Eurozone crisis: Impact on the UK · mechanisms by which the Eurozone crisis could have an impact...

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House of Commons

Treasury Committee

Eurozone crisis: Impact on the UK

Oral evidence

Wednesday 14 September 2011

Professor Charles Goodhart CBE, London School of Economics and Political Science, Professor William Perraudin, Imperial College, London

Simon Hayes, Chief Economist, Barclays Capital, Jan Randolph, Director, Sovereign Risk, IHS Global Insight, Simon Tilford, Chief Economist, Centre for European Reform

Ordered by the House of Commons to be printed 14 September 2011

The Treasury Committee

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Mr Andrew Tyrie MP (Conservative, Chichester) (Chairman) Tom Blenkinsop MP (Labour, Middlesbrough South and East Cleveland) John Cryer MP (Labour, Leyton and Wanstead) Michael Fallon MP (Conservative, Sevenoaks) Mark Garnier MP (Conservative, Wyre Forest) Stewart Hosie MP (Scottish National Party, Dundee East) Andrea Leadsom MP (Conservative, South Northamptonshire) Mr Andy Love MP (Labour, Edmonton) John Mann MP (Labour, Bassetlaw) Mr George Mudie MP (Labour, Leeds East) Jesse Norman MP (Conservative, Hereford and South Herefordshire) David Ruffley MP, (Conservative, Bury St Edmunds) John Thurso MP (Liberal Democrat, Caithness, Sutherland, and Easter Ross)

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List of witnesses

Wednesday 14 September 2011 Page

Professor Charles Goodhart CBE, London School of Economics and Political Science, Professor William Perraudin, Imperial College, London Ev 1

Simon Hayes, Chief Economist, Barclays Capital, Jan Randolph, Director, Sovereign Risk, IHS Global Insight, Simon Tilford, Chief Economist, Centre for European Reform Ev 10

Treasury Committee: Evidence Ev 1

Oral evidenceTaken before the Treasury Committee

on Wednesday 14 September 2011

Members present:

Mr Andrew Tyrie (Chair)

Tom BlenkinsopMichael FallonMark GarnierStewart Hosie

________________

Examination of Witnesses

Witnesses: Professor Charles Goodhart CBE, FRA, London School of Economics and Political Science, andProfessor William Perraudin, Imperial College, London, gave evidence.

Q1 Chair: The Committee is in a very lively moodthis afternoon, as you probably noticed as you walkedin. This is a very big, very important, very topicalsubject and I am particularly grateful to both of youfor coming in at such short notice and for beingprepared to give evidence to us today. I would like tobegin with a question to Professor Charles Goodhart,which is to ask what he sees as the key transmissionmechanisms by which the Eurozone crisis could havean impact on the UK.Professor Goodhart: I think that the main effectwould come through our net external trade, because ifthere is a crisis I would have thought that theEurozone is likely to go into a period in which outputwill fall. Something near to 50% of our exports go tothe Eurozone and if the Eurozone was to go into asevere recession it would adversely affect our exportsand, since the forecasts for our growth next year—such as it is—depend very heavily on net exports, thatwould be a major transmission route.The other issue that could arise would be the declinesin wealth, because the banks hold claims on a rangeof these European countries. Incidentally, I think weare most at risk to Ireland rather than to any of theother countries, and it is not necessarily clear thatIreland would get caught up at all if the problem wasprimarily in the southern Mediterranean countries. Butgenerally, if the Eurozone goes into difficulties,confidence will go, asset prices will decline, wealthwill decline around the country and confidence willbe considerably weakened, both by the asset valueeffect and by the effect of no credit.

Q2 Chair: Do you have anything you want to add,Professor Perraudin?Professor Perraudin: Your question doesn’tdifferentiate between different possible outcomes withthe Eurozone. I think there would be radicallydifferent implications for us if Greece and Portugaldefaulted, on the one hand, compared with problemswith Italy and Spain, and I think that—

Q3 Chair: Just on that, you feel that there will bea default by Greece? You are in the majority camp,are you?

Andrea LeadsomJohn MannJesse NormanMr David Ruffley

Professor Perraudin: It seems highly likely. It seemsdifficult to conceive of how they can dig themselvesout of the fiscal problems that they have. I think thatcountries can repay extraordinary levels of debt, ifthey have the administrative facilities andarrangements and if they have the will to do so.Historically, if you look back, there have been caseswhere countries had debt for a much larger fraction ofGDP than Greece currently has but I don’t think fromall the—

Q4 Chair: Can you give us a few examples, just forthe record?Professor Perraudin: The UK, after the NapoleonicWar, paid off an extraordinarily high debt and did soin a period of deflation. I don’t think that is relevantat all for the current Greek situation, because theyhave severe difficulties in their tax administration andthey apparently don’t have the political will to tacklethe financial problems they face.Professor Goodhart: Romania is a recent exampleunder Ceausescu, who drove the standard of living ofthe Romanian public into the ground in order to payoff his debts to the West.Chair: Yes. He physically sent the police force roundknocking on every door in the country, stealingproperty and then selling it off at a discount, includingtaking away light bulbs to prevent people from usingelectricity, so I think that—Professor Goodhart: I hope it doesn’t come to thatbut that is a modern example that, if you have thepower and the control, you really can pay off a hugeamount of debt.

Q5 Jesse Norman: Could I ask either of you todescribe how Greece might be able to default withinthe Eurozone? People understand what defaultingoutside the Eurozone is, because they can see that itwould mean issuing—however much trouble—acurrency, a Drachma perhaps, and then trying to takethe case and recapitalise in some way. How would itwork inside the Eurozone though, or how might itwork inside the Eurozone? Because this is beingconsidered as a real possibility. I just want to know isit a real possibility or is the reality that—

Ev 2 Treasury Committee: Evidence

14 September 2011 Professor Charles Goodhart CBE, FRA and Professor William Perraudin

Professor Goodhart: The difficulty that I see is thatif the default is primarily a default of not paying theinterest or the principal on their bonds, then the Greekbanking system holds so much of their own country’sbonds that effectively those banks would be bankrupt.You can run a country in which the Government’sabilities to make payments is very heavily restricted,but in my view it is almost impossible to run a countryin which the banking system doesn’t exist and thepayment system doesn’t exist. The difficulty,therefore, is that if the default takes the form of notpaying out on bonds, and the Greek banking systemthen all goes belly up, the Greek Government, in orderto support the standard of living of its population,would have to somehow support its banks. At themoment it can’t because it has no money, and that isthe main reason why, if the default is to take the formof not paying out on bonds, I think they would have toleave the euro in order, effectively, to provide financethrough the printing press in order to recapitalise itsown banking system.

Q6 Jesse Norman: What you are effectively sayingis that the glib line that was, for example, advancedon the Today programme this morning by RolandRudd, that you can default within the euro, isprobably nonsense?Professor Goodhart: It depends what you mean bydefault. There are, for example, states in the UnitedStates that in the case of failure to make paymentsactually the bond holder is the last person to get hit.So you can have a default in which the form of thedefault is you simply don’t make payments to yourown public sector workers, for example, which is aform of requiring, really very rapidly, the Greeks torun a balanced primary budget because they simplydon’t have any money to make any payments exceptthose for which they have tax receipts.

Q7 Jesse Norman: That is very helpful. Would youagree with the thought—again this is a question toeither of you gentlemen—that it is very easy to runtogether what are fundamentally two different butconnected things: one is a crisis of sovereign debt andthe second is a crisis in the money markets? There areconnections between these two, but whereas onemight understand that a sovereign debt crisis has acertain pre-determined process of resolution or non-resolution—it can be affected by politicians—a crisisin the money markets may obey no such timetable. Isthat a thought that has any persuasiveness with you?Professor Perraudin: I think that confidence and riskpremiums are crucial elements in all of this. Beforewe were talking about the transmission mechanismsof the crisis through trade, as Charles was mentioning,but I think there are significant additional dangerswith transmission mechanisms through the bankingsystem and through a further collapse of confidencethere. I don’t think that sovereign debt crises ingeneral are ever divorced from what is going on inbanking. If you think back to the Asian crisis, theproblems of the sovereigns there and of their bankswere completely connected.

Q8 Jesse Norman: The opposite might be true,might it not, which is that there is some progress onthe sovereign debt issue and yet the money marketscontinue to freeze up and bank funding becomesextraordinarily difficult?Professor Perraudin: Yes.

Q9 Jesse Norman: Is it your view at the moment thatbank funding is pushing us towards a renewal of thecrisis we had?Professor Goodhart: Clearly so, particularly dollarfunding, foreign currency funding, which it is harderfor the Central Bank, either the national Central Bankor the ECB, to deal with even where there are stilloutstanding Federal Reserve Bank swap lines that canbe utilised, but nevertheless the funding through thewholesale markets, in particular in dollar form, hasbecome much harder.Professor Perraudin: Yes, I think the complexity ofwhat is going on makes it harder for people to haveconfidence in their counterparties. If it were just aquestion of Greece, as a standalone entity with its owncurrency, defaulting then you could expect that, sincethis has been flagged for months or years, peoplewould adjust their portfolios, they would hedge;everything would gradually come to a position thatvulnerable levered financial institutions werereasonably protected against it. But because we haveboth possibilities of insolvency and possibilities ofbreakup of a currency, it is very difficult to know howinstitutions would be affected. So we are again backin the same position that we were with the subprimecrisis where nobody knew how anyone else wasexposed to what was happening. So I think that thedangers of financial contagion are exacerbated by thefact that it is both solvency and currency going onat the same time, and there are all sorts of differentpossibilities with a set of countries that could becaught up in it. Just like the subprime crisis, there areissues about whether people have made provisions.With some of these sovereigns they continue to haverelatively high ratings. If you look at Italy, youwouldn’t really think that the probability of Italydefaulting was the same as the historical probabilityof an AA-rated entity defaulting, so there is a kind ofdisconnect between current ratings that may be usedby banks in doing their provisioning and what the realrisks are.All of that means that it is hard for people to beconfident what their counterparties are exposed to andhard for them to believe that, after the accounting thathas been done by the banks or other financialinstitutions’ accountants, whether we really knowtheir exposures. I was talking to a corporate treasurerrecently and they had adjusted their exposure, or theyhad systematically reduced their exposure to localbanks in some countries, but their customers were allhighly exposed to the local banks. So the dimensionsof financial contagion are quite complex and there isplenty of potential for that to cause further trouble.

Q10 Jesse Norman: Just to be clear, you have saidsome incredibly interesting things. We are talkingabout a situation in which there is political and



economic threat to the markets; there is an effect fromsheer complexity; there is an effect from cheating andnon-transparency on the rules; and there is a bankcontagion route and a corporate contagion route. Thatseems remarkably helpful and interesting.Could I just ask a final question? Bracket out thequestion of the sovereign debt crisis we are in—justimagine that in some sense the can is kicked down theroad or there is some solution to that, or nothinghappens for the time being—and we nevertheless arefacing a money market bank funding crisis. What arethe kinds of mechanisms in an emergency, given whatwe have known from the last three or four years, thatyou would now expect to see put in place and are thecurrent mechanisms we have in place alreadysufficient? You will recall that the Bank Governor hastaken a very benign view in front of this Committeeon the lessons to be faced in the event of crisis inthe markets.Professor Goodhart: A huge amount has already beendone. The ECB has provided an enormous amount ofliquidity and through its six months’ refinancing bankscan get as much liquidity as they want. The difficultyis not so much euro liquidity. The difficulty is morein their foreign currency financing, again because ofconcerns about their ultimate solvency.

Q11 Jesse Norman: On the dollar account inparticular?Professor Goodhart: Yes, the dollar account inparticular, which again was a real problem in Europewith the subprime crisis and it very nearly knockedout quite a number of banks around Europe in 2008.It involved a huge utilisation of the Federal ReserveBoard swap lines, which again will have to come intooperation. In these kind of circumstances, in a globalsystem where banks borrow in dollar-based wholesalemarkets, in some respects the Fed actually acts as thelender of last resort to the banking systems aroundthe world.Professor Perraudin: I agree with Charles that a lothas been done by Central Banks but also a lot hasbeen done by the banks themselves, so they are muchmore clued up about liquidity management oversignificantly more prolonged periods of crisis thanthey were before the last crisis.

Q12 Chair: Just to be clear, a moment ago you weresaying, weren’t you, that broadly speaking you don’tbelieve the returns that these banks are putting in?You were saying that these may be made up; you don’tbelieve the stress tests.Professor Goodhart: The banks gave sufficientinformation to allow people to adjust insofar as theywanted to. The point is not that the banks are in asense being illegal. The banks are following the legalrequirements of the accounting arrangements as theystand at the moment.

Q13 Chair: We are talking about the continentalbanks?Professor Goodhart: Certainly the continental banks,which enable you to value the bonds in your bankingbook at a very low discount indeed. If they were in

your trading book you have to mark them to marketbut if they are in the banking book you can value thempretty much at face value and, of course, many ofthese bonds are nowhere near the face value. So theyare not acting illegally, in no sense are they actingin any—Chair: I just wanted to clarify that.Professor Perraudin: But they might not be actingprudently. Through the last couple of years peoplehave had choices about how they accounted for lossesin exposures where they were very difficult to markto market, so they were marking them to modelbecause it wasn’t very easy to get direct quotes. Asmarkets dried up there were a lot of differentapproaches used for valuation and, as Charlesmentioned, in the banking book they are notnecessarily directly responsive to what is happeningin market values, so you may be looking at provisionsbased on what you think is happening to the defaultprobability. If you were using ratings, which aresomewhat smoothed—the rating agencies adjustthem—sovereign ratings are not a completely directreflection of the true quality of the pot.Chair: You are sounding like a bureaucrat, “not acompletely direct reflection”. What you are talkingabout is ropy ratings.Professor Perraudin: Yes. There is quite a lot ofvariation. I remember I did some work for one of therating agencies and helped them look at how they didvaluations of illiquid securities, and at some point Igathered that they had one way of doing it, whichwas what I was looking at, and then they had anotherapproach, which was also—Chair: Maybe we will have you back at another timebecause we are thinking about taking a look at riskrating agencies, sooner or later: they deserve it.Professor Perraudin: Yes, but just—Chair: I am sorry to cut you short but I know MichaelFallon is eager to get in.

Q14 Michael Fallon: Just a very quick question. Weare seeing growing distrust between the banks at themoment but do the monetary authorities, the financeministries, have any greater visibility of theseexposures and default probabilities than they did threeyears ago, last time?Professor Perraudin: I am sure that the FSA, and allthe various banking regulators, have been crawlingover people’s internal rating systems and approachesto evaluating credit quality in their books, so I amsure there is an intensified effort around all of that—

Q15 Michael Fallon: Do they know more than theyknew during the last crisis?Professor Goodhart: Well, we don’t know very mucheven now. What is the probability of default in, shallwe say, Italy? No one can put a number on it. It is nota sort of probability distribution that is known. Itreally comes much more under Knightian uncertainty,in part because it is so influenced by politicaldecisions and it is very hard to put you politicians intoa sort of Gaussian distribution; you don’t fit veryeasily.



Professor Perraudin: There is almost no data of AAratings being defaulted, so it is very difficult tomeasure statistically. In fact, it is almost impossible tomeasure statistically, so ultimately decisions have tobe made that are judgements.Chair: We have already gone as far as Knightianuncertainty and Gaussian distribution, so I am sure weare taking most of the public with us at the moment.

Q16 John Mann: I will attempt to simplify with aninitial question. I am sure I am reading too much intowhat you are saying, but in your view is there anycomparison with the risk to the UK economy that wehad in 2008 to the current situation?Professor Perraudin: If there is a kind of narrowinsolvency problem with Greece and possiblyPortugal defaulting, then I don’t think it is at all thesame scale. It is difficult because if there is a defaultby them then there would be a crisis of confidenceaffecting other countries. The question really is if thedefaults could be limited, then I think we are lookingat a relatively small economic impact over a horizonof six months or a year, but if the problems spreadover into major economies then obviously this couldeasily exceed the problems we had in 2008.Professor Goodhart: I think there is an additionalproblem, which was that in 2008 the fiscal positionsof most Governments were considerably stronger thanthey are now and, as of the beginning of October2008, interest rates were considerably higher than theyare now. That means that we had in 2008 a lot ofinstruments, official Government instruments, whichcould be used and were used to offset the bad effectsof 2008. These have been very largely used up andthe potential available additional space, either fiscallyor in monetary policy, is much more limited now thanit was in 2008. So you have the potentiality foranother severe shock with less in the way ofGovernment instruments to offset it and protect thecommunities against it.

Q17 John Mann: We already have a liability withexisting Eurozone bailouts. Can you advise how muchthe UK’s liability is at the moment?Professor Perraudin: I don’t know the figures.Professor Goodhart: I don’t have the figures in mymind. I am rather hoping that in your next sessionthey will provide those kinds of figures for you. It isa considerable amount. The amount that has beenalready spent in the SMP, the ECB bond purchases,and the amount of money that has already been spentin both phase 1 and phase 2 of the bailout of Greeceand in the support of Portugal, Ireland and Spain isconsiderable. A lot of money has been spent, yes.

Q18 John Mann: Would you expect us to be askedfor more and if we were how much more would youexpect us to put forward?Professor Goodhart: Who is “us”? Are you talkingabout the Eurozone Governments?John Mann: Yes, within the Eurozone.Professor Goodhart: The kind of figures that get putaround in market circles are that the EFSF shouldhave a capacity of something of the order of €2trillion, I think it is, in order to deal with this.

Q19 John Mann: Is there any danger to our creditrating through the consequences of this, in your view?Professor Goodhart: If the Eurozone goes really intosevere recession and if America is also, shall we say,sluggish, it is going to be difficult for this country tomaintain its growth. If this country finds it difficult tomaintain its growth, the tax revenues will not be asbuoyant as in the present forecasts, for example likefrom the OBR. Under those circumstances, we willfall behind the programme of deficit reduction that iscurrently in place. Then the credit rating agenciesmight look at our worsened deficit and debtprojections under those circumstances and say, “Inthose circumstances, it is difficult to see why the UKshould have AAA while the US has gone down anotch”.Professor Perraudin: We would presumablyappreciate against the euro. It depends quite how theeuro splits up, but the turmoil within the Eurozone,unless a core currency emerges that would presumablybe strong, we would probably find ourselvesappreciating against the euro. So what would happento our cost of financing the national debt, whether thatwould go up or down, I am not quite sure.Professor Goodhart: The Americans got downgradedand their interest rates have gone down and I knowthere has been a flight to safety. Under thesecircumstances we are still regarded as relatively safe.

Q20 John Mann: One final question and that is aquestion in relation to the behaviour of politicians inthis country. In your view is there a danger that wehave become overly distracted by the structure of UKbanking, as opposed to concentrating on the biggerimminent problems of the consequences of Eurozoneturmoil?Professor Goodhart: In a sense, we are not incommand of Eurozone turmoil. It is not for us to tellcountries such as Germany, France, Italy, Portugal andGreece what they should do to maintain their system,while it is for us to take a view about our own bankingsystem. I think one has to look to one’s own areawhere one has a responsibility, and we do have theresponsibility for looking after our own system. Wedon’t have the responsibility—you don’t have theresponsibility—for looking after the Eurozone system.John Mann: You make it sound a bit like we are abunch of England cricketers going in to face the WestIndian fast bowling attack without any pads on, “Let’sjust wait and see what hits us and hope that we mightbe able to catch the ball as it comes towards us”.Professor Goodhart: I very much hope that the Bankof England and the Treasury are undertaking a fairdegree of contingency planning, but they can’t domuch more than that because it is a contingency overwhich they have no control.Chair: It is good to know you think they are paddedup ready to face these bowlers.Professor Perraudin: Yes. Picking up a couple of thethings that you said, just slightly going back to yourprevious question about how we compare with theearlier crisis. I think our baseline forecast is obviouslymuch worse for the UK economy. We are in a



situation where our banks are struggling to meethigher capital requirements and a whole raft of newchanges to do with liquidity, so there is a lot ofrebuilding of bank balance sheets. On top of that thereis the reorganisation of the banks, which could havevery long-term benefits over decades but the timingof it is a bit regrettable. So I think that is allbackground to where we are. It is important toconsider the extent to which the banks will be able tocontinue lending over the next few years. I would beworried, looking at the euro crisis, that it is yet anotherissue that will reduce confidence in banks, put morepressure on banks. However unpopular bankers maybe, it is nevertheless the case that the economyrequires continued intermediation and volume oflending. So I see all of these things as coming togetherand exacerbating the economic weakness that wehave currently.

Q21 Andrea Leadsom: That all seems to me to be alittle bit depressing. I feel we are slightly perhapstalking ourselves into a long dark tunnel from whichthere is no exit. On the one hand you are saying wehave used up all our “get out of jail cards” in 2008.On the other hand you are saying that we have noinfluence over Europe and all we can do is look to ourown issues. You are saying that we have theaccounting completely wrong. I would just like topush back a bit. Surely we are a member of the EU;we do have a say, in fact, certainly over things likethe FSM, as to whether that is used or expanded; andwe would have to have a say if the ECB was going totry and issue Eurobonds. Presumably, there is also apotential contingency proposal that the ECB startsdoing asset purchases of impaired debt from thebanks, like they did in the US. There are all sorts ofpossibilities that Britain should and could have a viewon. There is also the possibility that we change theaccounting rules and say that banks and sovereignsnow need to mark to markets the debt that is on theirportfolios, and indeed make provisions for it. Wecould even start playing hardball with the ratingagencies and start looking realistically at whether theratings agencies are getting these things wrong. Wehave already discussed the fact that it is ludicrous tothink that America is anything other than AAA, sinceit continues to have the means and the desire to repayits debts, and to rank it the same as Italy is utterlyludicrous in anyone’s book.You are effectively throwing up your hands in despair.Is there no scope for any of these possibilities? Shouldwe not be doing something with our Eurozonepartners?Professor Goodhart: We can certainly try and advisethem. I think that what should have happened is whatthe Chairman of the IMF, Madame Lagarde, proposed,which was that there should be recapitalisation of thebanks. If the banks, particularly on the continent, wererecapitalised to a degree that would protect themagainst the kind of revaluation of sovereign bonds thatyou are suggesting, then I think that the likely dangersfrom a potential default in Greece, or even morewidely, would be much reduced. The real problem isthis interaction between sovereign debt and thebanking debt that William was talking about.

Q22 Andrea Leadsom: Just to interrupt you,Professor Goodhart, should we, as a Treasury SelectCommittee with all the influence that we have, besaying to the ECB that it should be requiring all bankshenceforth to mark to market their sovereign debt asa strong recommendation from this Committee, forexample?Professor Goodhart: You cannot properly andhelpfully do that, unless that is accompanied—andindeed I would argue preceded—by an appropriaterecapitalisation of the continental banks, so that whenthere is this revaluation they are still in a good, strong,solvent state. The problem about revaluation, througha mark to market of all sovereign debt at this moment,is that—I have no idea what the figures would be—Iwould not be confident that there would be a sufficientoverall majority of European banks that would nowbe in a position to stand that.Professor Perraudin: We are where we are, so theability for banks to get out from under the rubble toescape things is severely limited. It is almostimpossible to hedge exposure. The volume of some ofthese exposures is so major that people—

Q23 Andrea Leadsom: Would you not agree thatactually knowing where the problems are—becausewe are all talking about how it is terriblyinterconnected, nobody quite knows how much andbanks are very nervous—and more transparency is theanswer? Isn’t knowing what the problem is part waytowards solving the problem?Professor Perraudin: I don’t think total transparencyintroduced in the middle of the crisis wouldnecessarily be a good thing.

Q24 Andrea Leadsom: Okay, but can I justchallenge you on that? A long time ago MargaretThatcher said, “You can’t buck the markets”. Justrecently Angela Merkel said the European Unionpoliticians will not follow the markets. It seems to melike there is a fundamental disagreement there and Ithink Margaret Thatcher was proved right. Surely nowfor politicians to be saying, “We are just not going todo what the markets want” is a challenge to themarkets that we simply cannot afford to meet. So tosay that to change tack now and go for transparencyis not going to solve anything, what is going to solveanything then? What can we recommend? What stepscould we take to try and prevent the crisis that isalmost certainly going to hit us within the next fewmonths?Professor Goodhart: A major recapitalisation of thoseEuropean banks that need it.

Q25 Andrea Leadsom: How do we identify thatwithout the required transparency to know exactlywhat their mark to market position is?Professor Goodhart: The internal regulators will havesufficient information on that. They do know theinformation. They know what each bank holds; theycan apply mark to market accounting for themselves.They are in a perfectly good position to do that.Chair: Anything to add, Professor Perraudin?



Professor Perraudin: Yes, I broadly agree that if theGerman and the French banks have not made adequateprovisions or if they have not been cautious enough,then certainly what they are doing is understood bytheir own regulators. The regulators will see what thepractices are and they can easily investigate that.Chair: Well, we have that point on board.

Q26 Andrea Leadsom: Can I just make anotherpoint on a slightly different tack which is, what doyou think the impact is of Britain holding back fromthe fiscal problems in the Eurozone and not jumpingin and bailing out? What impact do you think thatwill have on the Eurozone’s approach to Britain inthe future?Professor Perraudin: The UK has made contributionsin helping Ireland and it makes contributions throughthe IMF, so it would be surprising for the UK to beassuming substantial fiscal burdens to rescue theEurozone.

Q27 Stewart Hosie: Professor Goodhart, in amongall of this there is an argument that says the ECBshould be issuing Eurobonds to cover all of theEurozone’s debt, but in addition to that there is asimplistic argument that says that as the Eurozone hasever closer monetary union, it should therefore haveever closer fiscal policy. What is your view on that?Professor Goodhart: I am already on record because,although it is not very widely known, in the early1990s the European Commission introduced anexercise to consider what fiscal measures ought to beintroduced to back up and support monetary union.There was a report that came out in the EuropeanUnion. We came to the view that with a centralisedEU budget of I think it was 2.5% of EU GDP, youcould introduce an appropriate contra-cyclicalstabilisation mechanism, and that you could adjust thebudget in a way that would enable monetary union tohave much greater strength.This report was pigeonholed by Jacques Delorsbecause at the time he was trying to raise the EUcentralised budget, I think, from 1.5% to 1.8%, andwhen we came out with the suggestion it should be2.5% or 2.6% he thought it would frighten the horses.Anyhow, when he got his 1.8% through, this then wasput forward and it was very rapidly sat upon by thericher countries of the EU, including the UK,Netherlands, Germany and Sweden. It did not havesupport. There was very little support at that time—and until now—for any greater centralisation of fiscalcompetencies. It is really only with the crisis that wehave had in the last year and a half that there has beenan appreciation that, under strain, a monetary unionwithout fiscal support is in great difficulties.

Q28 Stewart Hosie: The contrary argumentpresumably would be if there was monetaryloosening, as we have in the UK, they might wantfiscal tightening to counterbalance that to meet otherGovernment objectives. I suppose the reverse wouldbe true if you were embarked on a process ofmonetary tightening: if inflation grew, the countries

would want the flexibility to have fiscal loosening,would they not? Would the ability to manoeuvre likethat not be gobbled up or eroded because of fiscalpolicy?Professor Goodhart: Having some degree of fiscalcentralisation—and remember 2.5% is tiny. In mostoverall federal countries, like the USA or Brazil orAustralia or Canada, for example, the amount offunding that goes through the federal centre usually isof the order of about 35% to 40%, so 2.5% is reallytiny—Professor Perraudin: Yes, but that is in countrieswhere people are voting for decisions in a centralisedway.Professor Goodhart: That again goes back to thequestion of, if you were going to require somewhatmore fiscal centralisation to support your monetaryunification, do you need—as I think William wasrightly implying—a greater degree of politicalcentralisation? My own feeling, and it is a purelypersonal one, is that one of the great weaknesses ofthe EU as a whole is that the EU authorities, likeBarroso and Van Rompuy, are not elected. You and Ihave no role in this. They are actually appointed in asmoke-filled backroom—except that prime ministersare no longer allowed to smoke in these rooms—byprime ministers in a sort of national haggling.Stewart Hosie: Indeed, and I would love to get intothe politics of democratising Europe but that is notwhat we are doing today.Professor Perraudin: I would not really agree thatone has to have fiscal co-ordination that involvessupport from one country to another in an ongoingway. A much simpler type of fiscal co-ordinationwould just be debt ceilings or balanced budgetrequirements on countries that are in a commoncurrency area. The issue then is that you give up amajor economic lever for affecting your economy. Sothat is why I think that some of the ideas that peoplehave been discussing of using macro-prudential policyto affect the level of economic activity, by adjustingcapital requirements for banks through the cycle, is aninteresting alternative way of bringing some control ata local level.

Q29 Stewart Hosie: I was counting that in my headas one of those fiscal mechanisms, because it is notpure monetary policy but it has the same impact ofloosening or tightening availability of cash in aneconomy. So you are not convinced about going downthis fiscal uniformity route?Professor Perraudin: I think it just sort of ups thebidding each time, doesn’t it? As Charles was saying,one can do that but then you need changes in thepolitical arrangements, so I think it is all too far togo. A much simpler approach is constraints on fiscalpolicies, but then you have these other issues of howdo you affect the level of activity.

Q30 Stewart Hosie: I will ask both of you, in whichcase, whether you would agree fundamentally withChristine Lagarde. She didn’t use the word “cap”specifically but she said, “Fiscal adjustment is critical



for the long-term sustainability of public finances inmany economies”—not just certain countries, butmany economies. She was effectively arguing for theuse of fiscal policy in that way, but not asking for itto be uniform, certainly across the Eurozone.Professor Perraudin: It would be difficult to haverules that were not uniform across the variouscountries, I would have thought.

Q31 Stewart Hosie: Would you like to expand onthat? How would that work? Give me an example ofa uniform rule that might apply both to Italy andGermany, say.Professor Perraudin: I think it would be difficult forcountries in negotiation to accept different levels ondeficit as a percentage of GDP. I guess that one couldhave constraints that had more than one dimension.So obviously, if you have no debt whatsoever—if youhave a zero stock of debt—presumably you cansustain a larger deficit over a short period. It might bethat constraints would have to take into account thedebt level and the deficit together. There arecomplexities there because you can have a zero deficitand yet you have to roll over your debt, so you canactually have a run against a sovereign borrower thathas a zero deficit. This phenomenon that we see withsovereign defaults is very similar to banks, so youcould have a run. Even though you have a profitablesolvent bank, you could have a run.

Q32 Stewart Hosie: Indeed, but when one adds anational savings ratio into that equation, in addition towhether the country is profitable, whether there is adebt or whether there is a zero deficit, it does rathermake a single uniform target quite difficult to achieve,does it not?Professor Perraudin: Sure. I am a simple financeperson, not a macroeconomist. Often people say,“Well, there are imbalances here and there”, but Iwould have thought the simplest thing is just to regardthe sovereign countries as borrowers and then youhave the outstanding debt and the deficit, because youcan pitch those at different levels in the accounts, butI would not see the need to bring in vague notions ofcurrent account imbalance or—I don’t know—allsorts of other things.Professor Goodhart: I would disagree with youstrongly there.Professor Perraudin: The danger is you would getsome sort of really complicated formula so you needsomething transparent and simple.

Q33 Stewart Hosie: Professor Goodhart, let’s say wecall the 2.5% a stability fund for the Eurozone, whichis how it would work. Would that always be enough?Would there be a ratchet effect? Would we ever haveto use 2.5% of wealth in that way?Professor Goodhart: I don’t know. It seemed good atthe time, in 1993. Just reverting to what William wassaying, I don’t think this balanced budget lark is eithernecessary or sufficient. It is not sufficient because youcan have a situation, like Ireland and Spain, wheretheir budget balance was extremely under control.

They had a national construction boom, and when thatwent sour it effectively landed on the Government. Itis also the case I understand—although I don’t knowthis for sure myself—that Japan has had a balancedbudget requirement and every year the Diet says,“Well, it’s crisis time so we’ll ignore it”. OneGovernment cannot commit the next Government, andthe next Government can always find a loophole. Sothese balanced budget constraints are not what theyare written up to be.What is more, the European Commission has nowdeveloped what I think is a much better approach thanthe old Maastricht 3% and 60% approach, which isthe Excessive Imbalance Procedures, known as EIP—if you are interested in this, lots of stuff has beenwritten on it. The excessive imbalance involveslooking to see where a country overall appears to bein an unsustainable position, and this may be on thecurrent account side; it may be on the constructionside; it may be on the public sector side. Then the ECis going to try and examine the country in muchgreater depth and bring forward measures orsuggestions about how it can improve itself. I thinkthat this is a very considerable step forward and to beapplauded. What I think is still a huge weakness inwhat they call the EIP is the sanctions about whathappens to you if you do not meet it. The problem isthat the sanctions that they are suggesting are stillthese old ideas about just fining the country that doesnot meet the target. Now if the problem is a publicsector weakness, imposing huge fines does not reallyhelp anybody.

Q34 Mr Ruffley: Could I ask both of you somequestions about UK bank exposures? You havealready indicated the limitations on estimating someof the figures. What is the order of magnitude, do youthink, of potential losses to UK banks that haveunhedged exposure to core countries in the Eurozone,and to non-core countries should they enter severecrisis?Professor Perraudin: Well, I don’t know.Mr Ruffley: I know it is a relatively difficult questionbut, in terms of the order of magnitude, would youhave any feel for the exposure of UK banks touncovered sovereign debt holdings of both the coreEurozone countries and the periphery?Professor Perraudin: I do not have reliableinformation on that.Mr Ruffley: What would your educated estimate be?Put it another way, do you think it is potentially aproblem for UK banks or unlikely to be a problem forUK banks?Professor Goodhart: What are you describing ascore? Are you including Germany as core?Mr Ruffley: Yes. On the one hand, what is the answerto the question if we are just looking at: first, abanking crisis with the peripheral countries; and thensecondly, if it is the whole of Europe, includingFrance and Germany?Professor Goodhart: I think if it is the whole ofEurope the number of policy changes would have tobe so great that the world would just look totallydifferent. If you are talking about core Europe andwidespread defaults, either at the sovereign or at the



banking level, I just don’t think that this is the kindof exercise that can be usefully done. You can do it,perhaps, with what would happen if there wereproblems in Italy. I think to—

Q35 Mr Ruffley: Let’s take that then. What wouldbe the exposure of UK banks to a sovereign debt crisisin Italy? Is the exposure such that UK banks wouldhave a real problem or would it be an inconvenience?I am trying to get a sense of the order of magnitude.I am not asking you to give a specific numericalrepresentation, but what would be the exposure, say,in the case of Italy?Professor Goodhart: I am desperately trying toremember some sort of matrices on all this, which Ionce saw, but my memory is slipping. I am afraid thisis a factual point and if you want a factual answer Ithink you should make a written request to thosepeople who would know that answer, and I don’t.Professor Perraudin: I think there are BIS statisticson inter-country lending, so you could look up that.

Q36 Mr Ruffley: Yes, but I am asking you from yourknowledge, and you are the experts in banking: isyour sense that it might be a difficulty for UK banks,yes or no?Professor Goodhart: I think we are most on the hookto Ireland, because the UK banks did a great deal ofmortgage lending into Ireland, and I think that thereare also considerable interbank links with the Irishbanks, or at any rate there were. Certainly of theperipheral countries, I think that real difficulties inIreland would be the greatest problem for us.

Q37 Mr Ruffley: What about in terms of holdings byUK banks of EU sovereign debt, whether it is the corecountries or the periphery—Greece, Portugal, Ireland?Professor Goodhart: Everybody holds a great deal ofGerman debt and everybody holds a great deal ofFrench debt. I don’t know the figures on Italian debt.

Q38 Mr Ruffley: Could I ask about the stress tests?I think you have touched on this in your earlieranswers. UK banks have been pretty much given theall clear, as have European banks, and you haveindicated what the limitations are on the results ofthose stress tests. Could you just indicate instraightforward terms what factors you think maytrigger a crisis in the periphery or in the corecountries, such that would make the all clears on thestress tests a nonsense? What do you think is going tomake the stress tests look a bit sicker than they are atthe moment?Professor Goodhart: Sovereign debt failure.

Q39 Mr Ruffley: Anything else?Professor Goodhart: The extent to which that mightbecome contagious and that, of course, would beworsened, insofar as the economies in Europe shouldnow fall into negative output growth.Professor Perraudin: I think our banks would onlybe significantly affected by failures of Spain or Italyor Ireland. I don’t think that we would be substantiallyaffected by smaller countries. So it is really a questionof whether one can find ways in which to limit

contagion and spreading of sovereign defaults tomajor countries. That is the key question for ourbanks.

Q40 Mr Ruffley: Where do you think the answermight lie? You talk about measures being taken.Professor Goodhart: It would depend how thedefault, if there was to be one, would be handled. Thegreat danger is that you might find that a default of,shall we say, Greece was forced, but that might leadto sufficient losses that there could be banking runs inother countries and the contagion could spreadincrementally from one country to another. Acontagious spread could mean one default leading todefaults of both sovereigns and banks elsewhere. Thequestion is how a forced default of one country couldbe contained. I would hope that is something that theauthorities in the Eurozone—because it would beprimarily for them—are now thinking about veryseriously.

Q41 Mr Ruffley: One final question arising fromanswers you have given to my other colleagues is, isthere any way of making the cheating more explicit?Professor Perraudin: Cheating by whom?Mr Ruffley: Well, the mark to market question, thedifference between the banking book and the tradingbook, is there anything that usefully can be done toclean all that up? You articulated it very clearly—while there may be full value in the banking book, ifthey are marking to market in the trading book itmight look very different.Professor Perraudin: I do not regard it as cheating. Ithink that having a non-mark to market approach inthe banking book is not dishonest or shocking. It issimply a way of accounting for values gradually overtime for things that banks intend to hold to their finalmaturity.Mr Ruffley: But does it matter?Professor Perraudin: The key thing is whether properprovisions are made against deterioration in creditquality and that really ought to be visible tosupervisors. So it is a question of making sure thatsupervisory practices by different countries aresatisfactory.

Q42 Mr Ruffley: You were implying in your earlieranswers that the provisioning was maybe not asrealistic as it should be, or you implied that theprovisioning was questionable.Professor Perraudin: There are certainly concernsabout that.Mr Ruffley: A final question, is there a debate goingon in relation to the countries where there isquestionable provisioning?Professor Perraudin: They are seeing the problem oftaking that approach right now because it is adding toconcerns about their banks. This is one of the reasonswhy the French banks have been downgraded today.

Q43 Mr Ruffley: So it is being exposed, slowly butsurely?Professor Perraudin: Yes.



Q44 Andrea Leadsom: I just want to challenge youon that, Professor Perraudin, because you say they arenot cheating, they are not doing anything wrong, andso on, but if we roll the clock forward a couple ofyears are we going to be sitting here saying, “Right,so is no chief executive of a bank going to go to prisonfor the fact that they were falsely accounting duringthe latest crisis?” Surely there is the playing by thebook of, “Well, we don’t have to mark to market” andthere is the stating the bleeding obvious, which is thatif we have a crisis that is very real and could betomorrow—it could be next week for all we know—would it not be the prudent position of a seniorexecutive in a bank to say, “Right. We need to startmarking to market and making provisions againstsovereign default”? Would that not be the prudentposition? If we get two years down the line and theydidn’t and we do have another banking crisis, are theystill going to walk away scot-free for not making thatprudent decision?Chair: Let’s just have an answer to the first of thosetwo questions because we might be able to—Professor Perraudin: I think they are taking advicefrom their accountants and then their policies shouldall be visible to their supervisors. I don’t think that ifsomebody does that in a way that their supervisorssign off on they are then guilty of some offence.Chair: One quick further rejoinder.

Q45 Andrea Leadsom: Yes, but as I say, there is thedoing it by the book, “This is what my regulator toldme to do”, and there is the prudent director’scompetence requirement that says to you,“Transparency in marking to market in this marketenvironment is absolutely essential”, isn’t there?There are those two things and it seems to me thatwhat you are arguing for is, “Well, rules is rules andwe just did what the rules said”. What I am saying toyou is, is it not the case that senior people—don’tforget paid a huge amount of money, an awful lot ofit being paid at the moment by the taxpayer—oughtto be seriously looking for prudent reasons at whatthey should be doing with marking to market ontheir portfolios?Professor Goodhart: The regulators ought to berequiring them to do the prudent thing. Let me try andput it in more colourful language. If you want thebanker to go to jail in two years’ time, I hope you willask that the regulator goes with him.Chair: And all those academics who were busycommenting on it as well, perhaps.Can I just end by asking you, Professor Goodhart,whether you agree with Nigel Lawson who on theradio today said that the Eurozone was doomed andthat what we had to do was prepare for the post-Eurozone world, that it was so fundamentally flawedthat it would have to be replaced, against theChancellor of the Exchequer’s view, which is that we

must do whatever we can and we must hope that theEurozone holds itself together?Professor Goodhart: I think that the Eurozone willcontinue in some form. Whether it continues inexactly the form that it has today is at the momentvery uncertain.

Q46 Chair: Is it easier to solve these problems asyou suggested, or ameliorate these problems byshovelling some recapitalisation into these troubledbanks in northern tier countries, than it would be tokick Greece out of the Eurozone, go for the stress asa re-creation of a separate currency and accept theirbad debts into a bad bank or a bad institution fundedby northern tier countries?Professor Goodhart: I think that there is a seriousquestion whether you can kick Greece out and have—

Q47 Chair: But they did cheat, didn’t they? I amsorry to interrupt. I mean there isn’t any doubt there,is there? They got Goldman Sachs in to do the job,didn’t they? I think that has been widely reported andaccepted, so there are plenty of grounds for a sharpexit.Professor Goodhart: I understand that there wasnothing that Goldman Sachs did that wasn’t legal.There are various accounting mechanisms for shiftingincome between periods that are perfectly legal butare not, shall we say, entirely transparent.Chair: I am very sorry that I interrupted your replyto my question about whether we might be better offgoing down that route, enabling a devaluation of thecurrency and the Greek economy to recover.Professor Goodhart: I think if you had said in May2010 that it would probably be easier to have Greeceexcluded and then go on as before, that was verydoable. I think that the crisis has got beyond that kindof stage. We now have a number of countries that areperceived as being in severe difficulties; in some ofthem there are worries about whether they aresustainable. What worries me is, if you were to haveGreece excluded from the EU and some kind of rescuefinance arrangement, whether this would necessarilybring the whole exercise to an end. I rather doubt it.It could have been done earlier. I think it may be toolate for that now.Chair: I am very grateful to you both for givingevidence today. If there are further thoughts that havebeen triggered by these exchanges we would be verygrateful to receive them. If you do find the time, or ifyou have already done it perhaps, Professor Goodhart,we would be appreciative of a very short note on thisquestion of the shortcomings of balanced budgets andtheir successor, the EIP, on which there wasconsiderable interest around this table. Thank youvery much. We will adjourn for five minutes and thenresume with the second session. Thank you both forcoming in.


Examination of Witnesses

Witnesses: Simon Hayes, Chief Economist, Barclays Capital, Jan Randolph, Director, Sovereign Risk, IHSGlobal Insight, and Simon Tilford, Chief Economist, Centre for European Reform, gave evidence.

Q48 Chair: Thank you very much for coming beforeus this afternoon, at short notice, to give evidence. Ofcourse, as you can imagine, most of the things wewant to hear about are pretty much answers to thesame kind of questions that I think all three of you, orperhaps only two of you—I certainly noticed two ofyou in the room—have heard over the previous hour.Perhaps I can begin pretty much where we left off.What is the most intelligent solution to this crisis inyour view? Let’s go through each in turn, startingfrom my left to right. Mr Randolph?Jan Randolph: That is a €14 trillion question, I think.First of all, the solution requires the two mostpowerful institutions in Europe to get together andwork out a short, medium and long-term plan. By thetwo most powerful institutions, I mean the ECB,European Central Bank, and the predominantGovernment and lead creditor nation, which is theBerlin Government, representing the monetary side onthe one hand and the fiscal side on the other. I thinkpart of the reason why this drama has gone on so long,and will continue to go on, is they have not actuallyworked out a strategy that involves tactics and aproper plan.I think, first of all, in the short term, tactically, theECB has to change. It can no longer be “son ofBundesbank”, as the Germans would want it as acondition of exchanging the Deutschmark for theeuro. It has to rise to the new challenges of being acentral bank for the Eurozone as a whole. That is verydifficult, but the Germans cannot have it both ways—being hard line on Germanic monetary policy and atthe same time expect the euro to exist in its currentform. That obviously has raised tensions within theEuropean Central Bank board, and so on, with the lossof German members, although they will be replaced.It is important because I think in some ways theinvestors, the longer term investors—I am not talkingabout the short-term investors, the speculators—havelost some sort of confidence in their investments,particularly the peripheral sovereign bond markets ofthe Eurozone, and as a consequence have loweredtheir exposures, which has directly raised newborrowing costs. We are seeing that play out.In part there are fundamentally good reasons for that.Relative credit risks were ignored in the boom years.When interest rates came down—every time a newcountry joined the Eurozone EU interest rates camedown—asset prices went up, with sovereign bonds atthe top of the Christmas tree and all the other assetclasses and property at the bottom went up. It wasgreat, and markets were making money every timethis happened and they were encouraging the processand ignoring the fundamental credit risks. At points,Dublin and Madrid were borrowing at less interestthan the German Government. What does that sayabout relative credit risks or lurking problems inbanking systems and property, and so on?We have a partial reversal of that now, since the lastquarter of 2009, and that is extremely painful becausethe implication is higher interest rates, which meansthat asset prices have to come down, which raises

questions about book value and what is the fair valueof these bonds that we hold.I have argued that ECB has to change. It can no longerbe “son of Bundesbank” and the Bundesbank rulebookhas to be put aside, even if just temporarily. That willmean being much more activist and providingliquidity in every single market that requires it,including sovereign bond markets, in the same waythe US Fed would act, because in some respectsinvestors—and they are predominantly domesticinvestors to the country concerned or elsewhere in therest of Europe, because very little sovereign debt inEurope is held outside Europe, in complete contrast tothe US, for example—in a sense, see SpanishGovernment debt as somehow borrowing in a foreigncurrency still, rather than a local currency. That opensa question about whose Central Bank is this? TheECB, if it wants to snap the psychology at themoment, has to make it clear to the markets that it isprepared to defend each and every central bank, likethe Three Musketeers would, in response to it.

Q49 Chair: Just to be clear on the legal position,though, it can only do that up to what its balance sheetcan bear—is that not correct in EU law? Therefore,what you are proposing actually would require a treatychange if it was very large sums.Jan Randolph: If need be. The current strategy hasbeen, basically, muddle along, pressed on—a fullstretch, if you like—with essentially risk burdensharing games being played out between the EuropeanCentral Bank and the Berlin Government. No onewants to carry the can for the risks if greater liabilityis extended out to Greece or whoever, and they needto agree on the burden sharing and how that is to playout. For example, if the Eurozone Governments insistthat the EFSF, which the way I see it is essentially ababy mini IMF—although it is learning to grow upvery rapidly and quickly to learn all the best lessonsof the IMF, including contingency lines of credit andso on—be made more flexible, if there is going to bea cap on that, that pushes more onus of responsibilityon to the ECB. If that means expanding its boundary,so be it.

Q50 Chair: Very interesting. Simon Tilford?Simon Tilford: I agree with much of that but I willcome at it from a slightly different perspective. I thinkthe immediate thing they need to do is stop obsessingabout long-term problems, such as the long-termposition of public finances, in particular MemberStates and their so-called competitiveness, becausethis crisis was not caused really by fiscal ill discipline,with the exception of Greece, and countries are notindebted because they lack competitiveness. If bycompetitiveness people are talking about productivity,well, low productivity might explain why a country isrelatively poor, but it does not explain why it has lotsof debt. We are living through the aftermath of thefinancial crisis. We saw excessive capital flows; forvarious reasons they froze; various economies were


14 September 2011 Simon Hayes, Jan Randolph and Simon Tilford

thrown into deep recessions; public finances balloonedas a result of that.The core to the problem is now the banking sector.They have to get on top of the banking sector and toeschew uncoordinated, excessive fiscal austerity,because at the moment we are in a vicious circlewhereby everyone is tightening fiscal policysimultaneously. The fiscal tightening we see in someindebted Member States is totally counterproductive.If we take Greece, for example: despite all thecabbages that have been thrown at the country, at themoment Greece is tightening fiscal policy by morethan any developed country ever. What has happenedis that that fiscal tightening has pushed that economyinto a deep, deep slump—a far deeper slump than theEU or the IMF said would happen as a result of afiscal tightening of that order. At this point, investorsare not worried about the degree of fiscal tighteningin Greece. If Greece announced tomorrow that it isgoing to tighten fiscal policy by another eightpercentage points of GDP over the next three weeks,investors would just think, “Oh well, this is no morecredible than the current fiscal programme.” The onlything that would restore confidence in Greece—notthat I think it is possible at this stage—would be acredible route back to growth and hence debtsustainability. That is not going to happen by forcingthem into a deep slump and depression, which I thinkactually threatens democratic accountability inGreece.They need to stop this moralistic posturing about thevirtuous and the profligate and get over it. Theresponsibility for this crisis lies on both sides. It lieson the side of those who lent imprudently and thosewho borrowed imprudently. It is an argument aboutmoney, essentially: who pays for capital that wasmisallocated to various Eurozone economies, thelenders or the borrowers? At the moment, the lenders,the creditors, are in the driving seat and they aredetermined that the taxpayer in the debtor countriesfoots the whole bill. What they are essentially sayingis that, “We can lend imprudently without any realrecourse to proper risk analysis, and you are going tomake us whole, irrespective of what it does to youreconomy and your society.”To make it work, they have to come clean about whatthey have done. A single currency comprising a veryheterogeneous group of economies has to have somedegree of fiscal integration; you have to have somedegree of debt mutualisation. Unfortunately—well,not unfortunately—that can only happendemocratically. You can’t push through a debt unionunder the radar. This has profound implications fordemocratic accountability, for national sovereignty.Unfortunately, they have made it very hard to win anydemocratic argument in favour of such debtmutualisation because the countries that are in thedriver’s seat at present—the Germans, the Dutch,etcetera—have cast this crisis in a thoroughlyunhelpful fashion, i.e. about, “We have lived withinour means. We have been responsible. We have beenvirtuous. They have taken the mick, essentially. Theyhave lived beyond their means. They have broken therules,” and so on. That is making it very, very hard towin any argument in Germany and elsewhere in

favour of the kind of fiscal integration that mostpeople, most economists, most outsiders, believe mustform some component of any lasting solution to thecrisis. Of course, that has to be democratic and thathas to be won, and they have made it almostimpossible to win those arguments.Jan Randolph has already talked at length about theneed for a Central Bank that performs the full rangeof lender of last resort functions. They have to havethat. That is as important, obviously, as some kind ofdebt mutualisation. In the previous session, we heardat length about the need to recapitalise. Of course, itis an interwoven sovereign debt banking crisis but, toall intents and purposes, Eurozone policymakers aretreating it as a sovereign debt crisis. They have donevirtually nothing to address the banking sector issues.Finally they need to face basic economics—the beliefthat we can all slash public spending simultaneouslyand the confidence fairy will suddenly persuadehouseholds to go out and buy new cars and companiesto go out and invest, because it is not going to happenlike that. The IMF came out with some great researchyesterday expounding, laying out quite how grave therisks are of everyone cutting by this muchsimultaneously at a time when there is no scope to cutinterest rates. Basically, there is nothing to offset that.What is essentially happening is that a strategy thatwould be sustainable for a small open economy withits own currency is being wheeled out as a strategyfor a large closed economy. A small trade-dependenteconomy with its own currency can devalue and cutpublic spending and still grow because it can generatenet exports and that offsets the contractionary impactof big cuts in public spending on demand. It is not asif the Eurozone as a whole can do that. That is a zerosum game.So I think on four crucial points there is a long wayto go. As we heard in the previous session, theproblem is that we are approaching the endgame,really, and it is quite possible to imagine this crisisspiralling out of control in a matter of weeks, ratherthan months and years. I think it is difficult at thisstage to be that optimistic.

Q51 Chair: Extremely interesting as well. Are youable to add much to both of those two, Simon?Simon Hayes: I think so. There is no shortage ofangles to this, I’m afraid. My starting point would bethat the most important near-term objective is toprevent contagion to Spain and Italy because, in termsof thinking about how this could go really horriblywrong versus just being unpleasant, that is the linethat I would not want to cross.There was a discussion earlier about exposures to thevarious countries. I have some figures on that. UKbanks have exposures of about £660 billion to the euroarea as a whole, which is about 15% of their overallassets. About half of that is to France and Germany,very little to Greece and Portugal. As someonementioned, I think Ireland is the biggest directexposure but still, that is only around 2% of UKbanks’ total assets. So really, the direct exposure tothe crisis countries isn’t that big. What you would beworried about much more is a much broader crisisacross the euro areas as a whole. Also, UK banks’



exposure to sovereign debt isn’t that great, but theirlending to the non-bank private sector across Europeis quite substantial. Again, it is not a direct exposurebut what you would be concerned about is if therewere broader problems across the European economy.One of the things, one of the most direct ways whereyou could be affected there, is if there were a break-up of the euro, inasmuch as if any country leaves theeuro, presumably they redenominate the debts in thenew currency; it falls against the euro and you havetaken a hit on that already. There are various waysthat could play out; who knows who ends up holdingthe euro as their currency? Obviously, if some of thelarger countries were to leave the euro, then you couldsee UK banks taking a hit through that channel. Thatalmost seems like the unthinkable thing; that is theline that you don’t want to cross.Spain and Italy I think do need supporting because onour calculation—

Q52 Chair: Just to be clear, how do you intend todifferentiate in order to provide that support? You arebasically saying support those and cut the rest adrift,aren’t you?Simon Hayes: No, what I am saying is it really is amatter of priority. The financial markets are clearlysceptical.Chair: If you prioritise them you will be cutting theothers adrift. At the moment, we are prioritisingGreece, Portugal and Ireland, aren’t we?Simon Hayes: I think in the near term this comesdown to the ECB’s bond purchases for Italy andSpain, because the financial markets are clearlysceptical about Italy and Spain’s ability andwillingness to—Chair: It has worked fairly well with Italy. The longbond market has improved a lot.Simon Hayes: With the purchases.Chair: Yes.Simon Hayes: What I am saying is that that needs tocontinue and that there needs to be some officialsector support to those markets. Becausefundamentally, I think Spain and Italy, the amount ofadjustment that they need to do to remain solvent ismanageable. It is not an outrageous or unreasonableamount of adjustment, but the financial markets arenot convinced and that matters because, obviously, ifthe yields go up they can’t keep borrowing at 5.5% or6% and be sustainable on that basis. So there needs tobe an official sector structure in place to keep bondyields down and there is at the moment; it is the ECB.By the end of the month, maybe into next month, itshould be the EFSF. I think that that channel ofsupport needs to be kept open and will be there forsome time.Then the second thing that needs to happen if you aregoing to convince markets that actually Spain andItaly are going to adjust, they need to be able to seeevidence that they are adjusting. At the moment, wehave this problem where financial markets react sorapidly that countries come out over the weekend withsome new proposals about fiscal tightening, and thenby the end of the week it turns out that the particularproposals are not that acceptable and they may provedifficult to get through. You can’t really make these

sorts of adjustments politically on the timetable thatthe markets demand, so you have to buy yourselfsome time on that, and I think maintaining bondpurchase programmes for Spain and Italy is one wayof doing that.In the longer term, you do need to introduce crediblefiscal management arrangements across the euro area.As the discussion went on earlier, that could beapplying the same rules to each individual country andsaying that, “If we all meet these individually, overall,the euro area will be solvent”, or it could be an overallfiscal authority where you have some flexibility andsomebody who is allowing certain countries to runlarger deficits and others smaller, if that werepolitically feasible. Some seem to like that proposal;personally, I find it difficult to imagine that that wouldreally work. In either case, the euro area as a wholeis solvent and you need to have measures in place thateach Government signs up to convince markets thatthat is the way it is going to be in the future.Chair: Those were very interesting replies to what Ithought was a reasonably simple initial question.

Q53 Stewart Hosie: That was fascinating, more forbeing a little more prosaic or parochial in terms ofwhere the UK’s liability is at the moment from yourvarious perspectives. What is the UK’s liability tovarious Eurozone bailouts at the moment through theEFSF and bilaterals? Where are we as a whole withthat just now?Jan Randolph: The Bank for InternationalSettlements [BIS] have a unique perch in terms ofreporting from the banking system. National bankswithin the nation state, reporting goes normally to theCentral Bank and then goes up a layer again to Basel.They have a unique perch, even the IMF and OECDdon’t have, which is they can look at what goes crossborder on an asset and a liability basis. In thatposition, and it is a helicopter position, they can see360 degrees who owes what to whom, which bankingsystem owes what to which banking system. It is aunique perch. It is one that individual commercialbanks don’t have because they only have a side-onview, but they [BIS] are better able to look atconcentrations. To the extent that banks actuallyreport all their activities—and we had a big problemin the financial crisis where they didn’t, the emergenceof the shadow banking system, assuming that a lot ofthat has now disappeared, particularly in the States,that which is in the sunlight of reporting—then thenumbers are quite clear where our exposures are, ourdirect exposures in terms of the normal breakdown ofthe level of assets that a bank might have. Separatingthe core, for the moment, and the peripheries, clearlyIreland [for the UK] and also, to a certain extent,Spain.

Q54 Stewart Hosie: In addition to the banks’liabilities, there is also the issue of the state’s liability.I think the UK through its EU contributions and theEFSM is a maximum of 12.5% of £60 billion orsomething—£7.5 billion. Looking at the banks’exposure, RBS exposure to Italy and France is about



£7 billion; HSBC to the same countries is about £6billion; Barclays to the same countries is about £11billion; Lloyds, next to zero. These are big numbersbut they don’t strike me as catastrophic, even if therewas to be total default, which is highly, highlyunlikely. So what is the general view about the realscale of the potential contingent difficulty to the banksand to the economy here generally?Jan Randolph: We are trying to feel out perspectivehere, aren’t we, really?Stewart Hosie: Yes.Jan Randolph: It is a good starting point—whereyour perspective is before you can move on in termsof an analysis. If we look at the big debt markets, Italyfor example, I believe it is nearly as big as the GermanGovernment debt market, although with a muchsmaller economy. Half of that debt is held by domesticbanks—that is not unusual; that is actually typical.There are countries on the periphery that have a littlebit more cross-border into the Eurozone banking,mainly into the core, and I include the UK here nowin the core from the banking perspective. Like Irelandand Greece, over half is with other Eurozone banksand the UK. By the figures there, from the top of myhead I believe we are still the largest of the corecountries in Europe with $118 billion-something [toIreland], slightly more, slightly less, followed byGermany.Germany had a lot of investment in the financialsector in Dublin, because they liked the regulatoryenvironment there compared to back home and thedevelopment of the financial sector there. It isfollowed by Spain. But if you take these numbers andlook at what the total sovereign debt of that countryis, it is relatively small. It is true. If you look at thesize of the balance sheet, I remember as a rough ruleof thumb our four high street banks, roughly, had onthe asset side the equivalent to UK GDP. Some wouldsay that is horrendous, we should never get ourselvesinto that position where total banking systemliabilities is four times GDP. It is GDP. If somethinggoes wrong it is what we call contingent sovereignrisk from the banking system. We saw how that playedout in Iceland and Ireland. If banks can get too big tofail, so can banking systems.

Q55 Stewart Hosie: Given what you have just said—it is big numbers but it is not catastrophic numbers—should we get into a new crisis, either core or non-core, in the Eurozone area, what would the likelyimpact be on the UK balance sheet? What would theimpact be on UK credit rating, just to try and get apicture of where this might go if it does begin tounravel?Simon Tilford: I think it is worth looking at Lehman,just to get a handle on what looks like a manageablewinding down and the impact that can have. Whenthey looked at Lehman they thought, “Okay, thefinancial system can cope with this,” and then we sawwhat happened. I don’t think it is just a question oflooking at liabilities. It is what happens if, in the

eventuality of a default or a series of defaults, theinterbank market freezes and disrupts wholesalefunding operations, etcetera. Then you see animplosion of trust between financial institutions—whois sitting on what—and you get liquidity-typeproblems. It is not just a question of just the rawnumbers; it is all about confidence and trust.In terms of the impact on the UK and its credit rating,it really depends on how far it went. If it was justGreece and Portugal defaulting—I mean, I think thebest thing to happen at this point would be for themto say, “Okay, Greece’s debts are unsustainable, theyhave to be restructured,” probably the same forPortugal, and then they have to make a decision onIreland. Then they throw everything at the rest. Sothey restructure their debts and accept, yes, under norealistic forecasts for economic growth are they goingto be able to service debt burdens of that order. Butthen, when it comes to the rest—that is, Italy, Spain—yes, the adjustments are big but if only they had acentral bank behaving like a regular central bank andif they had more realistic fiscal targets, etcetera, theyweren’t having to tighten fiscal policy by quite asmuch as this in the teeth of a downturn, so fiscalpolicy was not quite so close, etcetera—if things werebeing handled rather more competently, then it wouldbe possible to demonstrate to the markets that theywere solvent. Investors need to be confident that thenecessary provision, the necessary support, is going tobe for them come what may.

Q56 Stewart Hosie: Given your view about thecentral bank acting as a central bank, and given theview that the ECB should be providing liquidity to allmarkets, including the sovereign market, would yourview generally be—and tell me if there is adisagreement—that the UK, because of the risk ofcontagion and the huge export market we have to theEU and to the Eurozone, should continue to offer thesupport that it possibly can in order to provide thatliquidity where it is necessary?Jan Randolph: I think certainly so, but there wouldbe an additional problem. We have to rememberLondon is the international financial market for mostmarkets still in Europe, so what happens in Europedoes affect us here in the City. That is our localeconomy.Yes, liquidity provision is important. We can look atdifferent transmission channels of contagion. We cansee clearly that banks hold debt, including sovereigndebt; they may also hold debt of other banks. Weforget how much banks actually do business with eachother. We normally think of them lending tocorporates and to Governments and households. WhenI was working for one British bank, our biggestcustomer was another British bank—these were twobig British banks. That is also the problem of the viralnature of financial crises and the way you are ropedup: climbing up a mountain, if one starts wobbling,you all start getting worried, and you can’t see thoseroped up behind the mountain and so you assumemost caution and that is where we are now.



We have contagion on direct hits—who holds what?We have contagion working through sentiment andpsychology—we don’t know who is roped up behindthe mountain that we could be linked to, the secondaryknock on effects. Then there is the liquidity fundingside—some banks are structured where they arehugely dependent on wholesale markets for liquidity;others are deemed safer because they have a retailbase of depositors. All these things come into play.Basically, we have a tightening of credit conditionsand the general financial conditions separate frominterest rate policy setting, the general tightening offinancial conditions, which isn’t good for the supplyof credit should there be a demand for credit, becausewe need these two working together if we want somefuel for recovery. Without those two going togetherwe are stuck in this anaemic crawling growth path.

Q57 Stewart Hosie: I am not going to go too far onthis. This is my last question just now. Simon, givenwhat you said earlier about protecting the countriesmost at risk just now, would your view be the samethat the UK should continue to contribute, whether itis bilateral or through the IMF or through any otherfunding, to make sure that that is done?Simon Hayes: Yes, it would on that. We have reachedthe stage now where this applies not just in Europe,but also in China and the US and more globally. Thedebt problem built up and there are two sides to that.There was excessive borrowing but it is also excessivelending. The first stage is always to make theborrower adjust and that is what we have been goingthrough. In some cases, making the borrower adjust istoo extreme a requirement and it becomes apparentthat the lender has to take some of the hit as well,because they also lent on unrealistic expectationsabout what the outcomes of investments were goingto be. I think that is the stage that we are getting tonow, where there is a certain amount of pain that hasto be gone through. We are realising that maybe it isunreasonable to expect all of the burden to rest on theborrowers, so the lenders, in their own interests, aregoing to have to come in and take some of the hit. Ithink the UK contributing to these sorts of packagesis part of that process.

Q58 Andrea Leadsom: Just a very straight answerfrom each of you, if you could. Are we beyond thestage of being able to prevent a crisis, yes or no?Jan Randolph: I would say that we are in a crisisalready, so—Andrea Leadsom: Yes, sorry, I should have beenmore specific. My definition of crisis is either asovereign default or a massive change in the structureof the EU. That to me would be the crisis. We are ina crisis period now and what I want to know iswhether there is anything, any combination ofpolicies, that could avert the inevitable crisis do youthink—yes or no?Simon Hayes: Yes, I think there is. I accept that themost immediate one would be to do with Greekrestructuring. You can have hard defaults and you canhave soft restructurings, and the soft restructuringroute is still open and still being explored.

Q59 Andrea Leadsom: Can Greece stay in the eurocurrency group under those circumstances?Simon Hayes: Yes, I think so. On our assessment, ifthis second programme is successful, if the privatesector involvement comes on as they hope, then ittakes Greece from being clearly unsustainable tobeing borderline marginally unsustainable. So I thinkyou have bought yourself some probability of gettingthrough this, but still with a big risk that you don’t; ahard default is certainly still on the cards.Andrea Leadsom: You are effectively saying that youmight not be able to prevent it but there is more stillto be done?Simon Hayes: Yes.Andrea Leadsom: Simon Tilford, what would yousay?Simon Tilford: Starting from where we are now, withthe current policy mix or current strategy for dealingwith the crisis that we have, I think it is unsustainablein its current form. That will not be just Greece andPortugal either. It will be more.Andrea Leadsom: Jan Randolph?Jan Randolph: I think essentially even though thiscrisis morphs and it has ricocheted from the originsback to 2008, it is essentially manageable. I thinkwhat is wanting is policy coordination, having theright institutions to deal with the situation. Sometimesmarkets expect and demand certain things to happen,but politics and policymakers work on a different,slower body clock, and sometimes things are notrealised until they are very clear for everyone. I think,certainly in the Greek situation, default is more oftenthan not a decision made by creditors, whether it issovereign or corporate. They decide. They precipitatethe default by not rolling over the money and theystop the financing. That could still yet happen toGreece, although I think Berlin and the others arefully aware of the consequences. If it was just Greece,they would probably do it sooner rather than later, butthe problem is contagion. That is where the ECBneeds to come in as a backstop. Greece is going tobe given enough time because structural adjustmentrequires it before you see any kind of genuine results.I think if the ECB is given greater powers tointervene, a full licence to act as a lender of last resortin all respects, for me that would defuse the bondmarket crisis, but it doesn’t defuse the underlyingcrisis to do with the Eurozone. They would have moretime to deal with that, but that would be a separatechallenge.

Q60 Andrea Leadsom: How do you see the ECBbeing given the powers—the technical powers—to actas lender of last resort? How is that going to happenfrom where we are today?Jan Randolph: It has happened already. Jean-ClaudeTrichet reopened the bond buying programme on 8August while politicians went off on holiday. To befair, Angela Merkel and Sarkozy provided a signedletter to Trichet to handle all financial matters in fullconfidence while they were away.

Q61 Andrea Leadsom: But there is a ceiling, isn’tthere? There is a ceiling and that ceiling isn’t high



enough. If the markets want to test that ceiling then itwill not be high enough, will it?Jan Randolph: Yes. This is it.

Q62 Andrea Leadsom: So it is not really a lender oflast resort, is it?Jan Randolph: They know that the ECB is half-hearted about this and the ECB should be determined.It should show the nuclear button and say, “Look, wewill” and convince the markets that they will.

Q63 Andrea Leadsom: How can the ECB be alender of last resort if it does not have the power tobe a lender of last resort? How will it get that powerif that is what it takes to avert the crisis?Jan Randolph: That is a good question. It is up to theowners of the Central Bank—the sovereignGovernments, and the most important is Germany.

Q64 Andrea Leadsom: That presumably will requiresome sort of new treaty and that is certainly not goingto work in the timeframe of the markets, is it? I amjust trying to get to the bottom of whether that isrealistic. You are saying that is the solution to preventa crisis.Jan Randolph: I am saying it is part of the solution.I see a Central Bank that is not up to the challengesthat the Eurozone presents itself as. We are still seeinga Central Bank moulded in a ‘70s and ‘80senvironment of West Germany. That was suitablethen. Now it [the Eurozone] is obviously bigger butits [ECB] mentality and thinking is still very much fora medium-sized efficient export engine economy—apowerhouse called Germany. The challenges of theEurozone are much, much greater and I think it needscommensurate powers and policies to deal with that.

Q65 Andrea Leadsom: You are partly saying it ispreventable but I am not getting any real handle onwhat this Committee should be recommending.Recommending that the ECB becomes a genuinelender of last resort with complete rights to obligatethe entire EU membership is just so badly not goingto happen in the timeframe, so short of that what elsecould be done to avert that crisis? In your view, isthere anything that we as a Committee should berecommending that could be done now to avert asignificant crisis?Simon Tilford: The unfortunate truth is you can dorelatively little. We are not in the currency union. Weare not participating fully in the European FinancialStability Fund. I understand personally the politicalreasons for that, but we have limited say over thesedecisions. Clearly, we are going to suffer hugecollateral damage if and when the Eurozone crisisreally blows up—there is no doubt about that. Giventhat we can’t really influence policymaking within theEurozone, we have to concentrate on trying toincrease—

Q66 Andrea Leadsom: We can influence banking,though, can’t we? We can influence bank regulationto a decent extent. Is there anything we could do inbanking?

Simon Tilford: In the timeframe necessary and in theways necessary, I am not sure.

Q67 Andrea Leadsom: Recapitalising of banks,forcing them to mark to mark to market theirsovereign debt and so on?Simon Tilford: The Chancellor of the Exchequer hasbeen quite outspoken on the need to recapitalise banksin particular Eurozone economies. He has also comeout in favour of some kind of fiscal union. For arelatively Eurosceptic British Chancellor, that wasquite a step. I don’t know what they can do beyondthat—I mean that is quite a shift. He is basicallysaying, “Okay, we are not part of it, but in order forit to work you are going to have to become muchmore integrated.” That isn’t something one wouldnecessarily have expected from a relativelyEurosceptic Chancellor of the Exchequer. I am notsure what they can do beyond that. They can backIMF calls for the recapitalisation of banks.What would be very useful, but of course the BritishGovernment is very poorly placed to argue it, is tohighlight the risks of uncoordinated and excessivefiscal austerity. The UK position on that is it is adifficult one for us to argue. Of course, our positionis different: we have had a big devaluation of thecurrency; we have our own central bank; we have verylow interest rates; we have a central bank that canprint. The risks of our tight fiscal policy are much,much, much less acute than the risk of such policyacross the Eurozone in economies with similarimbalances to our own but, nevertheless, it is a toughargument to make.Like it or not, I think all we can do is concentrate ontrying to bolster our defences. Our banks are, as awhole, better capitalised, but we have to ensure thatthey do have sufficient buffers to absorb what is likelyto be coming. We do need a strategy for economicgrowth. I think there needs to be a conversation aboutwhether, for example, it makes sense to be slashingcapital investment in this climate. When investorslook at the sustainability of the country’s fiscalposition, they are really not bothered about the next18 months to 24 months. They are bothered about thelong term, and one of the things that affects acountry’s long-term fiscal position is its growthpotential. Slashing investment in a country with very,very outdated and poor physical infrastructure froman already low proportion of GDP to next to nothing,I think, is unwise and does nothing to underpinconfidence in our public finances. So these kinds ofthings, I mean I am afraid all we can do is concentrateon strengthening our own economy, making ourselvesless vulnerable to this.

Q68 Andrea Leadsom: Simon Hayes, do you haveanything to add to that?Simon Hayes: Not materially. I think that in the nearterm the main thing that is required is that the marketssee that there is sufficient firepower behind bondpurchases, for instance, to ensure that Spain and Italycontinue to be funded. I think that that is more likelyto happen in an incremental way, in terms of there



will be crises and that will force Euro areaGovernments into upping the size of the EFSF, forinstance, but there is nothing that the UK really cando to influence that beforehand.So no, I agree. I think the UK’s defences are about asbolstered as they can be in that the sorts of crises thatreally would have a very significant effect on the UKeconomy are things like break-up of the euro and,much more dramatic, a sovereign debt crisis to biggercountries, and I really don’t see what the UKGovernment can do to materially influence thelikelihood of those things happening.

Q69 Andrea Leadsom: Just one last quick question,do you think that if there is a default or if there issome sort of break-up, some massive crisis in theEurozone, do you think that that would affect Britain’sprospects, as in its own credit rating and the viabilityof its own banking system? Obviously, we allrecognise there would be short-term massive pain,maybe another recession, but do you think it wouldactually undermine Britain’s longer-term prospects?Simon Hayes: I think it would. Again, you can drawa line: there are more minor crises where the UK maybenefit again from safe haven flows, and so on,because it reinforces the fact that the UK is in thismore solid position fiscally; but the fact is theeconomic and financial interlinkages and bankinginterlinkages, between the UK and the euro area, areso strong that if something is fundamentally bad forthe euro area, it is fundamentally bad for the UK. I amsure that would be reflected both in financial marketmovements and in the behaviour of the real economyover time. I think it is one of those things; it really isa very material risk because the hit to the UK couldbe very serious indeed.Simon Tilford: I think without a shadow of a doubteven the modest forecasts for economic growth uponwhich our fiscal projections are predicated assumepretty strong growth in net exports, i.e. we arebasically assuming that exports in one way oranother—exports directly and also investment inexport orientated risk to the economy—are going toaccount for a much bigger share of economic growththan has been the case for a very long period of timein the UK. A profound dislocation in the Eurozone,perhaps not even that, but just stagnant growth in theEurozone and ongoing instability, is going to have abad enough impact on the likelihood of us being ableto pull that off, given that well over—

Q70 Andrea Leadsom: But that again is short term.I am talking about our rating, the future for ourbanking sector.Simon Tilford: I will come to that, but basically givenhow much of our growth presupposes strong netexports, and given how important a market theEurozone is, and given the likelihood that, even onthe best scenario, they are going to stagnate for yearsbut more likely we are going to have a full-blowncrisis, then I think our forecasts for economic growthand hence the public finances look very rosy, veryoptimistic. If it transpires that growth is weaker and

far less progress is made on consolidating the UK’spublic finances, then I think a downgrade is a given.I don’t think Britain has much chance at all ofretaining a AAA sovereign credit rating.

Q71 Stewart Hosie: Just one question on that.Simon, you mentioned the Chancellor effectivelycalled for a fiscal union. This is the same question toall of you. Does it really make sense to have evercloser fiscal policy to mirror ever closer monetaryunion, or should the states in the Eurozone not havethe largest possible degree of fiscal flexibility in orderin some cases to be procyclical or countercyclical withwhat the ECB are doing in terms of monetary policy?Where is the balance on this?Jan Randolph: I am not quite sure whether you areasking what is an ideal optimal currency area.Obviously, that has a lot to do with the variousconstituent parts—are they converging? Are theymoving in the same direction? If they are not movingin the same direction economically, are therecounterbalancing influences, fiscal transfers, otherways and means? For example, Greece in the longerterm needs to regain some sort of competitiveness,viability, in this brave new economic world, not justwithin Eurozone but globally. That is true for us aswell. We are seeking a new path out there as well.To a certain extent the Germans have achieved thatexporting to the successful emerging markets.What strikes me very much is, if you want to be amember of a single currency, it was a bit like beingunder the gold standard in the 1930s. It was one ofKeynes’ great insights that if you have this situation—and there are similarities between currency union andgold standard—you have countries that are generatingstructural exports and others structural deficits. Overtime, you will get a build up in debt, which couldmanifest either on the private side or the public side,or a mixture of both. At some point you have asolvency crisis. We had to wait until the end of theSecond World War before we had the IMF poppingout at the end of this. We are getting exactly the samereplay now in Eurozone, the same sort of replay of aparallel story, new creation of a central fund, theEFSF.On the fiscal flexibility side, I don’t know. It dependswhere the debt goes because all deficits have to befinanced.

Q72 Stewart Hosie: Let me give an example. Irelandhave just cut VAT in the tourist industry—they haveeffectively kept money in that sector to grow it aspart of their attempt to increase growth in their overalleconomy. Were that to be impossible because of fiscalunion, would that be a good thing or a bad thing?Jan Randolph: Could you say that again, please? Thatwas a bit too quick for my one ear.Stewart Hosie: Sorry. Ireland have just cut VAT inthe tourist sector, deliberately to stimulate growth inthat part of the economy as part of the overall growthstrategy. Fiscal union may have removed that levertool from them. Would that be a good thing or a badthing?



Jan Randolph: I see what you mean. Yes, Ireland isprobably one of those that will eventually recover andrehabilitate sooner than I think people expect,precisely because of its flexible economy and the taxstructure is advantageous. Some of the advantages thatIreland had that made it attractive to foreign directinvestment are still there. The externals sector isbooming and when you look at the country you cansee the export surplus. It includes the services side aswell. It is booming and this is the external adjustmentthat some of us look at. It will spill over into thedomestic economy.On the tax structure issues, I can understand whyBerlin, for example, have said, unlike the French,when it comes to corporation taxes, “This is not a redline for us.” They are quite right, why should it be?We want to see a recovering Ireland. That is moreimportant for us than fetishising tax rates. It shouldnot be fetishised. If it is successful in deliveringgrowth, that benefits everyone.Simon Tilford: When people talk about fiscal union,when most people do, at least when most economiststalk about fiscal union, they are not talking about auniform sort of constraint on Governments. They arenot saying that. Basically, it is actually the reverse. Ifyou have a currency union whereby you havebasically a group of countries sharing a currency, andif we see huge trade imbalances emerge between theparticipating economies, it is very hard for economiesto adjust, for those imbalances to be unwound in theabsence of a fiscal union. What they are attempting todo at the moment is that we have these huge tradeimbalances within the Eurozone but the full burden ofadjustment for correcting those trade imbalances,which lie behind many of the problems we have, arefalling on the deficit countries. So deficit countries aregoing to cut their deficits by deflating theireconomies—basically by cutting wages and slashingpublic spending, so the 1930s, really.Now what a fiscal union would do—basically, whatthe Germans and the Dutch are saying is that they canparticipate in a currency union, we can run huge tradesurpluses indefinitely, but we do not need toparticipate in a currency union. The problem there isthat if the private sector will not finance the deficitsof the deficit countries, the public sector has to financethem in one way or another. If the public sector won’tand you won’t go to a fiscal union, basically the onlyroute out is for the deficit countries to adjust. Thatbasically means slashing wages. Anyone who thinksthat is going to be politically sustainable in Italy byas much as they need to do it, or in any of thesecountries, is guilty of gross ignorance of economichistory.When people talk about fiscal union, this is not a wayof imposing German procyclical, one-size-fits-allfiscal targets on everyone, which would becatastrophic, which is what they are trying to do. It isabout actually providing a mechanism to transferfunds between participating economies. Of course, theproblem is that there isn’t the necessary solidaritybetween the participating economies to underpin thatkind of network and it has to be underpinned

democratically. You can’t push that kind of thingthrough under the radar, although some people wouldvery much like to do so. Clearly, that is a fundamentalsovereign step and it can only be pushed through if itis sanctioned democratically. That is the problembecause at the moment there are very, veryconsiderable obstacles to that.Stewart Hosie: That is helpful.

Q73 Jesse Norman: Mr Hayes, do you trackBarclays’ own funding in the markets?Simon Hayes: No.

Q74 Jesse Norman: Let me ask you all then a widerquestion, which is, on a scale of one to 10, how doyou assess the ability of banks to fund themselves inEurope at the moment; with one being bad and 10being good?Simon Hayes: Could you just repeat the last bit,sorry?

Q75 Jesse Norman: Sure. On a scale of one to 10,one being bad and 10 being good, how do you assessthe ability of banks to fund themselves in the moneymarkets in Europe at the moment? I am just trying toget a handle on how serious the impending secondarybanking crisis would look.Jan Randolph: Again, a lot of banks fund themselvesthrough a retail base and so they can ignore whatmarket—Jesse Norman: I would have said there are very fewbanks in Europe that are not reliant on the wholesalemarkets in some way or other.Jan Randolph: I think liquidity funding is not reallyan issue. Obviously, you can measure stress, theLIBOR spread, for example. It is a gauge of fear, thesemountaineers climbing a mountain. The banks feareach other in terms of what they might be thinking ofdoing. We saw that LIBOR risk spread, which wasessentially a measure of the financial crisis. You cando the same for EURIBOR. You can also look at thedependence on the ECB balances for liquidity as ameasure of liquidity stresses, how far we are beingcold-shouldered or excluded from the basic liquiditymarkets, the funding markets, and therefore we haveto depend on the sovereign, the Central Bank, forliquidity. There are different ways you can measurethese things and then try and understand what do theyactually mean? What is—

Q76 Jesse Norman: In one sentence, what is yourassessment at the moment of those measures and whatthey mean?Jan Randolph: Obviously, I think it is worse than itwas before. I don’t personally think it is near aLehman-type situation, mainly because we do havethese new backstops from the ECB liquidity facilities,six months unlimited and so on. You do have asovereign safety net.Simon Hayes: I think its significance might be a bitof a red herring. You can look at this in two ways.One is the Central Bank facilities are there and arewidely used and the ECB and the Bank of Englandhave certainly been very clear that they will be willingto provide liquidity as required.



Q77 Jesse Norman: If everything is as rosy as yousuggest, why are there hundreds of banks acrossEurope being directly funded by the ECB?Simon Hayes: Because it would be a lot moreexpensive for them to get funded elsewhere, but solong as the—Jesse Norman: It is vastly more than was evercontemplated when the ECB direct funded—Simon Hayes: So long as the ECB is providing thatliquidity, then you shouldn’t expect a crisis.

Q78 Jesse Norman: So why has the CDS spread onthe Royal Bank exploded over the last month and ahalf?Simon Hayes: The CDS markets don’t always behavesimilarly to the two interbank markets in othermeasures of stress. We don’t always pay a lot ofattention to them because they are very thin marketsindeed. I think in terms of funding costs, one thing isthat on the spreads, even though the EURIBOR spreadmay have increased, the actual EURIBOR rate hasnot. All that has happened is it has not gone down.The actual funding—Jesse Norman: If people are not actually able to fundthrough it you are not going to see much movementin the spread, so it is a matter of how much isactually done.Simon Hayes: You don’t need to because the ECBand the Bank of England, and the Fed via the swaplines, will provide the liquidity. I think the concernsare much more to do with the sovereign debt issuesand the ramifications of euro membership.

Q79 Jesse Norman: That is helpful. Tell me, youhave talked about the importance of preventing thecontagion from spreading to Spain and Italy. Which ismore at risk? Which are we more worried about?Which should we be more worried about, Spain orItaly, from a UK perspective?Simon Hayes: I don’t think that you could isolatethem. If one ran into problems then it is hard to seehow you could have a crisis in one that was not abroadly euro-area crisis, I think.

Q80 Jesse Norman: It was fairly obvious that Greeceis the sickest of the PIGS. People could see certainfactors. You are suggesting there is no qualitativedifference at the moment that would allow us to saySpain is worse off than Italy, that we should be moreworried about Spain from a Eurozone perspective, oris Italy more worrying?Simon Hayes: They are both big, substantialeconomies.Simon Tilford: I think Italy ultimately, if you wantedto choose between the two, is the bigger threat. It isthe bigger economy. It is the one with a much lessstable political system. I think it is perfectly possibleto imagine in Italy that if they face the choice betweenyears of deflation and fiscal austerity or thealternative, there is a greater risk; if the politicalconstituency are in favour of staying the course, thereis a much greater risk that that constituency couldfracture in Greece than there is in Spain. Also, I thinkthe spreading of the crisis to Italy really has raised thestakes, no doubt about it.

Q81 Jesse Norman: That is interesting. You havetalked about the importance of complying with thenew set of EU fiscal rules or the promulgation ofsomething like that as part of a new regime. We heardfrom Professor Goodhart that you can’t fine people toget them to comply. That is counterproductive. Howdo you compel compliance with EU fiscal rules? Whatare the kinds of things we should be looking at? Or isthere actually just rampant moral hazard in a situationlike this where you can’t punish someone?Jan Randolph: The Germans talk about sanctions andthe question is, is it automatic or is it that you have togo to some court or committee to decide it? TheGermans would prefer an automatic sanction, ofcourse, but then if you look at it, that makes thesituation worse.

Q82 Jesse Norman: What would those sanctions be?Just a fine? What would it be?Jan Randolph: Yes, I mean this the reason why itdidn’t work in the past, because it was sent to acommittee to decide and it wasn’t automatic orenshrined in law, and so it did not pose much of adeterrent. It didn’t do so for France or Germany.

Q83 Jesse Norman: It is a piece of Euro fudge. Weare going to get a massive moral hazard. These thingscome out again. No one can compel the compliance.The good guys do the right thing; the other folks donot. Then there is a huge crisis about who bails whoout. That is what seems to be happening without aproper enforcement regime.Simon Hayes: I think ultimately there are no effectivesanctions because things can be fudged in the end andwill be. What you have to do is to build a constituencywithin the euro area for close monitoring andadherence to public finance rules. I don’t think thereis any alternative, so you have to get countries to signup to these things and you have to do them in such away that it becomes part of the system. I don’t thinkultimately there is anything that you can do. Jean-Claude Trichet mentioned that countries could beejected from the euro for not following the rules andthat could be used as an ultimate punishment, but youcan see that there are many circumstances in whichyou would not want to hardwire that into some rulesso that it happened automatically. If it is not going tohappen automatically, then there are whole myriads ofcircumstances in which you would not follow throughwith it.

Q84 Jesse Norman: Thank you. I am conscious ofthe passage of time. I will not keep you too muchlonger. Can the ECB in fact be given the powers thatyou think are necessary for it without a change in thetreaty, without a treaty change of some kind?Chair: It was the question I posed to you right at thebeginning, Mr Randolph, when you said if the ECBwould step up to the plate we would all be okay, towhich I replied, “Well, they can only do that to thelimit of their balance sheet”.Jan Randolph: Yes. I am not an expert on the legalconstraints that the ECB is under or its room for



manoeuvre. It is an animal defined by EU law. Iassume it has a certain amount of flexibility and all Iam arguing is that I see the way the ECB is behavingvery much as if it were still “son of Bundesbank”.That is not appropriate for the new times involvingnew Eurozone challenges when it has to face anumber of different kinds of economies and theirdifferent financial positions and all the differentmarkets that it is involved in. Yes, on one key issue,for example, quantitative easing, that is notcountenanced under Germanic monetary philosophy.It has to be sterilised all the time.If you look at the size of the asset book, if we look atour Central Banks, Bank of England, ECB and theUS, how have the assets side of this balance sheetballooned by comparison since 2008? It is veryinteresting. Obviously the US has gone up quite alot—threefold I believe. The Bank of England hasgone up quite a bit, if you look on their balance sheets.It is not always easy to see what is on the balancesheet of banks. They are a bit like dirty windows,cracked windows and covered curtained windowssometimes. The European Central Bank has done verylittle by comparison I think, but again that is the wayit was brought up by the Bundesbank. It needs to getreal, basically, for the new challenges. If it does nothave the powers, it should be given the powers.Jesse Norman: Is this your view as well?Simon Tilford: I think the constraints on the ECB arenot so much on the legal side but the political side. Itis quite unclear, really, what the ECB can and cannotdo. It could do a lot more than it is doing just from astrictly legal perspective.Jesse Norman: It already has powers and it isfailing to—Simon Tilford: Yes. The problem is that it is doing asmuch as it thinks it can do without prompting an openpolitical rebellion in particular member states, notleast Germany. It is worth bearing in mind we havenow had both senior Germans at the ECB resigningover their strategy. There is no doubt that there is aprofound split within the ECB. The ECB is in adifficult position because it can go ahead and dothings, but that might prove counterproductivebecause it might just feed market fears that this splitis doomed to come back out in the open and lead toan open argument about the ECB and its powers. It isnot straightforward.Simon Hayes: I think that the ECB is being used as akind of quasi-fiscal transfer mechanism in a way thatis undesirable, frankly, and that is what has caused thetensions. So I would not look to change things toallow it to do more of that. I would much rather itwere a plain vanilla Central Bank, and things like theFSF and the central fiscal authority, and so on, havemore transparent arrangements for the actual fiscaltransfers that are going on rather than doing itindirectly by these balance sheets.

Q85 Jesse Norman: Thank you very much. A veryquick question. Mr Tilford, you said, if I understoodyou, that as matters presently stood, you thought adowngrade in the UK’s credit rating was inevitable. Isthat right?

Simon Tilford: No, I am not sure I would say“inevitable”. I think if I had to bet one way or theother, I would say, “Yes”.Jesse Norman: Right; over a one to three-yearperiod?Simon Tilford: Yes.Jesse Norman: That is because of the lack of growth?Simon Tilford: Largely because our economic growthprospects are so poor—Jesse Norman: Notwithstanding the austerity, such asit is, but the low interest rates we are currently beingcharged on our debt?Jan Randolph: What is clear is the biggest damageto the rating that could happen is a loss of taxrevenues. That is the ability to pay back. That is thecentral pillar to the rating, any rating—my rating, thesovereign rating, corporate rating—your ability to payit. If your tax revenues bleed away and dry up becauseof recession or because of financial crisis that canfundamentally undermine your rating.Jesse Norman: That is extraordinary. If that was thecase, you ought to be piling out of the marketsbecause the markets are not discounting that kind ofchange—Simon Tilford: No, but as we see from the US youcan have downgrade and it can lead to an increase inbond prices and hence a fall in yield. Yes, it is onlypartly down to the extent of fiscal austerity. We havea lot of overly rich households. We have companieswho are sitting on cash rather than investing. Okay,part of that is to do with perhaps excessive restrictivefiscal policy, but we are in the aftermath of a veryserious financial crisis. Growth is normally very weakin the aftermath of a serious financial crisis. We aregoing into it with quite a lot of debt, having had aneconomy that was successfully driven by debt of onesort or another for a number of years. We have apainful rebalancing in front of us against a veryunfavourable global backdrop, so there are all kindsof headwinds to UK growth and I don’t think it is abig call to say that we will struggle to hold on to AAAin that environment.

Q86 Mark Garnier: Can I just come back tosomething you said about the credit default swapmarket being particularly thin? Does that mean thatit is effectively not much of a useful hedge againstdefaulting on sovereign debt?Simon Hayes: I think it is. It is only just one for veryspecialist investors and presumably they find it useful,but really it is more about how one interpretsmovements in those spreads and whether one puts alot of weight quantitatively on how far they move orwhat they are relative to other countries. Our approachis that we are pretty sceptical about that. It is neverreally very clear whether they tell you moreinformation about concerns about default or other risk.It is the same information that you are getting fromother markets, just magnified because of the lack ofliquidity.

Q87 Mark Garnier: Where I am coming from onthis is looking for the stability of banks and thefinancial system, but clearly obviously a lot of banks,including UK banks, hold sovereign debt around



Europe and indeed debt on other banks. What I amtrying to ascertain is whether there is a sensible waythat you can hedge that position or, in reality,something like the CDS is not going to be able to doit to any extent that is going to be meaningful in thecase of a country defaulting on its debt and possibly,subsequently, banks of that country also defaulting ontheir debt.Simon Hayes: In terms of the default, the CDS arewhat they say they are and they do hedge againstcredit events, but I think—

Q88 Mark Garnier: I will tell you why I am slightlycautious about this. It is because if you have a sort ofhouse of cards collapse, then eventually are the peoplewho are writing the CDS in the first place ever goingto be able to pay out on these? Simon Tilford, youlook enthusiastic about answering that one.Simon Tilford: No; I disagree with your analysis. Ithink there is a real likelihood that in such aneventuality, they would not pay out.

Q89 Mark Garnier: So the CDS market is, apartfrom a very, very loose guide as to what people thinkis going to happen, actually a pretty meaningless wayof trying to defend the holders against defaults.Jan Randolph: The way I see it is banks like tomanage the risk profile of their exposures and theseinstruments are a way of fine tuning, pruning back,mitigating certain risks they believe in, but the valueof CDS has conditions attached. They are only worthsomething if certain conditions are met, otherwise youare buying insurance for nothing. Quite often banksuse them to manage their country limits. If they feelas though they have too much exposure to Italy, theywill buy a few CDSs and they feel as though thatmitigates a bit of exposure to that country. That isthe way they are used. In terms of whether they arepredictive, in terms of default probability, that shouldbe the sovereign rating itself, but even then it is aprivate credit opinion. What matters at the end of theday are your borrowing costs. We saw the divergencethere in the US, in terms of what actually happens ina crisis situation—borrowing costs fall, even thoughthe credit rating has been downgraded.

Q90 Mark Garnier: Are credit rating agencies anygood? I remember having a conversation withsomebody about a year ago at one of these meetings,and they said, “Oh no, the credit ratings will mainlyreflect what the market is telling them” whichpresumably is completely the opposite of what theyare supposed to be doing. That sounds like the tailwagging the dog.Chair: We are considering taking a deeper look atthat issue at another time, so a brief answer would beappreciated. I am sure we will tap your knowledge onit more deeply later.Jan Randolph: On sovereign ratings?Mark Garnier: On the rating agencies.Jan Randolph: Yes, black boxes.Mark Garnier: So no good at all.

Chair: You are a black box yourself, aren’t you, MrRandolph?Jan Randolph: I am quite transparent. I take all myclothes off when I do a rating.

Q91 Mark Garnier: Again, I am concerned aboutthe banking system, in particular the UK bankingsystem. Is our exposure to the troubled countries andthe banks in those countries significant enough tocause a real problem if they were all to collapse? Thatis the first part of my question. Secondly, if that hada knock-on effect on other countries, would thesecondary crisis coming from the bigger countries beenough for our banks to have a serious problem?Simon Hayes: My understanding would be no. Firstof all, UK banks’ exposures directly to the crisiscountries—to public sector debt and bank debt—arevery small. What is much larger is our exposure to,say, French and German banks. They are of manyorders of magnitude larger. So then the channel wouldbe that you would have a default in Greece orsomewhere and then that affects French and Germanbanks, but it would have to affect them to the extentthat they then defaulted on some claim that UK bankshave on them and I just see that as extremely unlikely.I think the banks would certainly be able to withstandthese narrower crises, where you are talking aboutsome of the small peripheral countries defaulting. Theline would be drawn at the level of those banks and Idon’t think they would back up into UK banks. As Ihave said, the bigger concern is if you had somethingthat infected the much larger euro economies andsome sort of breakup of the euro, then you are in muchmore serious circumstances.

Q92 Mark Garnier: Then you would think there wasa very serious problem potentially for UK banks, theUK banking system?Simon Hayes: Potentially—it depends on how thingsare played out but, as I said, one obvious mechanismis if you get countries that actually leave the euro anddepreciate, then that is a de facto partial default onall your euro-denominated lending that you have donethere. It is really the UK banks’ exposures to the non-bank private sector—households and businesses—thatis the material element of their exposures to theseeconomies. So it would have to be macro-channel orthrough the currency channel really to be of majorconcern.

Q93 Mark Garnier: If countries did start defaultingand there was a problem with the balance sheets ofthe banks that hold the sovereign debt, do you thinkthere is an argument for a mechanism such as aTARP—a Troubled Asset Relief Programme—to beset up in Europe by the European authorities to enablethem to go in and buy those troubled assets from thebanks? Is that possible?Simon Tilford: I think so, yes. I am not as sanguineabout the outlook for either the Eurozone bankingsector or the impact in the Eurozone banking sectoron the UK. I think, yes, as we talked about earlier, thedirect links look containable, but that ignores the



impact that a freezing of the internet market wouldhave and the impact on confidence, and so on. I think,yes, there is a huge volume of bad debt within theEurozone as a whole concentrated in particular assetsof particular countries and, one way or another, that isgoing to have to be addressed. Obviously there needsto be bank recapitalisation. There could well be anargument for a TARP-type scheme in addition to thator to augment that, yes.

Q94 Mark Garnier: Have you made any estimationas to how big it would need to be?Simon Tilford: I am afraid not, no. It is kind ofbeyond—Mark Garnier: Ballpark figure?Simon Tilford: It is just one of those things. We area small organisation; we just do not have that kindof manpower.Mark Garnier: If somebody was to hold your feet tothe fire, €1 trillion, €2 trillion?Simon Tilford: Of bad assets? I have no idea. I reallydo not know the answer.

Q95 Mark Garnier: Just one last thing. I missed thebit leading up to this, but you saw the possibility of awrite-down of the UK rating. Did you say it was goingto definitely happen or it could happen?Simon Tilford: I think we are entirely vulnerable. Imean, I am not saying it would be the end of theworld if it happened, necessarily. I mean, people canfetishise these things, but given the headwinds facingour economy—and given the level of debt, both theabsolute level of debt that we know about but alsovarious contingent liabilities—it looks highlyvulnerable. I think, of the AAA economies, onlyFrance probably looks more vulnerable.

Q96 Mark Garnier: Given the fact that there is thislarge implicit guarantee behind the UK banks becauseof the British problem, does that not necessarily meanthat if we downgrade the UK as a country, then thatimplicit guarantee becomes less valuable so, therefore,there is a direct knock-on effect on the banks?Jan Randolph: Yes. The importance of the sovereignrating acts like an anchor to the credit risk map in theentire country and everything important in thatcountry; the politics, the finances, financial balancesin the economy and all the players in it. So what tendsto happen is that if the sovereign rating goes up, withor without direct links to equity in banks, it tends tolift all the other ratings with it, and then if thesovereign rating falls it tends to drag everything downwith it. It is controversial whether to have a corporatebank rating superior to the sovereign level anyway,the sovereign circle—Simon Tilford: That is in normal times though, isn’tit, and we are not looking at normal times. If we seewhat has happened in Japan over the last 15 years,there have been successive downgrades and lookwhere yields are, and they are still—Jan Randolph: Yes, that is very interesting, but if youwatch the rating agencies long enough and look at thereasons why they change, upgrade or downgrade, youbegin to learn things about their model, even if they

don’t reveal it. You use a deductive process, if youlike. The unwritten rule is that when net public debtgoes above 100% of GDP, there have to be goodreasons why you have still a AAA rating unless thereare risk mitigation factors, like what the world’sglobal currency called “the dollar”, and we wereapproaching that level and that is why we were put onnegative outlook. That was switched back off to stablebecause the new Government came in and took frightfrom the Greek crisis and said, “Yes, we have to joinin the German austerity here, otherwise we might getbitten from behind in the bond markets with a countryrisk premium” by which time it is too late already orit is more difficult to get yourself out of the hole.Simon Hayes: I think what has changed in the UK’sposition over the last couple of months is—I agreewith Simon—that the growth outlook for the UK ismaterially worse than the OBR has in their forecast.So, from that perspective, I would say it was goingto be difficult for the Government to meet its deficitreduction plan. So I would expect some slippagethere. However, to the extent that the problems in theUK economy are because internationally, they aresimilar within Europe and the US, there are additionalproblems that mean that demand is weakened. UKexports are not as strong as we would hope. The UK’srelative position is unchanged, if not improved, if youlook at what has happened in the markets over the lastcouple of months. So, from that perspective, youcould well actually see the UK retain theextraordinarily low funding costs that it currently has,because it is not in the bad bucket; it is in the goodbucket. It is benefiting from safe haven flows.

Q97 Mark Garnier: Given the fact that we have£1.45 trillion worth of personal debt in this country, itdoes mean that we are much more susceptible to a risein funding costs to the bank, which will thenobviously be passed on to the consumer. Does thatmake us more risky in terms of the effect it could haveon the population?Simon Hayes: It is the sort of thing that ends up beinga drag on growth, as it already is. The tighter thecredit conditions are the more that is going to keepconsumption weak.

Q98 Mark Garnier: I think my question is: are wemore susceptible to that because of the position weare in than, say, Germany or America might be? Theyare different economies, but does our very high levelof personal debt relative to the rest of Europe—forexample, I believe that 50% of all personal debt in thewhole of Europe is in the UK, which is nearly 10%of the population—make us much more susceptible asa country? It is a hindrance to growth, as you say, butwhat happens if we start seeing funding costs to banksgoing up and, therefore, the cost of borrowing on thehigh street going up as well?Jan Randolph: Personally I think, it is like a lot ofthe Anglo-Saxon economies where housing is used asan asset—if prices are rising, the asset builds up. Wethen use additional debt to finance consumption. Thatmodel broke down basically, and there is no questionthat the financial crisis was a balance sheet crisis in asense, and its impact was principally on the private



sector in the UK, in the English-speaking economiesas well as Spain. That debt de-levering process thatis currently underway, it may be healthy in terms ofrestoring balance sheets by raising savings again butit is bad for growth, because there is very littleconsumption.In terms of vulnerability, if high interest rates are inorder or higher funding costs, then it makes the debtservicing a lot more expensive, so it is an additionaldrag, and by the time all this stuff is unwound it isgoing to take a lot longer, I imagine.

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Q99 Chair: In a word, yes or no, will the Eurozonehave the same membership in 12 months’ time that ithas now? Simon Hayes.Simon Hayes: In 12 months’ time, yes.Simon Tilford: No.Jan Randolph: Yes.Chair: I think that summarises the sort of evidencewe have been getting from all three of you,respectively, through the afternoon. Thank you verymuch for coming. It has been extremely illuminatingand we appreciate it.

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Eurozone crisis: Impact on the UK · mechanisms by which the Eurozone crisis could have an impact...

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