Too big to fail becomes too big to bail

With the debt crisis heading towards Portugal and after that to Spain, the whole collapsing banking

It's a beautiful, sunny day here in south-west Florida as I write, and I'm sorry to hear about the snow and cold you folks are having back home. Winter in New Hampshire, where it regularly gets to -20˚F, seems less attractive now that the kids have flown the nest.

On Monday 29 November, the reconstituted Office for Budget Responsibility (OBR) published a little crystal-ball gazing. The new director, Robert Chote, was sensible to stress how difficult it is to forecast in these days of huge economic uncertainty. That the OBR upgraded its growth forecast for 2010 (from 1.2 per cent to 1.8 per cent) was not surprising, given the recent data releases. But the slight reductions to its projected growth figures for 2011 and 2012 - to 2.1 per cent and 2.6 per cent, respectively - still seem overly optimistic, as is clear from the chart (below). Compared to the consensus forecasts, as well as those from the International Monetary Fund and the Organisation for Economic Co-operation and Development, the OBR's projections look high. They are broadly comparable to the European Commission's forecast. Only the Monetary Policy Committee of the Bank of England (BoE), which has consistently overestimated growth throughout the recession, is more bullish. Its growth forecasts are aspiring to be hopeless.

graph

Era of austerity

According to the OBR, the unemployment rate will rise in 2010 to 8 per cent on average, falling back to 6.1 per cent by 2015. This would be well above the 5.4 per cent rate that prevailed at the onset of the recession in the second quarter of 2008. In comparison to the June forecast, unemployment is forecast to be higher in every year from 2012 to 2015, even if the OBR has lowered its estimate of the direct job cull in the public sector by 200,000 - a "very optimistic" outlook, according to the Chartered Institute of Personnel and Development.

Dr John Philpott, the CIPD's chief economic adviser, said that "if employment, unemployment and average earnings follow the path forecast by the OBR, the 'era of austerity' will be felt more in workers' pockets and living standards than in terms of lost jobs. As such, the OBR forecast is most encouraging, but it is still too soon to conclude that a rosy outlook for jobs is a dead cert."

The OBR's forecast assumes there will be strong growth in net trade, consumption and investment. Net trade is expected to make a positive contribution in the years ahead. But this looks less likely, given slowing growth in Europe, especially outside the core countries of France, Germany and the Netherlands.

There is little indication that investment is going to increase at the near-double-digit rates the OBR is forecasting. Firms see a fearful consumer, and are unlikely to start investing until there is solid evidence on the demand side. Consistent with that, there was further evidence in the past week that consumers are retrenching once again. Consumer confidence fell in November by 2 points to -21, driven principally by rising expectations of unemployment over the next 12 months.

The Office for National Statistics (ONS) published data on consumer spending, which fell last year for the first time in ten years. The annual Family Spending report from the ONS showed that average weekly household spending in the UK was £455 in 2009, down from £471 in 2008. Not good news.

In his autumn forecast statement on 29 November, the Chancellor, George Osborne, claimed that "Britain is on the mend". Steady on, now - it's much too early to declare victory, given the marked risks to the downside. Even the OBR calculates that the chance of the economy contracting next year is one in ten. The National Institute of Economic and Social Research (NIESR) thinks the chance is closer to one in six, because of fears about weak growth prospects for Europe.

One obvious gale-force wind headed in our direction is the spreading sovereign debt crisis. The €85bn Irish bailout package did not calm nerves for very long. Bond yields have risen sharply for most eurozone members, including France, the Netherlands and Austria. The spreads of Spanish, Italian and Belgian bonds over benchmark German bunds have risen to their highest levels since the launch of the euro.

During November, the euro fell by 7.5 per cent against the dollar and 3.3 per cent against the pound. The concern is that the crisis will spread next to Portugal and then, because of their close economic ties, to Spain. The EU's bailout fund may be too small to rescue Spain, which has a GDP over six times larger than that of Portugal. "Spain has a funding requirement in excess of €150bn for 2011 and Italy needs close to €340bn," said Gary Jenkins, from Evolution Securities in London. "With the market moving rapidly on to Spain and Italy, it is possible that too big to fail becomes too big to bail."

Irish exposure

The unexpected jump in unemployment in Italy, from 8.3 per cent to 8.6 per cent in September to October, raises - as Markit's chief economist, Chris Williamson, put it - "concerns about a two-speed eurozone recovery".

The rise in yields in Ireland suggests that the crisis there is far from over. The latest growth projections provided by the Irish government seemed overly rosy and there is growing doubt about the country's ability to recover so swiftly. This is of particular concern to the UK, because Ireland is our fifth-largest trading partner, accounting for 6.2 per cent of our exports. The total exposure of the UK banking sector to Ireland is as much as £82bn. The OBR admits that "this exposure is a risk to our forecast". It sure is.

Osborne, in his autumn statement, said: "This is an uncertain world but the British recovery is on track. Employment is growing. One million more jobs are being created. The deficit is set to fall. The plan is working. So we will stick to the course. That is the only way to help confidence to flourish and growth to return." The only way? Surely not. I still have no idea where all these new jobs are supposed to come from.

David Blanchflower is professor of economics at Dartmouth College, New Hampshire, and the University of Stirling