Sean O'Grady: No wonder the Bank of England Governor is feeling grumpy

Economic Life: The opportunity to forge a new deal in the eurozone and a 'New Bretton Woods' came and went during what we thought was the recovery

In his Inflation Report press conference the Governor of the Bank of England, Sir Mervyn King was, to us seasoned King-watchers, a bit grumpy. That is not his habitualdemeanour, at least in public. Then again, he has a lot to grump about.

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The Bank had to downgrade its growth forecasts, again, and had to admit that inflation would indeed hit 5 per cent, on the CPI measure,later in the year. The risks to the British economy, he rightly pointed out, came principally from abroad, about which he and his colleagues can do very little except pile up the sandbags around our own banking system and economy.

Indeed, the obvious risks to growth from the incessant sovereign debt crises in the eurozone are so substantial that the Bank doesn't even count them in its "fan chart" of possible outcomes. Again, it's correct in "abstracting" those, in the sense that there isn't a meaningful figure that can be attached to them. Yet we all know that they could render the Bank's calculations irrelevant. Sir Mervyn might also be forgiven for being out of sorts because, as his deputy for monetary policy, Charlie Bean said, the recessionary hit to the economy's capacity to produce may be more substantial and long lasting than might have been hoped. That means that growth will be slower and inflation higher for any given level of interest rates than would have been the case if the factories hadn't shut, the offices closed and the pubs and shops gone bust in the great recession. Or interest rates have to be higher than they would otherwise be – another way of saying we will have to be poorer. Or that the non-inflationary rate of unemployment has gone up. They did that at the previous inflation report too.

To see that jargon in tangible form, you only have to wander around any town and see the number of redundant, empty and abandoned pubs, shops, offices, industrial units and former banks, premises that have been idle for years now, and with little sign of them being put back to productive use – ever. They may as well be demolished, as some sites have already been, the productive potential gone forever. It is as if some alien air force had come and rained bombs down upon us.

Much of our physical and even human capital has been scrapped, and more than the Bank presumed before. Meanwhile, British business sits on £60bn of spare funds, too nervous to invest it because of the manifest economic and political risks, so rebuilding economic capacity will take longer than it might.

All this is not so very unusual in a "recovery" that follows a financial crisis, and has happened before, although you have to go back a long way to find precedents. In any case, it is a phenomenon that should make us all nervous.

The good news, as Sir Mervyn pointed out, is that so far private sector job creation has been healthy, and in the spring was geared towards full-time permanent positions rather than the part-time and temporary work that characterised the earlier stages of our slow recovery.

Inflation too is set to come down very sharply – the Bank even claims inflation could be negative right now if it were not for the VAT hike and imported (especially fuel, energy and food) inflation. That ought to ease the squeeze on living standards.

Still, all the Bank's projections explicitly discount much of the risk from abroad. It is time now to consider what that risk precisely involves, and how this island fortress can be best defended against it.

How will it hit us? Via the British banks, intimately linked to the stresses on European ones; through trade, as 50 per cent of our exports go to the eurozone; and through a generalised knock to confidence and "animal spirits" – people's will to invest and start businesses.

The first transmission mechanism will be – probably already is – coming through the money markets. A second credit crunch has been a real possibility for many months, on the cards because of the poisonous interplay between sovereign debt crises and the still-weak banks.

The welding of the two was a product of the "too big to fail"mentality, where governments offered banks implicit guarantees – especially after the Lehman Brothers collapse in 2008. It was also a result of open-ended guarantees to depositors and creditors offered by governments.

These two are now producing what economists like to term "negative feedback loops" – vicious circles. So, if France loses its AAA credit rating then the French government bonds held by its banks are devalued. Then their balance sheets automatically shrunk, their capital adequacy is dented and their ability to lend to the real economy and other banks, and to borrow from savers and other banks, is curtailed.

Without transparency – and even with it – that can easily turn into a contagion, and there are some signs of stress in the inter-bank markets. If the banks refuse to lend to each other at virtually any interest rate, as happened in 2007, a second recession is almost guaranteed, and UK growth falls off the Bank's fan chart.

The Bank, we can be sure, has new weapons at its disposal to protect the UK's financial system, via its various repo and discount window arrangements (much neglected by commentators but crucial in a crisis), and has done its best to cajole the UK institutions to improve capital adequacy. We also have living wills and, soon, probably, ring-fenced retail banks that will ensure that "too big to fail" doesn't hit the UK taxpayer once again. What we, and Europe, do not yet have is adequate arrangements for cross-border failures and, even more crucially, the funds to rescue the banks again.

To take the French case again, it would not be easy for the French government to nationalise distressed banks if the French treasury found it impossible to issue the bonds to do so. That is the terrifying debt end-game that is spooking the markets. And, perhaps, upsetting the Governor's usual equilibrium. He must have spent a good deal of his time constructing contingency plans.

So what should the world do with all its excess debts – and excess savings in places such as China and the oil-rich Gulf states?

Sir Mervyn's answer is: "One way or another, the losses that were built up in recent years will have to be shared between creditors and debtors; in the world economy between creditors in the East and debtors in the West, and within the euro area between creditors in the North and debtors in the South.

"The key question is whether that burden-sharing will take place in the context of a downturn in the world economy, or whether it will take place in the context of a rebalancing of overall demand."

He has probably sat through far too many futile international conferences to be optimistic about matters being resolved in an orderly way, and events are forcing a violent resolution of global imbalances. The window of opportunity to forge a new deal in the eurozone and a "New Bretton Woods" came and went during what we thought was a recovery. It was, in retrospect, something of a fool's recovery. The Bank perceives this international political failing better than most. Grouchy as he is, Sir Mervyn King is no fool.

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