1. www.pwc.co.uk
What caused the
financial crisis? Where
do we go from here?
NICVA CEE Masterclass 21
October 2011
Dr Esmond Birnie, Chief
Economist, PwC

2. Global growth
Trends and prospects
World GDP growth
(Although doubts over 2011 – 2013+ divergence “East” and “West”)
7
Long-run average = 3.5%
6
GDP Growth (% Y-on-Y)
5
4
3
2
1
0
-1
-2
1973 1976 1979 1982 1985 1988 1991 1994 1997 2000 2003 2006 2009 2012
Source: IMF, www.imf.org/external/pubind.htm (exchange rate weighted).
PwC CEE Masterclass 21
October 20112

3. Greedy, wicked bankers?
• 9 February 2009 Vince Cable MP said the guillotine should be
restored for bankers
• Rage against bankers may make us feel better in the short term,
but long term solution require a reasoned consideration of the full
causes of the downturn
• Responsibility may be more widespread
CEE Masterclass 21 October 2011
PwC 3

4. Banking crisis- too much debt across the board
• By 2008 UK banks debts had risen to twice level of GDP (increases in
some other economies but UK, and RoI (421%) and especially Iceland
(580%), unusually high)
• Importantly, other debt/GDP also rose during the 2000s (in the
UK from 150% in 1987 to about 300% in 2009)
• A moderately rapid increase until 2003 and then acceleration 2003-8
• But, in terms of banks, PwC analysis (2010) suggests spike in gross
debts/income in UK 2008-09
CEE Masterclass 21 October 2011
PwC 4

5. Banking crisis- complexity of derivatives
• Various financial instruments (CDOs) obscured , because made less
direct, the connection between creditors and lenders
• Note, also, how far system internationalised-
US sub-prime becomes our problem
English/Scottish banks linked to RoI
French/German banks tied to Greece etc.
CEE Masterclass 21 October 2011
PwC 5

6. Banking crisis of 2007-8 begins- sub-prime
problems
• A long boom in US (and UK, RoI) house prices came to an end (1997-
2006 US house prices up 124%, UK 97%)
• Interest rate rises provoking sub-prime mortgage defaults in US
• Transmission from sub-prime problems through to US banks, to
wider (and international) capital markets
• February 2008 Northern Rock nationalised
• Bear Stearns rescued by Fed Reserve loan
• BUT when the next crippled bank came along, no appetite for bail out
CEE Masterclass 21 October 2011
PwC 6

7. The banking crisis of 2007-8, continued…
• Lehmans failed 15 September 2008
• 18 September 2008 money draining out (half Trillion$ in hours)
• Bail outs- AIG, 10 largest US banks, Chrysler, GM, RBS and HBOS
• Plus in US guarantees to Fannie Mae + Freddie Mac
RBS- thro. Acquisition of ABN Amro had acquired a lot of US“trailer
parks”.
A.m. of 7 October 2008 shares plunged 30%
“This was once the conservative Scottish bank where I had opened my
first account as a teenager. It was now on its knees. And what, its
chairman asked were we going to do about it”, Alistair Darling
CEE Masterclass 21 October 2011
PwC 7

8. Role of regulators- too little (or too much, or too
ineffective)?
“We have been in a casino where the government was handing out free
chips and the regulators were buying drinks and telling us which
numbers to bet on”, Eamon Butler.
• Some critics say “not enough” regulation
• The regulation we had “missed” a lot– failing banks got through
various stress tests/not allowing for sovereign default
• Unintended consequences- work to the limit, making banks more
similar hence intensifying risk
• For sure, the regulators did not see 2007-8 coming
CEE Masterclass 21 October 2011
PwC 8

9. Central banks- Greenspan’s (Chairman US Federal
Reserve) folly?
• Were US interest rates kept too low for too long in the 2000s?
OR, a reasonable response to a “glut” in global savings?
• The role of a central banker like the person at a party who has to take
away the punch bowl before anyone too drunk?!
• Also criticism of Bank of England’s role
• For sure plenty of “hubris” about– assertions by Gordon Brown and
others that the business cycle had more or less gone for good
CEE Masterclass 21 October 2011
PwC 9

10. Governments’ response- support the banks at all
costs
• Avoid repeat of 1930-32 (in the US thousands of high street banks
fail, spending power collapses, output and jobs slump by 20%)
• Too big to fail?
CEE Materclass 21 October 2011
PwC 10

11. The triumph, or the limits of Keynesianism
Richard Lucas 2009 “I guess everyone is a Keynesian in the fox hole.”
• Government deficits and borrowing rose to wartime levels (without a
world war)
• Does the experience of the US and UK represent “antibiotic
resistance” given previous doses of the Keynesian “medicine”?
CEE Masterclass 21 October 2011
PwC 11

12. The nightmare continues
• The global financial crisis of 2007+ did not really end in 2009-10
• In fact, mutated
• The issue has become not just the solvency of banks but the solvency
of states and governments too
CEE Masterclass 21 October 2011
PwC 12

13. Euro crisis- a flawed project?
• Two bail outs of Greece (even now its debt/GDP ratio almost
certainly unsustainable)
• The bail outs of RoI and Portugal
• Spain and Italy may be waiting in the wings (“too big” for current EU
rescue funds)
• When the euro started in the early 2000s many economists
questioned its wisdom as constituted– was continental Europe really a
“natural currency area”?
• Design flaws:
- When “PIIGS” competitiveness moved out of line with Germany- no
ready adjustment
- monetary union without fiscal union
CEE Masterclass 21 October 2011
PwC Slide 13

14. Fixing the euro?- unpalatable alternatives
• PIGS try to work (i.e. grow) their way out of debt--- is this
feasible/austerity very painful and maybe counterproductive?
• Some/all of the weaker economies leave (be pushed out) of the euro -
they could then achieve a devaluation (at huge cost ,default… Argentina
in Europe, although is the Latin American precedent actually
favourable [NEXT SLIDE]?)
• A debt write off---- may well be “necessary” but burden on Germany
• Share the defence of “sovereign debt” e.g. through eurobonds----
might restore some market confidence but, again, a heavy demand on
Germany
CEE Masterclass 21 October 2011
PwC Slide 14

15. Don’t cry for me Argentina: after default, a
bounce?
Argentina and Greece
4
3
GDP, growth rate
compared to
2
previous
quarter, seasonally
1 adjusted.
0 Period beginning:
2 3 4 5 6 7 8 9 10 11 12 13 Q3 1993, Argentina
-1 Q2 2003, Greece
-2
-3
-4
-5
-6
Years since Argentinian currency board and Greece joining the euro
Source: World Bank, National accounts:
PwC

16. Economic outlook still brightest in
BRICs, stormiest in Europe (forecast GDP growth
for 2011) Russia
2.7 UK
Canada Germany 4.2
1.2
Ireland
3.0
1.0 Greece
US
France -3.8
1.6 1.8 Japan
Spain Italy
Mexico
-0.5
0.6 0.9 China
4.3
9.5
India*
8.0
Brazil Australia
South Africa
4.4 3.2 2.8
* CEE Masterclass 21 October 2011
Source: PwC main scenario for GDP growth in 2011
PwC 16

17. Global economic outlook- what next?
• Double dip- not inevitable, but possible. Vulnerable because
weaknesses in each of the US, Japan + eurozone
• Confidence (or lack of) is the key– like the 1930s but this need not
imply that the same solution would work this time
• “Balance sheet and de-leveraging issues”, Ben Bernanke
• Hence, real danger of lost decades scenario- like Japan in 1990s
• Over the long run 2010-2030 rapid growth in emerging economies
should continue (subject to Russia is problematic, India and China may
have their own credit bubble + supply side difficulties)
CEE Masterclass 21 October 2011
PwC 17

18. Where this “rebalancing” could take us- The
World Economy by 2050
Total E7 GDP (PPP) as
% of total G7
Compare the total size
2007 c. 60
of the seven biggest
emerging economies 2010 c. 75
to the seven largest 2020 100
“Western” economies
(the G7)* 2050 200
GDP per capita in Shanghai in 2010 already similar to
that in some northern English counties
Source: PwC forecasts.
* BRICs+Indonesia+Turkey+Mexico,compared to US+Japan+Germany+UK+France+Italy+Canada.
PwC

19. A sign of change
Falling behind China
GDP per capita in Shanghai in
2010 already similar to that in
most of NI (allowing for cost of
living– purchasing power
parity)
PwC 19

20. If we can think about growth
UK Growth Review (Cable+Osborne) Preliminary to the NI Executive
November 2010+... Economic Strategy – identified
strategic aims for Executive...
• Planning
• Innovation
• De-regulation
• Employability
• Competition
• Competitiveness
• Skills
• Business growth
• Infrastructure
• Infrastructure
• SMEs
THIS FRAMEWORK GOOD BUT
• Rural economy
THREATS:
• Open data
- Too much focus on short term
(employment vs productivity)?
- When will we get the Economic
Strategy, PfG, decisions on Corp. Tax
and SFA?
PwC CEE Masterclass 21
October 2011

21. Corporation Tax reduction?
Headline observations
• Need to re-balance NI economy
• Long term (25 yr) project
• To extent CT reductions lead to greater competitiveness and hence more
investment, jobs and growth– hence welcome UK wide reductions
• But what about lower NI specific rate?
• Experience of ROI suggests slow burn and/or one of a number of factors
• The powers to vary tax more widely (in addition to Corporation Tax) are of particular
interest
• The cost of cutting Corporation Tax must be borne by the Executive
IN SHORT, CT REDUCTION WOULD WORK BEST AS PART OF A PACKAGE OF
FISCAL INCENTIVES (e.g. TAX CREDITS, APD, AVOID THE ENGLISH SYSTEM OF
ELECTRICITY PRICING, ALCOHOL EXCISE)
PwC CEE Masterclass 21
October 201121

22. Going for growth
(continued)
Goals identified for UK economy by McKinsey (2010), these apply also to NI
• Improve productivity (not just in manufacturing but services too)
• Become an excellent location for FDI
• Get transport and energy infrastructure right
• Maximise opportunities to earn export revenues from health and educational
sectors
• Innovate through clustering
• Devolution below the regional government level (i.e. to dynamic cities and local
government)
• Minimise the economic negatives of an ageing population and take the economic
opportunities
PwC

23. Banking reform proposals in the UK- the Vickers’
Commission plan
• Not total separation of high street from investment banks, but
firewalls and extra safety cushions
• Goes against grain of international banking development over several
decades (but reminiscent of US Glass-Steagall Act of 1930s)
• “The proposals will damage London’s competitive position”, Martin
Jacomb FT
• OR “…old fashioned principles- better capitalised, less leveraged
and focused on the needs of customers..”, Sarah Brooks Consumer
Focus Head of Financial Services
• Higher capital requirements
• Cost to banks £5-10 bn p.a., social cost of £1-3 bn but p.a. cost of a
bail out/downswing c £ 40bn
CEE Masterclass 21 October 2011
PwC 23

24. This time really is different or back to the Hungry
Thirties?
“Now”, 2007+ “Then”, Great
Depression
1929-30s
Decline in output UK GDP down UK GDP down
7.1% RoI GDP 5.7%
down c. 15% most “RoI” GDP flat
of Western c.5-6% US, Germany
decline c.20% decline
Decline in US down 5.3% US down 20.5%
employment
Absolute living UK,US real GDP
standards per head about 4-
5 times higher
World trade By 2011 back to By 1932 30%
2007 peak down in volume
CEE Masterclass 21 October 2011
PwC 24

25. This time is different or back to the Hungry
Thirties?
“Now” 2007+ “Then”, Great
Depression 1929-30s
Inflation > B of England’s 2% UK deflation
target but still Other countries, e.g. US,
“moderate” Germany severe
deflation
Bank failures c. 100 worldwide 1000s (espec. US
including high street)
Exchange rates Extent of $, £, euro, Yen Great volatility/beggar
volatility limited my neighbour
Most of EU locked in UK advantage of early
euro exit from gold standard
Undervalued Yuan
Global econ leader US being passed by 30 year hiatus UK to US
China
CEE Masterclass 21 October 2011
PwC 25

26. Some lessons from 2007-11 global crisis
• General failure of markets or of a particular market (finance)?
• Governments also failed (e.g. regulation, lax monetary policy)?
• The failure to see the crisis coming was pretty widespread (naïve
belief business cycle had been banished)
• We now criticise financial innovation but, sometimes, it contributes
to growth
• Globalisation may have reduced the frequency of “minor”
downswings but also ensured when we get a crisis it is a big one!
CEE Masterclass 21 October 2011
PwC 26

27. Be “G-local”: the impact of the world crisis on
your sector
• Less (private) cash about
• Less public funding (and less EU too)
• NI has hitherto had a very large community and voluntary sector
with many individual organisations
• Moving into a world of retrenchment, consolidation with a premium
on capacity building and management
CEE Masterclass 27 October 2011
PwC 27

28. Thank you, any questions?
Esmond Birnie
PwC | Chief Economist
Direct: +44 (0)2890415808 |
Mobile: +44 (0)7850907892
Email: esmond.birnie@uk.pwc.com
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