ALCHEMY FOR RECOVERY - RECOMMENDATIONS FOR THE G20 SUMMIT FROM SOME OF THE UK'S TOP ECONOMISTS

C O N F I D E N T I A L SECTION 01 OF 03 LONDON 002860



SIPDIS

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STATE/EEB: DAS NELSON, STATE/EEB/OMA: MARLENE SAKAUE, ALEX

WHITTINGTON

TREASURY: MCCORMICK, BMURDEN, WMONROE, CCARNES



E.O. 12958: DECL: 11/14/2018

TAGS: ECON, EINV, UK

SUBJECT: ALCHEMY FOR RECOVERY - RECOMMENDATIONS FOR THE G20

SUMMIT FROM SOME OF THE UK'S TOP ECONOMISTS



Classified By: Ambassador Robert Tuttle for reasons 1.4 b and d.



1. (C/NF) Summary: Coordinated stimulus measures to

jump-start economies should be a main outcome of the G20

meeting, several prominent economists told the Ambassador

during a November 12th luncheon roundtable. While measures

do not have to be exact across-the-board, their timing should

be in sync. Economies need to be stabilized before radical

reform measures are taken. Leaders also need to agree to

strengthen immediately the Financial Stability Forum, and

give it the mandate for early warning and improved

coordination. If the Summit is not deemed a success, the

markets will be harsh in their judgment. While many parties

were to blame for the global crisis, attention has not been

drawn sufficiently to the role of China, which contributed to

the easy credit by providing cheap money. One unintended

outcome of the Summit will be the G20's expectations to be

seated at the table at all future, high-level economic

meetings, and the greater importance of China in global

economic decision-making. The root cause of the crisis was

the rapid expansion of credit in the U.S. and Europe, and the

inadequate policy responses, the economists agreed. End

Summary.



2. (SBU) On November 12th, the Ambassador hosted an

off-the-record luncheon with several of the UK's top

economists and economic observers: Roger Bootle, CEO,

Capital Economics, and formerly one of then Chancellor of the

Exchequer Gordon Brown's panel of economic forecasters, the

"Wise Men"; Sir Samuel Brittan, economic commentator for The

Financial Times; David Green, Advisor, Financial Reporting

Council, and former head of international policy coordination

for the Financial Services Authority; Anatole Kaletsky,

principal economic commentator, The Times; Martin Weale,

Director, National Institute of Economic and Social Research.



What the Summit Needs to Achieve

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3. (C/NF) Consumer markets are paralyzed; spending has

stalled. The immediate response must be to re-inflate

economies by providing direct credit and debt forgiveness,

and by increasing the money supply. Emergency fiscal

stimulus measures are needed, and such measures need to be

coordinated among the major economies, the participants said.

This must be one of the primary outcomes of the November 15th

Summit. China's $586 billion stimulus package was a necessary

measure to help its stalling economy, remarked Green, but

without similar coordinated re-inflationary measures, the

effect on global markets would be minimal. While each country

could pursue separate policy instruments, there must be

agreement among the G20 leaders to reduce interest rates,

even if they fall to record lows, to allow foreign exchange

rates to be as flexible as possible, and if need be, to

write-off some consumer debt, argued Kaletsky. Coordinated

fiscal stimulus measures might be the only way to stave off a

global deflationary recession. If the Summit does not produce

such a coordinated response, it will be deemed a failure, and

the markets will react, he stated.



4. (C/NF) The Summit should also lay the foundation for more

radical reforms, they said. While the participants disagreed

whether new institutions or a new financial architecture - a

Bretton Woods II - should be created, they all agreed that

existing mechanisms were inadequate. Regulators of the

markets and the financial sector need to understand what is

happening in the broader economy and should be charged

specifically with ensuring market stability. Internationally,

the proper organization to take on this mandate would be the

Financial Stability Forum (FSF),said Green, and this mandate

needs to be given to the FSF immediately. In the UK, The

Bank of England's mandate should include not only

inflation-targeting but also economic stability. Regulators

of the Financial Services Authority also should ensure that

financial instruments offered by banks contribute, and not

undermine, macro-economic growth and stability, said Bootle.



The Causes

--------------



5. (C/NF) The rapid expansion of the credit market of the

past decade - in the form of mortgages, consumer credit, etc

- was the primary cause of today's economic crisis. The

credit expansion was a transformational event, said Kaletsky,



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and led to record growth in emerging markets, record levels

of home ownership in the U.S., UK, Europe, record levels of

consumption. All of this was positive. The problem was the

financial sector wanted to continue credit expansion beyond

levels already reached and adopted financial instruments of

dubious quality - and the regulators failed to notice or to

react. The perceived failure of Federal Reserve Chairman

Greenspan to monitor and regulate these instruments and to

keep watch on the rising asset prices was particularly

criticized by the luncheon participants. Another problem is

that economists have no understanding of the markets, and

market experts have no understanding of the macro-economy,

Brittan stated. They speak a different language, and that

presented a vacuum of understanding and failure in oversight.



6. (C/NF) While a slowdown was inevitable, a meltdown might

not have been, said Green. However, the decision to not

bail-out Lehman Bros accelerated uncontrollably the

de-leveraging process, which accounted for the free fall of

stock prices. Lehman's problems also highlighted to

investors how little oversight there had been of investment

firms. Lehman gambled in hedge funds and other financial

instruments, and no one was watching, he argued.



China - The Power Broker

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7. (C/NF) Another contributing factor that has not garnered

much attention is the role played by China. Its use of its

surplus helped drive the global consumer boom by providing

banks low-cost capital. Chinese leaders were also swayed by

the high and quick returns of their investments, and did not

seek out quality, but longer-term and lower-return

investments, said Weale. (Note: On this point, the

economists argued about why there were so few quality capital

investment projects, especially given the aging

infrastructure of the U.S., UK, Europe.) Chinese complicity

helped spur on the consumer-driven growth of the past decade.

If more money had been spent internally or even on overseas

infrastructure projects, Europe and the U.S. would have

likely entered into a recession sooner, contended Kaletsky.

When the Chinese abruptly decided to pull back on their

investments in mortgage bonds, that is when the floor

collapsed, he said, spurring on the ever-widening gap between

mortgage and treasury bonds, and helping to plunge our

economies into recession.



8. (C/NF) China also holds a key to economic recovery. It

can use its nearly $2 trillion in reserves to stimulate its

economy (as in its fiscal stimulus package of $586 billion),

to bolster the resources of the IMF and other international

bodies to help shore up emerging economies, and to invest in

infrastructure projects, said Kaletsky. Other economists at

the table did not predict that China will exert such

leadership. The Chinese will not change their investment

behavior, said Brittan, and therefore, China should be

treated as exogenous in any global recovery plan. However, if

the Chinese were to take an active role in helping solve this

crisis, western political leaders must understand that

conditions might be placed by the Chinese on their

investments. They might demand indexed, package securities,

or equity holdings, Brittan commented, setting the stage for

disagreements between the creditor and borrower nations.

Kaletsky also agreed that there could be a real confrontation

in financial diplomacy.



9. (C/NF) The Chinese are not the only ones who will demand a

greater say in new financial rules and architecture. The

November 15th Summit will set a precedent, and from now on,

G20 countries will expect to participate in all major

economic forums. They will question the legitimacy of the G7

mechanism, said Kaletsky, and as a result, western leaders

need to be prepared to be more inconclusive.



Comment

--------------



10. (C/NF) The economists were universally multi-lateral in

their beliefs, and argued quite convincingly that no

government can solve the problem independently. They were not

as quick as others in the U.K, including Prime Minister

Brown, to proclaim that the U.S. was cause of the problem,

although they did point to Federal Reserve Governor

Greenspan's cheap credit policies as one of the contributing



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factors. They seemed to agree that democratic governments

find it politically difficult to counteract market trends

that provide consumers with short-term benefits - even when

they can foresee eventual negative consequences. Perhaps most

importantly, they thought the current crisis was severe

enough to override any concerns about deficits or inflation

-- governments should "flood their economies with money."

End Comment.



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