The Bennett Newsletter
"UK: Poison Chalice"
The Markets will demand from the new British government a decisive plan to deal with its ₤163 billion budget deficit and action on its huge, growing national debt. The politicians will probably lack the intestinal fortitude to do it. They ignored it during the election campaign despite warnings from the European Union and the Institute of Fiscal Studies (IFS). They talked tax cuts and kissed babies. The bill will now be urgently presented, and penalties will apply.
I argue that the UK has hit a brick wall. It has ill-used several golden years by squandering money to every squeaky wheel. It threw money at every problem, and all parties in the recent election campaign behaved irresponsibly by promising tax cuts and economic growth in the years ahead. It is now on the cusp of historic change, where the markets will impose monetary and fiscal discipline.
The manner in which the bond vigilantes have dealt to Greece and others, and the fragility of the London Stock Exchange, plus a large fall in the pound, emphasizes that markets expect serious spending cuts. In the Greek crisis pressure built on all big banks on concerns that their exposure to fiscally weak governments would increase their funding costs.
The Governor of the Bank of England has warned that the necessary medicine of tax rises and spending cuts will put the party which introduced them out of power for a generation.
The Reality.
The current budget deficit has blown out to ₤163 bn or about 12% of GDP. It is the highest in Europe. The National Debt is on course to reach ₤1.4 trillion in four years. Meanwhile, unemployment is high and perhaps rising. Treasury predicts that some departments face spending cuts of 25%. But Treasury does not reveal how much will be spent on debt interest.
British finances have Enronesque qualities. So many liabilities are both unfunded and unknown. The IFS estimates that unfunded liabilities for public sector pension were larger than net national debt. Others calculate this liability to be about ₤1 trillion, about 70% of GDP. This is not an immediate problem, but it will put huge pressure on future budgets as officials and teachers retire on generous inflation-proofed pensions.
The Labour Government built many hospitals and schools off-balance sheet in the Public Finance Initiative. The best estimate I have is that its liability is ₤139 bn (c.6% of GDP). The Conservatives have promised a new Office of Public Responsibility to penetrate the elaborate labyrinth of Treasury spending plans and growth forecasts.
It surpasses my understanding that a new office is necessary to audit Treasury. Why audit this august auditor? Might it have a Department of Silly Walks? Has the UK also hired experts to hide its worst financial features in order to preserve its credit rating?
Perhaps it is a taste for grandeur. Alistair Darling, the caretaker Chancellor agreed on May 9 to double Europe’s bailout fund (the stabilization mechanism”) to act in a crisis. It extends that fund to the Eurozone, having already assisted Latvia and Hungary. At the stroke of a pen, the liabilities have increased by ₤15 billion. Alistair Darling bravely resisted signing up for a massive new IMF-like fund to support the Euro. No one regards the Chancellor’s largesse as exceptional.
Will the new government be resolute?
The historical record of British Governments taking unpopular decisions is not strong. In 1974 there was also a hung parliament and the economy was in a mess. It was the “short parliament”, lasting February to October 1974. Labour curried favour by cutting VAT from 10% to 8% in July. True, there was a lofty justification of trimming inflation, but that was gobbledygook.
Government spending got so much out of control that eventually the IMF had to be called in. Its help was conditional on deflation. The Conservatives lifted VAT to 15% in 1979, and this was followed by extreme discontent and major riots in 1981.
I suspect the next government will eventually increase VAT to 20% as well as slashing government services, like child benefits. Unemployment, especially youth unemployment, will remain very high boosted by public service redundancies. This will be a powder keg, with feeling of deprivation fueled by some racial/ immigration antipathies. While radical protest has been muted in recent prosperous years of Labour’s bounty, riots and strikes are possible, especially in regions that have lost jobs through globalisation.
In effect, a responsible administration will impose deflation. When the Government did that in 1925, there followed the class war of the General Strike in 1926, and ongoing unrest among coal miners, textile and metal workers. The Greeks have no monopoly on street violence: deflation, unemployment, falling house prices, and injustice can inflame tensions.
Electioneering inevitably exacerbated the situation; more expensive promises were made (for example: increasing aid) while spending cuts were not unequivocally asserted. It would be unrealistic to expect the parties to promise deep cuts while they are maneuvering for the next election.
A Conservative-Liberal pact seems the most likely outcome at the time of writing. It is desirable that the partners will agree on austerity, but I am informed that they are idealistic, and will forge ahead with a low-carbon economy. As Copenhagen failed, the parties may commit themselves to an expensive policy which lacks any reciprocity from the big polluting countries.
Electoral victory is a poisoned chalice although British political parties have not absorbed the fact that, according to the EU, UK finances will be worse than any other major European country, even Greece. Its budget deficit will be 12% of GDP and its accumulated debt will be 90% of GDP by the end of next year.
The market will punish the British if their government fails to produce an early budget that meets the challenge of reducing the current budget deficit. Sterling is hemorrhaging. The markets want action and will be reluctant to provide the funds necessary to fund the deficit and national debt. Unless confidence is quickly established, they will demand a high premium for the risk of funding a country in a dire situation.
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