This is a transcription of the keynote speech delivered by Lord Gus O’Donnell at the LBMA/LPPM Conference in Vienna, 18 -20 October. It is a pleasure to speak at such a prestigious conference. I should start by explaining that my comments reflect my personal experience in the UK Treasury and as Cabinet Secretary to three Prime Ministers. They are not necessarily the views of TD Bank, although I am proud to be a strategic advisor to TD’s CEO, now Bharart Masrani and formerly Ed Clark.

I was attracted to TD by its focus on customers and its values, which helped it steer successfully through the global financial crisis.

Canadian banks had a good crisis, which reflects well on their regulator but also on the decisions made by their leaders. In particular, TD’s decision to get out of most structured products well ahead of the crisis was bold and extremely good news for all the Bank’s customers and shareholders. Since 2007, TD has basically grown at around twice the average of the other four big Canadian banks, whether measured in terms of earnings per share, the share price or market capitalisation.

Here in Vienna, at the heart of Europe, it makes sense to take stock of the ‘European project’.

Over the last few years as the Greek crisis has unfolded, I have lost count of the number of times that I have thanked God that the UK is not a member of the euro. I was heavily involved in the five tests analysis, which assessed the case for the UK joining the euro. It concluded that the UK could not live with a single interest rate set by the ECB. Other countries have found that living with the one interest rate, no exchange rate flexibility and the fiscal requirements of the euro area, necessitate policies that are politically very difficult. As Jean Claude Juncker said: “We all know what to do, but we don’t know how to get re-elected once we have done it.”

This raises the question of the future of the euro. The most likely scenario in my view is muddle through along the lines we have seen for so many years now. In other words, we have intermittent crises with the political desire to keep the euro dream intact winning out eventually over all other considerations. One extreme scenario is the complete breakdown of the Eurozone with a return to single currencies for most countries, possibly with some kind of link to a rump euro consisting of Germany plus a few other countries. At the other extreme would be a move to ‘ever closer union’ marked by real shifts towards political union, including large fiscal transfers. My own guess is that the probabilities of these three outcomes are roughly 60/20/20. The most likely scenario is consistent with a long period of slow growth, and constant political tensions.

Lord Gus O’Donnell speaking at the conference in Vienna.

The Eurozone has problems because it is such a heterogeneous area: for example, oil price shocks have different effects in different countries, exposures to commodity prices more generally are different. Public debt levels vary enormously, so the impact of eventual increases in interest rates on interest payments will also vary considerably.

These structural problems are unlikely to end soon. But the European project of ‘ever closer union’ as spelt out in the Maastricht Treaty means that enormous efforts will be made to stop the markets concluding that countries can move in and out of the euro. Hence, my belief that the most likely outcome is that the can will continue being kicked down the road.

The main legacy of the Greek experience will be seen in delaying the expansion of the euro to ever more member states of the EU. I hope more of them will do the detailed economic analysis needed before committing to adopting the euro, and I hope the existing members will think very hard about when to admit future applicants. This means that for some years we will have a group of ‘outs’ who will want to preserve their position relative to the ‘ins’. This is important for the UK. It means that we will have allies when pushing for stronger rights for the ‘out’ group relative to the Eurozone in our renegotiation prior to the EU referendum. This will be particularly important for George Osborne as he seeks to maintain the supremacy of London as a global financial centre.

The governments of Europe face many challenges, but in the economic sphere, they will increasingly need to answer the question about what they are trying to achieve. Central banks have simple inflation targets, but do we really only care about inflation? What about growth, unemployment, and productivity? We may be seeing the end of the era of what might come to be known as narrow inflation targeting. The Fed has a more complex mandate: achieving the maximum sustainable employment and price stability, which is interpreted as low and stable inflation. The Maastricht Treaty opted to give the ECB a simple inflation target reflecting the view held in 1992 that achieving low and stable inflation was the best that could be done to support growth and employment. In 1997, Gordon Brown set up an independent Monetary Policy Committee at the Bank of England with the objective of price stability, defined by an inflation target, but subject to that, the MPC should support the government’s economic policy, including its objectives for growth and employment.

The decision to have the primary focus on inflation was a difficult one and there was much debate about whether to have a dual mandate, like the Fed. In the end, Gordon Brown chose the simpler form because he had been advised that there was no long-run trade-off between inflation and unemployment.

“The Eurozone has problems because it is such a heterogeneous area: for example, oil price shocks have different effects in different countries, exposures to commodity prices more generally are different.”

Sir David Attenborough is interviewed about the Global Apollo Programme.

These decisions are being revisited: Mark Carney, before becoming Governor, raised the prospect of nominal GDP targets. The UK Treasury conducted a review in 2013 and the new leader of the opposition is conducting his own review. The Treasury review did not get the attention it deserved. In effect, they moved firmly away from narrow inflation targeting. Under the new system, “where shocks are particularly large and with persistent effects, the MPC is likely to be faced with more significant trade-offs between the speed with which it aims to bring inflation back to target and the consideration that should be placed on variability of output”. In other words, narrow inflation targeting is now as dead as monetary targeting. In the last few years, it is fairly clear that the Bank has acquiesced in a prolonged period of below target inflation as it was uncomfortable with the policies that would have been necessary to push inflation up to the target level. Indeed, if you go back and do the analysis, assuming the Bank was targeting nominal GDP, you do not get a very different interest rate path.

Personally, I would like a more radical change where the government has an explicit objective of improving the wellbeing of the nation, as David Cameron spelt out in 2010 and Angela Merkel is now exploring in Germany. We could then have an interesting debate on what that would imply for the target that should be given to the independent central bank. The bottom line is that such an approach weights losses higher than gains, implying that we should be prepared to trade off a lower average growth rate for reduced volatility: in other words, it does make sense to try to smooth out booms and busts.

Economic analysis based on wellbeing is increasingly breaking through into the mainstream of the economics profession: we now have three Nobel laureates in economics who have explored this area: Joe Stiglitz, Danny Kahnemann and now Angus Deaton. (If any of you are interested in what a wellbeing approach to policy would look like, it is spelt out in my Legatum Report, co-authored with Angus Deaton, Richard Layard, Martine Durand and David Halpern.)

The global financial crisis showed the need to be aware of the impact of low interest rates and low risk premia on asset bubbles, and hence growth and employment. In a world of very low inflation, with interest rates at their lower bound and widespread use of QE, there are strong grounds for looking at more than just inflation. Many are rightly concerned that years of abnormal monetary policy may have created conditions like very high house prices that may unwind in dangerous ways.

They have undoubtedly made retail banking less profitable and distorted asset allocations, making products like annuities, which have many advantages, unattractive.

Fortunately, one of the responses to the crisis has been to give the central banks more tools. In particular, I am sure that the Bank of England will look very carefully at its macro- prudential instruments as it seeks to navigate the exit to QE.

In the UK, the Chancellor can alter the mandate but would need to get Parliamentary agreement – amending the ECB target is much harder. So, any changes are likely to be the result of subtle reinterpretations by the ECB of how best to fulfil its given mandate. Fortunately, in Mario Draghi the ECB is led by someone who has shown himself very capable of managing delicate tasks like this. (The OMT programme, announced but never deployed, is a master study in how to achieve objectives without actually spending any money.)

But in the UK, the Prime Minister and Chancellor face a much bigger immediate challenge than setting the right mandate for the MPC. By 2017, there will be a referendum on the question of whether to remain in the EU or to leave. They hope to renegotiate the terms of our membership to such an extent that they can campaign wholeheartedly for us to remain in the UK. If he succeeds, the Prime Minister will be able to look back on a legacy of using referenda to settle three massively contentious issues: keeping our first-past-the-post voting system, keeping Scotland in the UK and keeping the UK in the EU. Those would be enormous achievements. However, if the EU referendum is lost, Scotland is likely to vote to demonstrate that it prefers the European Union to the Union with Great Britain. David Cameron would then go down in history as the PM who got Britain out of the EU and Scotland out of the UK, and there would be calls for him to resign immediately.

The campaign teams on both sides are preparing arguments on the economic benefits of their preferred option. The ‘outs’ will argue that we should reject the chronically slow- growing EU in return for closer engagement with the faster-growing non-EU world, typified by the Commonwealth and China. The ‘ins’ will point out that the EU is our largest trading partner by far and we are best off inside the EU tent trying to shape its policies. This week’s has a leader explaining the case to remain in. However, it is becoming clear that the assumption that all businessmen will support the ‘remain in’ campaign is wrong. There may well be more corporate leaders backing the ‘in’ campaign, but as long as the media ‘balance’ their views with their opponents’ views, the public may well infer that the economic issues are closely balanced and decide how to vote on other grounds.

Hence, there is an urgent need for more objective economic analyses of the case for and against BREXIT. For example, I hope the IFS will look at the budgetary implications of staying in or various scenarios of choosing ‘out’. There is also a need for a detailed sectoral analysis looking at the implications for manufacturing and services, particularly financial services. And an objective consideration of whether our macro performance would be better in than out is also essential.

This is not to say that the economic arguments are the only ones that matter. Migration is likely to remain a huge issue. The ‘outs’ will emphasise that we will no longer need to take so many migrants. The ‘ins’ will point to the economic benefits of letting in more migrants. Recent experience is forcing the EU to reconsider its policies towards migrants and asylum seekers. However, this issue plays out, it will have enormous salience for months to come, so is likely to influence attitudes. On balance, my guess is that this will help the ‘leave’ camp.

Many will want to know how much more control over our own affairs we would get if we left. Then there are the arguments about our weight in global decision-making: will it be enhanced by having a separate voice or diminished by no longer being a part of a global heavyweight like the EU? Chatham House is well placed to carry out this kind of work. The problem is that most of the people who are currently willing to fund such research are closely associated with one side or the other, which makes it hard to establish the objectivity of any such studies. There will also be a powerful group of voters who will be watching the Paris climate change talks closely. Those arguing for stronger measures to counter climate risks tend to be internationalist and will hope the EU takes a constructive position. If Paris is a success and the EU is thought to have played a constructive role, this may help the remain in camp. Those more sceptical about climate change, such as former Chancellor Lord Lawson, also tend to be anti-EU, so if the meetings are a failure, their position will be strengthened.

I have been pushing the Global Apollo Project, together with David Attenborough, Nick Stern and a number of colleagues from the House of Lords. The idea is that if one country, the US, could put a man on the moon in 10 years by simply directing its scientific prowess to that one end, surely the world could solve the problem of making renewables cheaper than fossil fuels by a co-ordinated approach to tackling the key research issues of storage and transmission.

I hope that something along these lines will be part of the answer emerging from the Paris talks. It is one of the best ways of countries meeting the ambitious targets they may set themselves at the Conference. But failure will suggest that international co-ordination is not working well and might encourage those who would want the UK to concentrate on its own problems rather than trying to play a big global role.

All in all, the referendum could well be very close, and that uncertainty will be damaging to the UK economy. This level of uncertainty is likely to reduce, or at best, delay UK investment, particularly from foreign investors hoping to locate inside the EU. It might also impact on the whole of the EU. An EU without the UK would be less business-friendly and less keen to control its budget and subsidies like the CAP.

One problem in the run-up to the referendum is that we will be somewhat in the dark about the likely outcome. After the disastrous performance of opinion polls in the run-up to our last election, there will be little trust in their findings.

The betting odds, which outperformed opinion polls in our last referendum, still strongly back the ‘remain in’ camp (1/2 versus 2/1 for exit). The polls say it is too close to call.

Prospects for the referendum may well move markets over the next year or more. Looking more broadly, the prospects for the euro area and the UK look likely to remain very different. In the UK, recovery is now well entrenched, and Mark Carney has said that the lift-off moment will “come into sharper relief towards the end of the year”. Economists are not expecting a rise until the second half of next year and the markets are now pointing to no increase until the first quarter of 2017. This means that in the run-up to the referendum, the economic news will continually confirm that the UK is outperforming the euro area. This is of course somewhat misleading as the UK economy was hit much more by the crisis, but it will influence perceptions.

Looking further ahead, it is clear that interest rates are likely to rise gradually, in small steps and to end up at lower levels than the historical norm. Carney recently referred to some work that has been very influential inside the Bank.

Currently, this exists only as a blog, but I am sure it will be published in full soon. The blog, by Lukasz Rachel and Thomas Smith, tries to explain the 450 basis point decline in global real rates over the last 30 years. Chart 1 below summarises their results.

They argue that the fall in the dependency ratio has increased savings, as workers save more. The rich also save more, so greater inequality raises savings. The Asian EMEs and the oil producers have on average run current account surpluses reflecting excess savings. Capital goods prices have come down relative to labour, so investment is cheaper, and this effect dominates the impact of the lower price on inducing more investment. Governments are investing less for budgetary reasons, and there are higher risk spreads.

So, what does a world where the global real rate settles at 1% look like? Real assets that have indexed yields start to look very attractive. Equities look better than bonds. And what of commodity prices? This is a world of subdued growth, so it seems hard to see a massive revival in commodity prices. Similarly, this is a world of low inflation so the demand for gold as a hedge against inflation may also be subdued. In the UK, those with long memories will feel that nominal rates at 3% are still unattractive and this will reinforce the sense that property is a better investment than fixed interest products.

We are also entering a period where the US and the UK will be reversing QE, while the ECB is doing the opposite. We have very little evidence of the impact of such a process. Many years of zero rates will have resulted in distortions that could be costly to unwind.

Of course, this is just one scenario. Beware the unknown unknowns: global shocks, by definition, are unexpected.

The list of trouble spots around the world is as long as ever: Syria, Israel, Libya and many more.

These conflicts are leading to mass movements of people across borders, which are creating further tensions.

It is our curse to live in interesting times. Mervyn King’s desire to make central banking boring is a distant dream. The key challenge that the UK and Europe face is whether to confront these challenges together or separately.

Lord Gus O’Donnell, Strategic Advisor, to TD Bank Group was appointed in June 2012. In this role, he will provide TD with advice and counsel on a range of economic, government, regulatory and strategic matters, travelling between Canada, the U.S and the United Kingdom.

He is also Chairman of Frontier Economics, non-Executive Director at Brookfield Asset Management, a visiting Professor at the LSE and UCL and a member of the Economist Trust. He is also Chair of the Advisory Board of the Behavioural Insights Team at the Cabinet Office.