Stephen King: To cut, or not to cut... That is the question facing Britain's government

If creditors lose their faith in ordinary government bonds the entire financial edifice could come crashing down
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The Independent Online

Before the general election, the key debate focused on spending cuts now or spending cuts tomorrow, an inversion of the more traditional choice involving jam. Labour and the Liberal Democrats wanted cuts to begin in 2011, while the Tories thought cuts this year would be better. Unsurprisingly, economists were also split on the issue. Those of the Keynesian variety thought premature cuts would wreck the recovery because demand would be withdrawn too swiftly. Others, worried about the threat to the UK's international credit rating, thought delayed cuts would wreck the recovery, because interest rates would rise and sterling might collapse. Both groups shared the same underlying objective but wanted to head off in entirely different directions. No wonder people don't trust economists.

Following the election, the newly-formed coalition – a mixture of those who wanted to cut now and those who wanted to cut later – has decided that cuts now might be rather a good thing. This is hardly surprising. The debate has moved on, largely reflecting events in the Mediterranean. True, the UK is not a member of the eurozone and, thus, isn't under quite the same strains facing the likes of Greece and Spain. If we want to improve our competitiveness, we can in theory encourage sterling to soften (a point made by Bill Martin, the Cambridge economist, in his recent paper, Rebalancing the British economy: a strategic assessment). If the Greeks and Spanish want to improve their competitiveness, they have to cut prices and wages, a process which doesn't come top in the political popularity stakes.

Nevertheless, it's easy to see why there is a new sense of urgency to deal with the deficit. International investors are becoming increasingly worried about the solvency of sovereign nations. Those with unsustainable fiscal positions – where, if nothing is done, the ratio of government debt to national income will persistently rise – are in danger of falling under the spotlight of nervous bond holders. These armies of investors are no longer interested in making money. They're much more worried about losing money. Over the last few weeks, they've rushed to the door on the Mediterranean coast marked "exit" and headed for safety. They've been buying dollars and gold in a bid to remain as liquid as possible. In the process, they have forced additional austerity on economies which were already on their knees.

The obvious lesson from all this is that countries cannot easily live beyond their means. Admittedly, not all profligate nations are in immediate danger. The US, with its international reserve currency status, has escaped the shenanigans in Europe even though its own fiscal position leaves a lot to be desired. And when the sovereign crisis first struck, it was very much a Greek affair because, uniquely, Greece had been economical with the truth in qualifying for euro membership. Since then, however, the contagion has spread, in part because the process of bailing out Greece has revealed discord within the eurozone over the extent of any fiscal support package. If Greece has ended up in trouble, might other eurozone members follow suit? And if other eurozone members trip up, might Britain be next?

Admittedly, it's a big leap from Greece to the UK but, with the Spanish government struggling to appease investors and Spanish unions threatening to arrange a general strike, it's not so difficult to imagine problems in the UK, too. After all, Britain's fiscal position is, if anything, worse than Spain's so keeping the UK out of the firing line may require decisive fiscal action now. The political penny is dropping. But what about the Keynesian defence? The UK had a much higher share of debt to GDP after the Second World War and didn't go bust back then, so why worry now?

Let me offer three responses. First, following the Second World War, Britain suffered years of austerity. The cost of repaying wartime debts was persistent rationing, with sugar becoming freely available only in 1953 and meat in 1954. Our debts back then had a hugely-constraining influence on what people were able to buy.

Second, as Britain drifted through the 1950s, it discovered that its debts constrained not only its economic progress but also its political influence: Suez may have been a military success but it was a political failure for the simple reason that the UK by then depended on financial support from the Americans, who were none-too-pleased with Anthony Eden's imperial escapade.

Third, holders of UK government bonds immediately after the War were almost entirely British, reflecting the collapse in cross-border capital flows in the first half of the 20th century. In other words, those choosing to lend their money to the British government had a voice in domestic politics. That's no longer the case today.

In the late-1990s and the early years of the 21st century, foreign ownership of gilts was already approaching 20 per cent of the total outstanding value. Foreign ownership then increased dramatically, reaching a peak of well over 35 per cent just before the onset of the financial crisis. Since then, the numbers have come down.

That's hardly surprising. Knowing that weaker sterling offered an escape route for the UK economy, foreigners were quick to get rid of their gilts, in the process contributing in self-fulfilling fashion to sterling's slide in 2008.

Also, given the Bank of England's willingness to purchase gilts from all-comers as part of its quantitative easing programme, foreigners decided to cash in.

Nevertheless, judged by post-war standards, foreigners still own a big chunk of the UK gilt market. While the numbers are not quite as extreme as those applying to Greece – where around 70 per cent of outstanding bonds are owned by foreigners – foreign creditors have an obvious reason to worry about the UK. They're not part of the British democratic process. As cross-border capital flows have increased enormously since the 1980s, so the political link between nation states and their creditors has slowly unravelled. Before the crisis, this was thought to be mostly a good thing. Cross-border capital flows surely meant that capital could be allocated more efficiently than in the past. Following the crisis, the picture is murkier (a theme I discuss in my recently-published book, Losing Control: The Emerging Threats to Western Prosperity {Yale University Press}).

While it's true that creditors have often been buying the wrong kinds of things, with too many investments in the US housing market, too much faith in the stability of the UK economy, with its "no more boom and bust", and too little scepticism about the dangers of excessive government borrowing in the eurozone, creditors are now beginning to fret not just about the minor losses associated with financial misdemeanours but the major losses associated with sovereign defaults.

The danger is not just that the creditors might take their investments elsewhere. Far worse is the possibility that, having already lost faith in asset-backed securities and the other esoteric offerings of modern international finance, creditors will also lose their faith in entirely ordinary government bonds. Should they do so, the entire financial edifice will come crashing down, plunging the world into a Great Depression Mark II which Keynesian policies were supposed to avoid. Fiscal belt-tightening in the UK may be painful but the alternative could prove a whole lot worse.

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