It’s payback time for indebted UK plc. But will public-spending cuts plunge us back into recession… or perhaps worse? Or will we muddle through? David Stevenson reports.
Three years ago this week, the FTSE 100 hit its highest point since the dotcom crash. On the surface, Britain’s economy looked healthy, as did the housing market. And the moneymen were happy to finance it. “As long as the music’s playing,” said former Citigroup chief Chuck Prince, “you’ve got to get up and dance. We’re still dancing.” That infamous quote is now financial folklore. Since June 2007, the planet has endured a worldwide banking crisis, leading to a stockmarket collapse and the worst global recession in living memory.
Britain was hit harder than most.
GDP fell by a total of 6.3% from the second quarter of 2008 to the third quarter of 2009. But the economy has since rebounded. Britain officially emerged from recession in the fourth quarter of 2009. Shares have recovered some of their poise and house prices have rallied sharply, with parts of the southeast seeing prices back up to their heady levels of three years ago. So are we on the road to a full recovery?
Sadly, no. The current bounce could be as good as it’ll get. ‘Double dip’ territory may lie just around the corner. Why? Because the economic rebound – not just here, but globally – has been driven largely by higher levels of government borrowing to fund economic stimulus measures. This in turn has been combined with a natural rebound as firms have restocked following the sharp slump in global trade. But now markets are getting jittery about the solvency of governments. So government spending has to be reined in – ‘austerity’ is the new buzzword. But while that’s good news in the long run, it’s likely to be a painful process.
The state we’re in
The British economy has seen a bounce, but is hardly fighting fit. UK retail sales, including fuel, were up 1.8% year-on-year in April, compared with a 2.5% fall in early 2009, says the Office of National Statistics. Yet sales volumes are still below the peaks of mid-2008. As for the industrial picture, again there’s been a rebound from the lows. However, while April’s industrial production was 2.1% higher than last year, it fell 0.4% on the month. Overall production was still more than 12% lower than in early 2008.
Britain has also tried to fire up the economy by printing money via quantitative easing. The Bank of England (BoE) has pumped ÂŁ200bn into the banking system to revive lending. But it hasn’t worked out that way. Although the money has flooded into assets such as stocks, Britain’s banks haven’t lent more because they’re still jittery about the bad debts on their balance sheets. Net mortgage lending has grown by less than 1% over the past year, while consumer credit is now shrinking. Lending to non-financial firms – businesses that make and sell real things – is shrinking at a near 4% annualised rate.
Why we have to cut
The trouble is, the government has run out of financial ammunition. It has to reduce its spending rather than try to prop up the economy with more borrowed money. This week the new Office for Budget Responsibility (OBR) – set up by the government “to make an independent assessment of the public finances and the economy”, according to the official spiel – had its say on the state of the economy ahead of Tuesday’s Emergency Budget.
The OBR actually reckons the outlook for Britain’s borrowing is a bit better than the last government had expected. By April 2015, it reckons the overall public sector net borrowing requirement will be ÂŁ22bn lower than forecast in the last Budget. But we’re still sitting on a current year deficit of around 10.5% – not much better than the likes of Greece. The structural deficit (the amount we’re overspending by, if you exclude any exceptional circumstances) is likely to turn out to be larger than expected. That’s partly because the economy’s growth rate (key to the amount of tax revenue the government will rake in) is also likely to be lower than expected.
It’s the structural deficit that matters. Britain’s problem is that it was spending too much even before the crisis hit. Consumers were over-indebted, burdened with mortgages and credit-card debt. So was the government. The recession has certainly taken its toll on the public finances. However, much of the spending that’s been done has largely gone on ‘natural stabilisers’, such as higher unemployment benefits, rather than on specific stimulus packages.
The reality is that recent levels of British public spending, buoyed by super-charged tax receipts from the financial sector, were never sustainable. And now that overspend has to be dealt with, before the markets force austerity upon us. As George Soros puts it, we’ve just entered “Act II” of the financial crisis. “Financial markets have started losing confidence in sovereign debt. Greece and the euro have taken centre stage, but the effects are liable to be felt worldwide. Pressure from financial markets is forcing reductions in budget deficits at a time when the banks and the economy may not be strong enough to permit the pursuit of fiscal rectitude.”
To put it bluntly, it’s payback time. Global bond markets will no longer tolerate ever-climbing budget deficits, whether governments or their citizens like it or not. That leaves our new government no choice. “Without action to reduce the shortfall, interest rates will increase,” says Jeremy Warner in The Daily Telegraph. “And an ever-rising proportion of our taxes will be wasted merely servicing burgeoning public debt, to the exclusion of other spending.”
As Mike Amey of bond fund manager Pimco points out, “UK sovereign debt risk will continue to be an issue as long as UK debt levels remain high.” Although Britain has its own currency and will therefore “always have the ability to repay its debts”, high debt levels will “put pressure on the currency and the inflation rate”, which in turn would tend to push interest rates higher.
The cuts will hurt
What will this mean for the British economy? Around the world, reduced government borrowing and spending is “liable to push the global economy into a double dip”, says Soros. Britain will be no exception. And one major effect will be longer dole queues. The public sector accounts for 20% of all UK employment.
Up to 750,000 such jobs could be lost over the course of this parliament, reckons Vicky Redwood at Capital Economics. So the jobless figures are likely to start deteriorating again. Expect a time lag: “it may be several months before public-sector job cuts kick in”, she says. “We still think unemployment (currently 2.5 million) could climb above three million.” The main hope of avoiding a surge in joblessness is for the private sector to pick up the slack. Some recent surveys have suggested firms are planning to start re-hiring. But that could easily reverse.
Why? Well, it would be easier to be optimistic if Britain was the only country with problems. But a cloud hangs over Europe in the form of a potential collapse in the euro (for more on the region’s ongoing banking problems). Suffice to say, with governments in that region furiously attempting to cut spending and restructure their economies, we can’t expect strong growth in many European countries for some time. That’s bad news, given the eurozone accounts for “just over 60% of UK trade”, says Amey. “If the eurozone’s debt problems result in a protracted period of economic weakness, it would be harder to sustain positive UK growth.”
In other words, we could easily slip back into recession. And there’s a further twist here. British banks are heavily exposed to some of the eurozone’s most troubled countries. For example, British-based lenders have ÂŁ158bn tied up in Ireland and ÂŁ103bn in Spain, says the Bank of International Settlements. Major eurozone defaults would mean more write-offs, which would further erode banks’ capital bases. That would hit lending in Britain.
Fewer jobs and tighter credit means consumers will have less money to spend. Meanwhile, likely Budget tax increases – such as hikes in the capital-gains tax rate and, more importantly, a rise in value added tax (VAT) – will siphon off much of what’s still spare. That means consumer spending, which accounts for some two-thirds of our GDP, will fall. The latest indicators suggest consumers are already starting to curb their spending. The Confederation of British Industry (CBI) reported sales balance – the number of retailers enjoying better sales compared with those seeing falls – dived from +13 to -18 in May. And the GfK/NOP consumer confidence measure, a good guide to future spending trends, has dipped for the last three months running.
Less money and jittery banks are also bad news for house prices. Affordability is already a major issue. The 10%-plus price gains seen over the last year (in some areas at least) have vastly outstripped the growth in wages over the same period. In fact in April, first-time buyers, who are needed to keep the market healthy, accounted for the lowest proportion of house-purchase loans seen since the last market peak in September 2007, says the Council for Mortgage Lenders. Small wonder – the house price/average earnings ratio is now around 5.25, according to Thomson Datastream data. That’s seriously over-extended. With mortgage finance likely to be rationed, an overall price drop to below last year’s lows looks likely.
So why cut at all?
Put this all together and some pundits, such as former BoE rate setter David Blanchflower, reckon the spending cuts and tax rises planned by the new government risk plunging Britain into another great depression. We wouldn’t go that far. Fund manager John Mauldin has coined the phrase the ‘Muddle-Through’ economy – where things get messy but we eventually pull through – which is what we expect to see.
Indeed, if anything, sensible spending cuts will reduce “the risk of a double-dip recession… at the margin”, says Amey. Getting the public finances under control should mean that “short-term interest rates in the UK will remain low for a number of years, which supports the private sector as it deleverages… the coalition government has demonstrated their intent to tackle the deficit immediately and we think that is generally good news”.
There’s also a long-term upside to lower government spending and borrowing. When the state becomes too dominant in the economy, new ideas and entrepreneurship are stifled. Money isn’t aimed at likely commercial successes, but “flows to areas based largely on arbitrary shifts in ideology, regulation and cronyism”, says John Stepek in our Money Morning email. “The economy becomes more about who you know than about what you know. You only have to look at Japan to see what happens when government spending becomes the economy’s main life-support mechanism.” With the financial sector no longer turning out super-sized tax payments with which to pay for ever-growing public services, our economy has to find its growth elsewhere. Reducing the size of the state is part of that process.
But getting there won’t be easy and you can expect austerity to hit markets hard.
Category: Economics