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
NOFORN

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

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

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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