in 2006, which caused investment sales to fall much faster than the primary market." C) High-risk mortgage loans and lending/borrowing practices

In the years before the crisis, the behavior of lenders changed dramatically. Lenders offered more and more loans to higher-risk borrowers, including undocumented immigrants. Subprime mortgages amounted to $35 billion (5% of total originations) in 1994, 9% in 1996, $160 billion (13%) in 1999, and $600 billion (20%) in 2006.


D) Inaccurate Credit Ratings:

Critics allege that the rating agencies suffered from conflicts of interest, as they were paid by investment banks and other firms that organize and sell structured securities to investors. E) Policies of central banks: Central banks manage monetary policy and may target the rate of inflation. They have some authority over commercial banks and possibly other financial institutions. They are less concerned with avoiding asset price bubbles, such as the housing bubble and dot-com bubble. Central banks have generally chosen to react after such bubbles burst so as to minimize collateral damage to the economy, rather than trying to prevent or stop the bubble itself


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. This process is designed to perpetuate itself thanks to a diabolical mechanism whereby debt replicates itself on an ever greater scale, a cycle that can be broken only by canceling the debt. 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, 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.


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, e.g. the Japanese Yen, the American Dollar, etc.)

Poor countries have soft currencies (values which can fluctuate). Debt crises can also occur just by the value of the developing countrys money going down, which can be due to a variety of other inter-related factors.

Paying off loans implies earning foreign exchange in hard currencies. Combined with falling export prices for many poor countries, debts become even harder to pay off.

Refinancing loans implies taking on new debts to service the old ones. Structural adjustment advice in the past from the IMF and others, has led to the cut back on important spending such as health, education, in order to help repay loans. This has implied a downward spiral and further poverty.

D) The Worlds 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). These moneys are often placed in foreign banks (and used to loan back to the developing countries). Many loans also come with conditions, that include preferential exports etc. In effect then, more money comes out of the developing countries than is given in. This

depresses wages even further due to the spiraling circle downwards to ensure that enough exports are produced. E) Backbone To Globalization: The economic decisions and influence in various international agreements, treaties and institutions by the wealthy and powerful nations also help form the backbone of todays globalization. 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. The policies of those who have the power and influence have been successful to help raise standards for some in their own nations, but at a terrible cost. Rich nations as well as poor incur debts, 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.



THE ADVENT OF THE GLOBAL FINANCIAL CRISIS COUPLED WITH GREECES PUBLIC DEBT ADMISSIONIN OCTOBER 2009 SPARKED DISMAY THROUGHGLOBAL MARKETS AS THE FULL EXTENT OF EUROZONE DEBT LEVELS WERE UNVEILED. ACCORDING TO THE ECONOMIST, GREECES BUDGET DEFICIT REACHED 15.4%,IRELANDS WAS 14.3%, SPAIN 11.2%, ITALY 5.3% AND PORTUGAL AT 9.3% OF GDP IN 2009. The European Union (EU) has rescued Greece and Ireland, and most recently Portugal has admitted its need for a similar rescue loan. Perhaps other wrecked countries will need to be helped at a later date. All three countries, Greece, Ireland and Portugal are economically small; Greece the biggest, makes up only around 2.5% of euro-area GDP. However, Portugals recent capitulation to EU authority has awakened fears that the debt contagion could spread to Spain, making the debt crisis far more serious. These preceding events and the scope of Spains own debt have raised shiver and panic in markets. This policy brief will attempt to ascertain the origins of the crisis, enumerate European and international responses, draw attention to possible alternatives to implemented policies, and finally explore the broader implications for Europe, the United States and the rest of the world.

I. 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. Reacting in a similar manner, Eurozone nations faced their own strand of fiscal distress due to heavy borrowing practices, property bubbles and living above their means. The accessibility to easy credit led to an overreliance on external credit sources to fund domestic debt. Additionally, the commercial and financial interdependence Europe developed with foreign nations made it more vulnerable


to economic volatility; resulting in a domino effect when crisis occurs in other parts of the world. Acknowledging the inherent hazards and risks of crises emerging due to the common currency; 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. The pact sought to ensure member states maintained budget discipline in order to diminish systemic risk and encourage monetary stability. In addition, the pact required greater coordination of monetary and economic policies from members of the monetary union, lowering a degree of national sovereignty and clout for certain member states.


Before the spread of the global financial crisis, Greece borrowed heavily from abroad to fund its large budget and current account deficit. The roots of Greeces fiscal calamity lie in prolonged deficit spending, economic mismanagement, government misreporting, and tax evasion. When pressed on where Greece had gone wrong, Prime Minister George Papandreou answered: Corruption, cronyism, clientalistic politics; a lot of money was wasted basically through these types of practices. Beginning with the adoption of the Euro in 2001, Greeces budget deficit averaged 5% per year until 2008, compared to a Eurozone average of 2% and its current account deficits averaged 9% per year, compared to a Eurozone average of 1%. In 2009, Greeces budget deficit was estimated to have been 13.6% of GDP. However, a reevaluation of Greeces balance sheets in the latter part of 2009 revealed Greeces budget deficit was in reality closer to 15.4% of GDP. 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.



Once hailed as the Celtic Tiger, Irelands economy performed exceptionally well due to a successful financial services industry and robust property market. Yet, 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, banks and the government. The Irish republic became the first Eurozone country to fall into recession in 2008. Over 2008-2009 its output decreased by 10%, and unemployment increased from 4.5% in 2007 to nearly 13% in March 2010. When the crisis hit in 2009, general government deficit was estimated at 14.5% percent of GDP. Unlike Greece, Irelands fiscal shortfall was incurred due to the escalating cost of propping up its undercapitalized banks. In response, the Irish government implemented a series of consolidation measures to help contain the deficit below 12% in 2010. In late November of 2010, Ireland formally sought support from the IMF and EU, and agreed to an 80 billion bailout that required the drafting of a new budget. Irelands new budget is a four-year plan that slashes $20 billion via spending cuts and new taxes; these cuts include extensive unemployment benefits and welfare payment deductions.


Portugals adoption of the euro originally resulted in an economic boom, yet increased its susceptibility to the banking systems volatile performance. The global financial crisis worsened these pre-existing and homegrown problems. After Irelands bailout, speculation quickly arose that Portugal would require a bailout as it shared some of the symptoms of Greece and Ireland. The governments repeated fiscal adjustments became increasingly difficult as they were met with strong political opposition. Moreover, on March 23rd, Portugals Prime Minister Jose Socrates resigned after failing to win support for the fourth austerity package in a year. Markets responded by slashing Portugals credit rating to near-junk status on March 29th, 2011 while ten-year bond yields rose above 8%. On April 6th, Portugals prime minister admitted that his country needed a rescue loan from the EU. The government has yet defined the amount or conditions of

this aid. Portugal now joins Greece and Ireland in the Eurozones sovereign-debt crisis. Portugals public debt levels are significantly lower than Greece, and its banking industry is comparatively more stable than that of Ireland. Rescue funds are enough to cope with Portugals situation, the fear however is that confidence in neighboring Spain will be shaken.


After 15 years of strong growth led by a housing boom, Spain was hit hard by the global financial crisis. Its output fell sharply driven by sharp declines in investment, exports, and private consumption, while weaker imports and rising government demand provided some offset. Moreover, Spains unemployment rate skyrocketed, reaching 20%. The government deficit declined from a surplus of 2 % of GDP in 2007 to a deficit of 11.2% of GDP in 2009, due to the large stimulus and evaporating cyclical and one-off revenues. Spain shares several of the weaknesses of the three fallen economies. The country has lost its competitiveness, and it has large current account deficit similar to Greece and Portugal. Spanish bond yields are narrowing, and are continuing to fall as of April 6th 2011. Prime Minister Jose Luis Rodriguez Zapateros recent decision not to seek re-election will likely add greater uncertainty to Spains already dubious fiscal future.


Confidence, trade and credit were quickly shaken due to the global financial crisis in Italy and a global reduction in demand reduced Italys exports, contracting Italys private consumption, and output. The countrys unemployment rate continues to be the lowest among the PIIGS nations. However, fear of unfavorable market reactions has limited Italys ability to use fiscal policy to stimulate its economy. The overall public debt increased to about 122.14% of GDP by 2010.



The global financial crisis, brewing for a while, really started to show its effects in the middle of 2007 and into 2008. Around the world stock markets have fallen, large financial institutions have collapsed or been bought out, and governments in even the wealthiest nations have had to come up with rescue packages to bail out their financial systems. 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, a global financial meltdown will affect the livelihoods of almost everyone in an increasingly inter-connected world. The problem could have been avoided, if ideologues supporting the current economics models werent so vocal, influential and inconsiderate of others viewpoints and concerns.

A Crisis So Severe, The World Financial System Is Affected Following a period of economic boom, a financial bubbleglobal in scopehas now burst. 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. Furthermore, other weaknesses in the global financial system have surfaced. Some financial products and instruments have become so complex and twisted, that as things start to unravel, trust in the whole system started to fail.


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, thus off-loading risky loans onto others. (For banks, millions can be made in money-earning loans, but they are tied up for decades. So they were turned into securities. The security buyer gets regular payments from all those mortgages; the banker off loads the risk. Securitization was seen as perhaps the greatest financial innovation in the 20th century.) As BBCs former economic editor and presenter, Evan Davies noted in a documentary called The City Uncovered with Evan Davis: Banks and How to Break Them (January 14, 2008), rating agencies were paid to rate these products (risking a conflict of interest) and invariably got good ratings, encouraging people to take them up. Starting in Wall Street, others followed quickly. With soaring profits, all wanted in, even if it went beyond their area of expertise. For example,

Banks borrowed even more money to lend out so they could create more securitization. Some banks didnt need to rely on savers as much then, as long as they could borrow from other banks and sell those loans on as securities; bad loans would be the problem of whoever bought the securities. Some investment banks like Lehman Brothers got into mortgages, buying them in order to securitize them and then sell them on. Some banks loaned even more to have an excuse to securitize those loans. Running out of who to loan to, banks turned to the poor; the subprime, the riskier loans. Rising house prices led lenders to think it wasnt too risky; bad loans meant repossessing high-valued property. Subprime and selfcertified loans (sometimes dubbed liars loans) became popular, especially in the US. Some banks evens started to buy securities from others.

Collateralized Debt Obligations, or CDOs, (even more complex forms of securitization) spread the risk but were very complicated and often hid the bad loans. While things were good, no-one wanted bad news. Side Note

High street banks got into a form of investment banking, buying, selling and trading risk. Investment banks, not content with buying, selling and trading risk, got into home loans, mortgages, etc without the right controls and management. Many banks were taking on huge risks increasing their exposure to problems. Perhaps it was ironic, as Evan Davies observed, that a financial instrument to reduce risk and help lend moresecuritieswould backfire so much. When people did eventually start to see problems, confidence fell quickly. Lending slowed, in some cases ceased for a while and even now, there is a crisis of confidence. Some investment banks were sitting on the riskiest loans that other investors did not want. Assets were plummeting in value so lenders wanted to take their money back. But some investment banks had little in deposits; no secure retail funding, so some collapsed quickly and dramatically. The problem was so large, banks even with large capital reserves ran out, so they had to turn to governments for bail out. New capital was injected into banks to, in effect, allowthem to lose more money without going bust. That still wasnt enough and confidence was not restored. (Some think it may take years for confidence to return.) Shrinking banks suck money out of the economy as they try to build their capital and are nervous about loaning. Meanwhile businesses and individuals that rely on credit find it harder to get. A spiral of problems result. As Evan Davies described it, banks had somehow taken what seemed to be a magic bullet of securitization and fired it on themselves. Creating More Risk By Trying To Manage Risk Securitization was an attempt at managing risk. There have been a number of attempts to mitigate risk, or insure against problems. While these are legitimate

things to do, the instruments that allowed this to happen helped cause the current problems, too. In essence, what had happened was that banks, 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. As they initially made more money taking more risks, they reinforced their own view that they had it figured out. They thought they had spread all their risks effectively and yet when it really went wrong, it all went wrong. In a follow-up documentary, Davis interviewed Naseem Taleb, once an options trader himself, who argued that many hedge fund managers and bankers fool themselves into thinking they are safe and on high ground. It was a result of a system heavily grounded in bad theories, bad statistics, misunderstanding of probability and, ultimately, greed, he said What allowed this to happen? As Davis explained, a look for way to manage, or insure against, risk actually led to the rise of instruments that accelerated problems: Derivatives, financial futures, credit default swaps, and related instruments came out of the turmoil from the 1970s. The oil shock, the double-digit inflation in the US, and a drop of 50% in the US stock market made businesses look harder for ways to manage risk and insure themselves more effectively. The finance industry flourished as more people started looking into how to insure against the downsides when investing in something. To find out how to price this insurance, economists came up with options, a derivative that gives you the right to buy something in the future at a price agreed now. Mathematical and economic geniuses believed they had come up with a formula of how to price an option, the Black-Scholes model. This was a hit; once options could be priced, it became easier to trade. A whole new market in risk was born. Combined with the growth of telecoms and computing, the derivatives market exploded making buying and selling of risk on the open market possible in ways never seen before.

As people became successful quickly, they used derivatives not to reduce their risk, but to take on more risk to make more money. Greed started to kick in. Businesses started to go into areas that was not necessarily part of their underlying business. In effect, people were making more bets speculating. Or gambling. Hedge funds, credit default swaps, can be legitimate instruments when trying to insure against whether someone will default or not, but the problem came about when the market became more speculative in nature. Some institutions were paying for risk on margin so you didnt have to lay down the actual full values in advance, allowing people to make big profits (and big losses) with little capital. As Nick Leeson (of the famous Barings Bank collapse) explained in the same documentary, each loss resulted in more betting and more risk taking hoping to recoup the earlier losses, much like gambling. Derivatives caused the destruction of that bank. Hedge funds have received a lot of criticism for betting on things going badly. In the recent crisis they were criticized for shorting on banks, driving down their prices. Some countries temporarily banned shorting on banks. In some regards, hedge funds may have been signaling an underlying weakness with banks, which were encouraging borrowing beyond peoples means. On the other hand the more it continued the more they could profit. The market for credit default swaps market (a derivative on insurance on when a business defaults), for example, was enormous, exceeding the entire world economic output of $50 trillion by summer 2008. It was also poorly regulated. The worlds largest insurance and financial services company, AIG alone had credit default swaps of around $400 billion at that time. A lot of exposure with little regulation. Furthermore, many of AIGs credit default swaps were on mortgages, which of course went downhill, and so did AIG. The trade in these swaps created a whole web of interlinked dependencies; a chain only as strong as the weakest link. Any problem, such as risk or actual

significant loss could spread quickly. Hence the eventual bailout (now some $150bn) of AIG by the US government to prevent them failing. Derivatives didnt cause this financial meltdown but they did accelerate it once the subprime mortgage collapsed, because of the interlinked investments. Derivatives revolutionized the financial markets and will likely be here to stay because there is such a demand for insurance and mitigating risk. The challenge now, Davis summarized, is to reign in the wilder excesses of derivatives to avoid those incredibly expensive disasters and prevent more AIGs happening. This will be very hard to do. Despite the benefits of a market system, as all have admitted for many years, it is far from perfect. Amongst other things, experts such as economists and psychologists say that markets suffer from a few human frailties, such as confirmation bias (always looking for facts that support your view, rather than just facts) and superiority bias (the belief that one is better than the others, or better than the average and can make good decisions all the time). Trying to reign in these facets of human nature seems like a tall order and in the meanwhile the costs are skyrocketing. The Scale Of The Crisis: Trillions In Taxpayer Bailouts The extent of the problems has been so severe that some of the worlds largest financial institutions have collapsed. Others have been bought out by their competition at low prices and in other cases, 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. The total amounts that governments have spent on bailouts have skyrocketed. From a world credit loss of $2.8 trillion in October 2009, US taxpayers alone will spend some $9.7 trillion in bailout packages and plans, according to Bloomberg. $14.5 trillion, or 33%, of the value of the worlds companies has been wiped out by this crisis. The UK and other European countries have also spent some $2 trillion on rescues and bailout packages. More is expected.


A Crisis So Severe, The Rest Suffer Too Because of the critical role banks play in the current market system, when the larger banks show signs of crisis, it is not just the wealthy that suffer, but potentially everyone. With a globalized system, a credit crunch can ripple through the entire (real) economy very quickly turning a global financial crisis into a global economic crisis.


For example, 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, or make it more difficult and expensive to obtain. In the wider economy, this credit crunch and higher costs of borrowing will affect many sectors, leading to job cuts. People may find their mortgages harder to pay, or remortgaging could become expensive. For any recent home buyers, 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, more businesses will struggle to survive leading to further further job losses. 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, institutions and ideologues that pushed for the policies that caused the problems are found. The crisis became so severe that after the failure and buyouts of major institutions, the Bush Administration offered a $700 billion bailout plan for the US financial system. This bailout package was controversial because it was unpopular with the public, seen as a bailout for the culprits while the ordinary person would be left to pay for their folly. The US House of Representatives initial rejected the package as a result, sending shock waves around the world. It took a second attempt to pass the plan, but with add-ons to the bill to get the additional congressmen and women to accept the plan. In Europe, starting with Britain, a number of nations decided to nationalize, or part-nationalize, some failing banks to try and restore confidence. The US resisted this approach at first, as it goes against the rigid free market view the US has taken for a few decades now. Eventually, the US capitulated and the Bush Administration announced that the US government would buy shares in troubled banks.

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, which could be part of a deeper root cause of the problem). Perhaps fearing an ideological backlash, Bush was quick to say that buying stakes in banks is not intended to take over the free market, but to preserve it. While the US move was eventually welcomed by many, others echo Stiglitzs concern above. For example, former Assistant Secretary of the Treasury Department in the Reagan administration and a former associate editor of the Wall Street Journal, Paul Craig Roberts also argues that the bailout should have been to help people with failing mortgages, not banks: The problem, according to the government, is the defaulting mortgages, so the money should be directed at refinancing the mortgages and paying off the foreclosed ones. And that would restore the value of the mortgage-backed securities that are threatening the financial institutions *and+ the crisis would be over. So theres no connection between the governments explanation of the crisis and its solution to the crisis. Despite the large $700 billion US plan, banks have still been reluctant to lend. This led to the US Fed announcing another $800 billion stimulus package at the end of November. About $600bn is marked to buy up mortgage-backed securities while $200bn will be aimed at unfreezing the consumer credit market. This also reflects how the crisis has spread from the financial markets to the real economy and consumer spending. By February 2009, according to Bloomberg, the total US bailout is $9.7 trillion. Enough to pay off more than 90 percent of Americas home mortgages (although this bailout barely helps homeowners). Europe And The Financial Crisis In Europe, a number of major financial institutions failed. Others needed rescuing.


In Iceland, where the economy was very dependent on the finance sector, economic problems have hit them hard. 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, public dissatisfaction at the way the government was handling the crisis meant the Iceland government fell. A number of European countries have attempted different measures (as they seemed to have failed to come up with a united response). For example, some nations have stepped in to nationalize or in some way attempt to provide assurance for people. This may include guaranteeing 100% of peoples savings or helping broker deals between large banks to ensure there isnt a failure. The EU is also considering spending increases and tax cuts said to be worth 200bn over two years. The plan is supposed to help restore consumer and business confidence, shore up employment, getting the banks lending again, and promoting green technologies. Russiaa economy is contracting sharply with many more feared to slide into poverty. One of Russias key exports, oil, was a reason for a recent boom, but falling prices have had a big impact and investors are withdrawing from the country. The Financial Crisis And The Developing World For the developing world, 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. High fuel costs, soaring commodity prices together with fears of global recession are worrying many developing country analysts. Summarizing a United Nations Conference on Trade and Development report, the Third World Network notes the impacts the crisis could have around the world, especially on developing countries that are dependent on commodities for import or export:


Uncertainty and instability in international financial, currency and commodity markets, coupled with doubts about the direction of monetary policy in some major developed countries, are contributing to a gloomy outlook for the world economy and could present considerable risks for the developing world, the UN Conference on Trade and Development (UNCTAD) reports. Commodity-dependent economies are exposed to considerable external shocks stemming from price booms and busts in international commodity markets. Asia And The Financial Crisis Countries in Asia are increasingly worried about what is happening in the West. A number of nations urged the US to provide meaningful assurances and bailout packages for the US economy, as that would have a knock-on effect of reassuring foreign investors and helping ease concerns in other parts of the world. Many believed Asia was sufficiently decoupled from the Western financial systems. Asia has not had a subprime mortgage crisis like many nations in the West have, for example. Many Asian nations have witnessed rapid growth and wealth creation in recent years. This lead to enormous investment in Western countries. In addition, there was increased foreign investment in Asia, mostly from the West. However, this crisis has shown that in an increasingly inter-connected world means there are always knock-on effects and as a result, Asia has had more exposure to problems stemming from the West. Many Asian countries have seen their stock markets suffer and currency values going on a downward trend. Asian products and services are also global, 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. India and China are the among the worlds fastest growing nations and after Japan, are the largest economies in Asia. From 2007 to 2008 Indias economy grew by a whopping 9%. Much of it is fueled by its domestic market. However, even that has not been enough to shield it from the effect of the global financial crisis, and it is expected that in data will show that by March 2009 that Indias

growth will have slowed quickly to 7.1%. Although this is a very impressive growth figure even in good times, the speed at which it has droppedthe sharp slowdownis what is concerning. China, 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). However, China also has a growing crisis of unrest over job losses. Both have poured billions into recovery packages. With China concerned about its economy, it has been trying to encourage its companies to invest more overseas, hoping it will reduce the upward pressure on its currency, the Yuan. Japan, which has suffered its own crisis in the 1990s also faces trouble now. While their banks seem more secure compared to their Western counterparts, it is very dependent on exports. Japan is so exposed that in January alone, Japans industrial production fell by 10%, the biggest monthly drop since their records began. Africa And The Financial Crisis Perhaps ironically, Africas generally weak integration with the rest of the global economy may mean that many African countries will not be affected from the crisis, at least not initially, as suggested by Reuters in September 2008. The wealthier ones who do have some exposure to the rest of the world, however, may face some problems. In recent years, there has been more interest in Africa from Asian countries such as China. As the financial crisis is hitting the Western nations the hardest, Africa may yet enjoy increased trade for a while. These earlier hopes for Africa, above, may be short lived, unfortunately. In May 2009, the International Monetary Fund (IMF) warned that Africas economic growth will plummet because of the world economic downturn, predicting growth in sub-Saharan Africa will slow to 1.5% in 2009, below the rate of

population growth (revising downward a March 2009 prediction of 3.25% growth due to the the slump in commodity prices and the credit squeeze). South Africa, Africas largest economy, has entered into recession for the first time since 1992, due to a sharp decline in the key manufacturing and mining sectors. The IMF has promised more aid to the region, importantly with looser conditions, which in the past have been very detrimental to Africa. Many will likely remain skeptical of IMF loans given this past, as Stiglitz and others have already voiced concerns about (see further below). In the long run, it can be expected that foreign investment in Africa will reduce as the credit squeeze takes hold. Furthermore, foreign aid, which is important for a number of African countries, is likely to diminish. (Effectiveness of aid is a separate issue which the previous link details.) Latin America And The Financial Crisis Much of Latin America depends on trade with the United States (which absorbs half of Latin Americas exports, alone, for example). As such Latin America will also feel the effect of the US financial crisis and slower growth in Latin America is expected. Due to its proximity to the US and its close relationship via the NAFTA and other agreements, Mexico is expected to have one of the lowest growth rates for the region next year at 1.9%, compared to a downgraded forecast of 3% for the rest of the region.



Dealing With Recession Most economic regions are now facing recession, or are in it. This includes the US, the Eurozone, and many others. At such times governments attempt to stimulate the economy. Standard macroeconomic policy includes policies to

Increase borrowing, Reduce interest rates, Reduce taxes, and Spend on public works such as infrastructure.

Borrowing at a time of recession seems risky, but the idea is that this should be complimented with paying back during times of growth. Likewise, reducing interest rates sounds like there would be less incentive for people to save money, when banks need to build up their capital reserves. However, as the real economy starts to feel the pinch, reduced interest rates is an attempt to encourage people to take part in the economy. Tax reduction is something that most people favor, 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, education, etc, would be at risk. However, because higher taxes during downturns means more hardship for more people, increased borrowing is supposed to offset the reduction in taxes, hopefully affording people a better chance to weather the economic storm. Finally it is at this time that public infrastructure work, which can potentially employ many, many people, is palatable. Often, under free market ideals,

government involvement in such activities is supposed to be minimal. Even the other forms of interference is usually frowned upon. However, most states realize that markets are not always able to function on their own (the current financial crisis, starting in the US, being the prime example); pragmatic and sensible adoption of market systems means governments can guide development and progress as required. Nonetheless, many governments have started to contemplate these kinds of measures. For example, South Korea reduced its interest rates, as has Japan, China, England, various European countries, and many others. Many have looked to borrow billions or in some way come up with stimulus packages to try and kick-start ailing economies. While these might be reasonably standard things to do, it requires that during economic good times, a reversal of some of these policies are required; interest rates may need to increase (one reason for the housing booms in the US, UK and elsewhere was that interest rates were too low during good times), borrowing should be reduced and debts should start to be repaid, infrastructure investments may not need to be as direct from government and private enterprise may be able to contribute, and most politically sensitive of all, taxes should increase again to offset the reduction in borrowing.



Britain has a high deficit and is facing the prospect of a hung parliament. But there are many differences between it and the crisis-hit southern European countries. he drama playing out in Greece has been watched with a mix of curiosity, schadenfreude and fear around the world. In the UK, as the markets brace for an indecisive election result and the country grapples with the biggest deficit in decades, the scrutiny of a nearby nation in dire straits has been particularly intense. Some portray the UK as a country in fiscal crisis, 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. 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. The UK does not share all of Greece's economic challenges: above all, it has the benefit of its own currency and an independent central bank. Also working in its favour is the fact that it has a flexible economy, as proven by employers' ability to tweak working hours and pay in the recession, limiting the rise in joblessness. 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. In the financial year just ended, excluding the cost of interventions to support the financial sector, public sector net borrowing the gap between the exchequer's tax take and its spending stood at 163.4bn. That was less than the government had feared but still the highest since the end of the second world war. At 11.5%, it is also higher as a percentage of GDP than Spain, Portugal and all other European Union countries except Greece and Ireland. 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. Alan Clarke and Paul Mortimer-Lee, two London-based economists at BNP Paribas, have warned that the City is grossly underestimating the chance of a downgrade from the UK's current top-notch AAA status. They warn that an

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%, compared with a consensus estimate of 10% risk . That, they say, could cost the taxpayer at least 10bn because of higher interest costs on government borrowing. But they do not share fears of a downgrade spiral. "Many countries several notches below us are going along fine. But it does mean we [would be] spending 10bn on interest payments that could otherwise be spent on schools and hospitals," says Clarke. National debt: The UK national debt clock is still ticking fast. The Debt owed is more than 900 billion to investors at home and abroad. The Government says their debt hit 1,043 billion by April 2011 and will hit 1.2 trillion just one year later. That is 1,216,000,000,000. To pay this year's 43 billion interest bill, every household will stump up more than1,800 in tax which is not a joke as it will cost and land up burning a hole in the pockets of the common man. 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. This unprecedented level of public debt in peacetime has huge implications for Britain's economy and their future. Q: Why is Britain in so much debt? The UK's budget deficit As a country, Britain has grown accustomed to living beyond their means. The Government's tax revenues are rarely enough to fulfill its generous spending promises, so every year Britain runs a large budget deficit. The money they can't

raise from taxation needs to be borrowed, and as taxpayers, the general public are the guarantee on the loan. Every year, this budget deficit is added to the national debt. In 1997 Labour inherited a budget that was actually in balance. After a painful and turbulent decade under the Tories, the public finances had finally been brought under control. But after four years in office Gordon Brown took out the country's credit card and let rip. By the end of 2009-10 the annual deficit had ballooned to 170.8 billion. 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, the budget was barely in surplus for more than a few years. Britains been maxing out a new credit card almost every year, even in the good times. If a company were run like this, it would have long been declared bankrupt. Public finances out of control At the very time tax revenues were declining and a debt crisis is ravaging the global economy, the politicians have chosen to go on an unprecedented spending splurge. To fund it, the Government borrowed a monumental 170.8 billion last year. If all goes well, we're set to borrow another 167.9 billion this year.


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. Q: Who do they borrow all this money from? The role of the bond market The British Government borrows money by selling bonds, known as 'gilts'. These bonds are sold at regular auctions held by the UK Debt Management Office (DMO), on behalf of Her Majesty's Treasury. The term gilt is short for 'gilt-edged security' and is a reference to their perceived safety as an investment. The Government has never failed to make a repayment on a gilt. When a gilt is sold, the Government guarantees to pay the holder a fixed interest payment every six months until the maturity date, at which point the full value of the bond is repaid. The proceeds from a gilt sale are then spent by the Government and the value of the gilt is added to our national debt. On average, the bonds that make up the national debt need to be repaid within 15 years. With government spending so far out of control, 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. When run on this basis, 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, summarized in the pie chart below:


Although the majority of gilts are held by British institutions, it's worth noting that the amounts held overseas have risen sharply since 2003. Currently just over 35% of their national debt is owed to foreign governments and investors. So it's not just Third World nations in hock to the rest of the world. Britains relying on the confidence of foreign investors to keep our own country afloat. "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 this context, public sector refers to central government, local government and publicly-owned corporations. Measuring Public Sector Net Debt (PSND) is the joint responsibility of the Office of National Statistics and HM Treasury. In their words, PSND "records most financial liabilities issued by the public sector less its holdings of liquid financial assets, such as bank deposits." The debt is financed by the sale of government bonds, or more recently, printing money via the Bank of England's Quantitative Easing programme.

Bank bailouts The Treasury have made some provision in their forecasts for the losses they are likely to make on the bank bailouts. As of April 2009, unrealised losses from financial sector interventions account for 134.5 billion of the national debt. Northern Rock and Bradford & Bingley account for 123 billion, with a further 9 billion going to compensate depositors with the Dunfermline Building Society. If this wasn't bad enough, the picture is going to get considerably worse. 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. When they finally crunch the numbers, expect the results to be ugly. According to EU figures, Britain has pledged 781.2 billion in capital injections, liability guarantees and liquidity support to the banking system. As taxpayers, we're on the hook for any losses. PFI The Private Finance Initiative (PFI) is a form of commercial partnership between government and private companies to build and maintain public projects. Since taking office in 1997, Labour has made extensive use of PFI to fund infrastructure programmes. PFI currently accounts for some 5 billion of net debt, although it is argued the true liabilities amount to significantly more. "What are they spending the money on?" Public spending in the UK today In 2009-10 the Government spent 671.4 billion of the money, despite tax revenues of only 496.1 billion. That's the problem, right there. Under current spending plans, the national debt will top 79% of GDP by 2014. The last time they borrowed this much money the freedom of the entire world was at stake in World War Two. The spending is given as follows in billions of pounds:


( 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

2009-10 195.5 99.9 66.4 27.2 38.7 30.1 25.4 19.6 13.6 9.6 5.6 6.4 5.5 127.9 671.4

2010-11 202.6 104 69.2 42.9 36.7 30.8 26.1 19.6 14 9.9 7.9 6.4 6.2 125.4 701.7


The public finances are dominated by the welfare state, which will cost the UK some202.6 billion to maintain this year. The welfare budget includes pensions and tax credits, plus unemployment, sickness, housing, council tax, child support and other benefits. In 2010-11, interest payments on the national debt will be the fourth biggest line in the budget, reaching 42.9 billion. When in opposition, Gordon Brown used to call escalating social security and debt interest payments the costs of failure. In his own terms, we're now failing on a scale never seen before. "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. But government is nothing like a business. The state doesn't earn anything. Instead, it confiscates its money from people in the form of tax. However, like any person or business, governments borrow and spend for two principal reasons: either to produce or to consume. The most obvious form of government consumption is when the state transfers money to people in the form of pensions and benefits. Spending on health and education can also consume money, especially when it fails to deliver improvements. The bottom line is that borrowing to fund this kind of expenditure won't pay for itself. When the cash is spent, it's gone and can only be repaid with higher taxes. Public investment Alternatively, when government spends money productively it invests in things like roads, railways, energy generation and communication networks. Investment in capital infrastructure like this is commonly associated with higher economic growth and output. It can help to facilitate trade and promote economic activity in the private sector, where a nation's wealth is created. In other words, borrowing to produce can pay for itself. But Britain is doing just the opposite. Public spending is set to rise by 119 billion between 2008 and 2011. Just 6% of this is associated with capital investment.

Another 38% is a result of higher social security bills during recession and the dead money of debt interest. This leaves the remaining 56%, which the Government is willfully borrowing to fund yet more unproductive consumption. Borrowing to consume means that once the money is spent, they have to borrow more just to stay afloat which is the reason the national debt is getting out of control. A grip on public spending should be kept. "How will national debt affect the future?" The consequences of national debt The British Government has been on a decade-long borrowing binge. High on debt and intoxicated by power, it's not showing any signs of stopping. There is now a long-term structural imbalance between what the government spends and how much money it raises in tax. This policy of never-ending budget deficit is unsustainable. Higher taxes and spending cuts On average, British government bonds pay interest for 15 years. The more they borrow, the bigger their interest payments get. Last year national debt interest cost the taxpayer 27.2 billion. In 2010-11 that figure soars to a jawdropping 42.9 billion. The more they spend on interest, the less they have to pay down debt or invest for the future. That interest is dead money, which means higher taxes for years to come. Stifling of business Government borrowing increases the total demand for credit in the economy, driving up the cost of borrowing in the process. Higher borrowing costs make it more expensive to finance investment in equipment, stock and other capital goods in the private sector. This harms the ability of the private sector to create the wealth and jobs needed to get us out of recession. To make matters worse, the government needs to sell its bonds at attractive interest rates to entice investors away from alternatives. This is known as the

'crowding out' of private capital and means even less investment in business and real jobs. High interest rates The Government relies on investors continuing to buy UK gilts to fund its spending habit. If the bond market gets nervous about our excessive borrowing and the demand for gilts falls, their price also declines as a result. Because they now cost less to buy, gilt yields start to rise. This means we pay more in interest for every penny we borrow, suffocating our deeply unhealthy economy even further. Everything from trade finance to mortgage payments would get more expensive. 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, meaning the major rating agencies believe we're still a good bet. But if we lose their seal of approval and the big investors that come with it, the consequences for our country could be devastating. If the market for gilts weakens, we can always print money to buy our own bonds, which is what the Bank of England is already doing with its so-called Quantitative Easing programme. This gradual debauching of sterling raises the spectre of high inflation once the economy begins to recover. If investors see their holdings devalued they'll be reluctant to buy gilts and may even start to sell, sending interest rates spiraling upwards. If we fail to get a grip on spending at that point and print even more money to cover the shortfall in gilt sales, extreme inflation and a potentially fatal sterling crisis would ensue. On the other hand, we may find ourselves in trouble much more quickly. If a gilt auction fails Britain would be plunged into a full-blown economic crisis. Overnight, we would be forced to make savage spending cuts to balance our budget, sterling would plummet and we'd need an IMF bailout to stave off complete bankruptcy. Economic and social breakdown could conceivably follow.

"Is the problem getting better or worse?" Forecasting national debt National debt is usually analyzed as a proportion of a country's economic output, or Gross Domestic Product (GDP). This allows for factors like inflation and also reflects a nation's ability to repay the money it owes. 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, namely government spending plans, taxation and the country's economic performance. Any spending that can't be supported by taxation needs to be funded through borrowing. Therefore, if the economy performs more poorly than expected, tax revenues decline and we run up more debt to cover the shortfall. What's more, if the Government's GDP forecasts are wrong, their national debt forecasts are wrong too. If recession is more severe or lasts longer than anticipated, the national debt-to-GDP ratio rises. Many independent forecasters believe the Government's own economic predictions are far too rosy. The IMF forecasts the UK economy will shrink by another 0.4% in 2010, in sharp contrast to the Treasury's prediction of 1.25% growth. Independent forecasters


surveyed by the Treasury believe that by 2011 the UK's economy will be 3% smaller than the Government predicts. Ultimately this all boils down to one thing: the national debt is probably going to get a lot bigger than we think. New Labour will forever be remembered as the government that doubled the national debt, from 40% of GDP in 1997 to 80% in 2014. "What can one do to prevent a debt crisis?" Averting a debt crisis in Britain As complex as the national debt problem may be, the solutions call for nothing more than basic common sense. These are just some of the simple steps Britain can take to maintain economic and social stability: 1. The Government needs to stop borrowing and spend less. If debt is the problem, repayment is the solution. That might sound obvious, but our politicians haven't grasped it yet. 2. Get the public finances under control and balance the budget. Start being honest about what services the state can no longer afford to deliver. 3. Stop demonising anyone who speaks out against our addiction to spending and waste. Public spending cannot be sustained at current levels, so cutting it is the only sensible course of action. 4. Take back the moral high ground. The consequences of excess debt are misery and dishonour.


Britain in grip of worst ever financial crisis, 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. 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. Shares rose strongly in the City, posting a rise of almost 200 points, 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. "There is not enough money. That may seem unfamiliar to people." he told Sky News. "But that's because this is the most serious financial crisis at least since the 1930s, if not ever." 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. The chancellor said further steps would be taken to boost growth in his autumn statement next month. "Given evidence of continued impairment in the flow of credit to some parts of the real economy, notably small and medium-sized businesses, the Treasury is

exploring further policy options," Osborne said in a letter to the governor. "Such interventions should complement the monetary policy committee's [MPC] asset purchases." Britain's first dose of quantitative easing, also known as QE1, was in 2009/10, with 200bn being injected into the economy. Labour said the launch of QE2 was an admission that the government's economic policy had failed. Ed Balls, the shadow chancellor, said: "With our economy stagnated since last autumn David Cameron and George Osborne are now betting on a bailout from the Bank of England. The government's reckless policy of cutting spending and raising taxes too far and too fast is demonstrably not working. 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." Some in the City were caught unawares by the scale and the timing of the Bank's move. Last month, only one of the nine members of the MPC, Adam Posen, voted for more QE, 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. "The pace of global expansion has slackened, especially in the United Kingdom's main export markets," the MPC said in a statement explaining its decision. "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. These tensions in the world economy threaten the UK recovery." The MPC said the slowdown in the UK economy, which saw no growth in the nine months to mid-2011, had in part been caused by temporary factors, but added that there was also evidence that the underlying pace of activity had weakened. 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".


King admitted that inflation could breach 5% next month but said that would be the peak. 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, with gross domestic product dropping by 7.1% in the biggest recession since the second world war. The flatlining of the economy since last autumn has left activity still 4.4 percentage points below its 2008 peak. The TUC's general secretary, Brendan Barber, said the decision to expand QE was the right one, but added: "While it is better than not doing anything, quantitative easing is no economic magic wand. "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." Business leaders welcomed the move. Graeme Leach, chief economist at the Institute of Directors, said: "Near-zero GDP and money supply growth made a compelling case and the Bank of England was right to launch QE2. It could be argued that the Bank of England was slow to introduce QE the first time, but thankfully it hasn't made the same mistake twice." By the end of the four-month programme, the Bank will have bought a total of 275bn in assets from banks, around 20% of GDP. The news prompted alarm in Britain's pension funds, which are concerned that QE pushes down interest rates and reduces the return on their investments, but Threadneedle Street left the door ajar for a further expansion of QE2 should the economy not respond. Michael Saunders, UK economist at Citi, said the deteriorating outlook for the economy would require the Bank to "do QE on a very big scale". He added: "We expect the cumulative total of QE (now heading to 275bn) will eventually reach 500bn or so. It may go even higher than that."


The Daily Mail reported as on 7th October 2011:

A triple blow to squeezed middle: As Bank chief warns of worst-ever crisis, 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 0.25% Household expenditure falls rapidly

The fragile finances of families, savers and pensioners suffered a huge blow yesterday when the Bank of England launched a desperate new bid to stave off recession. The Banks governor pumped 75billion of new money into the flatlining economy, saying the worst financial crisis in modern history demanded it. But Sir Mervyn King admitted there could be a severe price to pay. The move could:

Force another spike in inflation, with retail prices predicted to hit 5 per cent within weeks; Further reduce annuity rates for pensioners; Hammer savers, offering them little hope of a return on their investments.

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. Sir Mervyn expressed sympathy for savers but insisted he would not push Britain into a recession just to help them.


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, he added. I have enormous sympathy with the predicament that savers, and particularly those who are retired, face. They are suffering from the consequences of an economic crisis which they did not cause or are responsible for. But this is a situation where Britain, on its own, cannot easily get out of it. The only way to return to a situation with full employment, steady growth and a balanced economy is to make sure other countries expand their spending. We are doing it because there is not enough money in the economy. Now that may seem unfamiliar to people but it is unfamiliar. That is because this is the most serious financial crisis we have seen at least since the 1930s, if not ever. Critics branded yesterdays decision to print money a Titanic disaster which will deepen the squeeze on those already hit by low savings returns. The Banks decision to pump more money into the economy is also almost guaranteed to drive annuity rates below even their current historic lows.Had you cashed in a 100,000 pension pot in 1990, you would have received an annual income of 16,000. The equivalent figure now would be 5,945. Joanne Segars, of the National Association of Pension Funds, said: This is another kick in the ribs for many people who have worked all their lives and are trying to retire. Annuity rates are woefully low. To add to the crisis, inflation, currently 4.5 per cent, more than double the Governments 2 per cent target, is set to climb higher. Sir Mervyn said: In two weeks we will get another inflation number which may well go above 5 per cent but that, in our view, is the peak and it will then start falling and, 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. The Bank blamed the crippling rise in energy bills, up 14.3 per cent this year.


What next for inflation? The experts who fear a return of spiraling prices

The Bank of Englands obsession with stimulating the economy has set in motion a price rise spiral that will end in hyperinflation and wipe out British wealth. That, at least, is the extreme view. The so-called inflation nutters believe uncontrollable price pressure has already been unleashed. Adam Posen, a member of the rate-setting monetary policy committee (MPC), used the phrase last year, much to the annoyance of savers who have seen the real value of a 10,000 cash fall to a little more than 9,000 in the past two years. Posen, in contrast, could be described as a 'deflation nutter', given his persistent attempts to persuade other MPC members to hold off on rate rises and vote for more stimulus. Today, his wish came true with the committee voting to pump another 75billion of electronically created money into the system. Inflation, as measured by the retail prices index (RPI), has hovered around 5 per cent for the past two years and the consumer prices index (CPI) measure has been close behind. CPI, which hit a low of 1.1 per cent in September 2009, has powered away from its target rate of 2 per cent and stood at 4.5 per cent in August. So what next? While the evidence is not conclusive, it would be wise to assume that the Banks efforts to save the economy in 2009, when the world faced global financial meltdown, have made a significant contribution to price pressure.

The UK bank rate was pushed down and down between October 2008 and March 2009, until it reached 0.5 per cent. Then, with desperation creeping in to policymaking, a programme of quantitative easing was begun. This electronic form of money printing saw 200billion spent on buying government bonds, or gilts, by early 2010. Another 75billion is now on the way - the impact is unknown. Britains inflation problem is not entirely homegrown. There has been a global influence as fast-rising demand for raw materials in emerging markets has pushed up prices around the world. 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. He says the letter of explanation the Bank Governor Sir Mervyn King is compelled to send the Chancellor each time the target is breached, and the letter of response, has descended into farce. The Chancellors response is basically "Even though your forecasts have been woefully wrong *on inflation+ over the last two years, Im sure they will come good eventually".' Speaking at the M&G Inflation Conference earlier this week, 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. It has used its discretion to redefine the inflation target framework. Dr Sentance believes the Governor underwent a huge shift during the financial crisis, fearing long-term hardship for the economy with deflation as the biggest threat, and cannot be persuaded to adapt his opinion even in the face of high inflation.


He also blames the committee for benign neglect of the pound which, during the crisis, has seen the biggest decline of 25 per cent since 'coming off the gold standard in the 1920s'. He would like to see the committee have more confidence in the economy. While Dr Sentance says people should be concerned about inflation, he does not forecast anything like the horrors of 1920s Germany. Inflation projections for 2012 - CPI and RPI (Source: Treasury)



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