Hamish McRae: Dreadful public finances can only be rescued by an early return to growth
Friday 23 January 2009
The "Iceland-on-Thames" taunt about the state of UK Inc may be ridiculous, but the foreign exchanges evidently don't think so. While the exchanges invariably overshoot and undershoot, the fact that sterling is trading below $1.40 whereas little more than a year ago it reached $2.10 does carry a message, for it is not so much the level of the currency but the speed of the deterioration that is so alarming.
The markets are not saying that the UK economy and public finances are in a mess; they knew that already. They are saying that the mess is materially worse now that it was even a few weeks ago. They may also be saying something more: that whatever the travails of the world economy, the UK is in a relatively bad position to cope. Could they be right?
There are, I think, three separate issues: the state of UK banks, the relative prospects for the economy and the state of public finances. A quick word about the first two and a longer look at the third.
On the banks, it is hard to argue that they are in materially worse shape than most of their competitors. Royal Bank of Scotland is exceptionally weak, but that is in fair measure the result of the takeover of much of ABN-Amro. Without that it would be in trouble, but it would not in effect be bust, and it would not be in danger of being fully nationalised. At the other end of the scale, HSBC is probably the strongest bank in the world. The rest of the industry is somewhere in between, but if you look at UK banks in a global context I don't think they are any worse than the rest, and arguably have had more solid support from their governments than most.
There is, however, one more general point, which is that the UK does have a relatively large banking sector, and therefore as an economy might be particular vulnerable. That leads to the second issue, our relative outlook. This matters of course. The overall outlook for the world economy in the HSBC projections is as follows: a dip broadly similar to the early 1990s, a little worse for the developed world and a little better for the emerging nations. But there is a big split between the mainstream view that the UK will fare relatively badly and a minority view that is a little more optimistic. The mainstream view comes through in the new European Commission forecasts, which suggest a 2.8 per cent contraction this year and growth of just 0.2 per cent in 2010. The minority view is well put by Goldman Sachs, which forecast a contraction of "only" 1.6 per cent this year and 1.7 per cent growth next. The EC prospect is for the UK doing worse than the eurozone, while Goldman thinks it will do better.
One reason why growth might be better is the fall in sterling. European politicians are just starting to criticise Britain for this, which is a good sign. It suggests that they are concerned that our having exchange rate and interest rate flexibility might enable us to achieve a better recovery from the downturn than they will. There is no evidence of that yet, for exports have failed so far to respond to the UK's greater competitiveness, but you would not expect it. The familiar J-curve effect is at work. After a devaluation, the deterioration in the terms of trade makes the current account balance worse, not better. We are paying more for our imports and getting less for our exports. But after a while exports pick up and imports are squeezed; the current account improves.
An early return to growth is essential if our public finances are to be rescued. These are dreadful beyond belief. Add to that what has been happening to borrowing this year compared with last, and the overall rise in debt relative to GDP. The obvious point is that even without the extra burden of supporting the banks, public debt is already way above the 40 per cent ceiling set by Gordon Brown in 1997, and this has occurred before the full effect of the downturn has been felt.
You can see how this prospect compares with that of the other G7 countries in the final graph, from Consensus Economics. The perception of everyone's fiscal position deteriorated throughout last year, but we are seen to be in a worse mess even than the US. That is nothing much to do with the banking problems and all to do with the desperately weak underlying fiscal position. You remember all that "prudence with a purpose" stuff? Gordon Brown's reputation has been destroyed by these numbers, and it is very hard to see quite how the country's status as a borrower can be restored until there is a change of government.
So what will happen? Well, it is going to be hard to finance the deficit without a sharp rise in long-term interest rates. There are not enough savings in the country to do so. We are having the fastest rise in public debt that has ever occurred in peacetime, and it looks as though we will move from having a national debt of about 35 per cent of GDP to one of about 80 per cent of GDP by 2014. That is not as bad as Italy, and not nearly as bad as the debt levels at the end of the Second World War, but it will put us towards the top end of the global scale rather than being towards the bottom.
Can we finance it? In the sense that a national government that controls its own currency can always finance its debt, the answer is yes. We can print the money if necessary. There is a practical argument that we should under-fund the deficit, in other words not issue as many government securities as would be needed to cover the deficit, but rely on the Bank of England to create enough money to fund part of it. The case for this is that in a world of deflation, the only way of giving a monetary boost is to under-fund in this way; low interest rates are not enough. But it is a slippery slope, and breaks all the rules of normal financial management.
On the other hand, if this deficit is to be financed conventionally, the Government will squeeze out other borrowers. Money put into gilts is money not available to go into corporate bonds. Huge fiscal deficits crowd out other borrowers, which makes you wonder whether a deficit of nearly 10 per cent of GDP makes any sense at all. There have been a lot of references to the Great Depression of the 1930s and Franklin DRoosevelt's "pump-priming" of the economy. Well, some numbers dug out by Vito Tanzi in a new Politeia pamphlet reminded me that the peak borrowing under FDR in 1934 was less than 6 per cent of GDP. Both Britain and the US are heading into unknown territory. The US, given its size and the status of the dollar as a reserve currency, can perhaps get away with it; the exchanges are saying that we can't.
So there will have to be fiscal retrenchment within the next couple of years, with cuts in public spending and probably high taxes. Maybe this can be delayed until some sort of recovery is under way in 2010, but it will make the early part of the next expansion a pretty muted period, and I am afraid things will get worse before they get better. And the prime reason for that, as the exchanges recognise, will have been fiscal mismanagement on a monumental scale.
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