The Close of 2009

As 2009 comes to an end, where does the UK economy stand? As is common practice at this time of year, I thought a review (and commentary) might be appropriate.

There is some good news. It seems that UK households have finally realised that they actually need to save money, and that they are preparing for tougher times ahead. Of course, some of the Keynesian discussion about how bad it is to save in a recession being trotted out, but even the Times is dismissing this concern:

[referring to the Keynes argument] But that does not not appear to be the case here. Instead, all the evidence points to the savings ratio improving simply because of a number of the most heavily indebted households paying down their borrowings, along with a of minority of households overpaying their mortgages. That in itself does not necessarily jeopardise growth prospects — such as they are — for 2010 and is probably worth celebrating in that it confirms a long-overdue recognition from many consumers that they were too far in debt.

One of the curiosities in the figures is that hotels and retailers have reported a 0.7% growth in spending, which is puzzling in light of the switch to savings. However, that people are paying down debt is positive, but a question remains as to where those that are saving (rather than paying down borrowing), may be going. With low interest rates, are savers taking large risks?

The remainder of the news is not so positive. The latest rating agency to express concern about the fiscal situation of the UK is Fitch:

International ratings agency Fitch on Tuesday urged Britain, amongst other nations, to put forward "more credible" plans aimed at reducing state debt or risk "pressure" to its top credit ratings.

The UK is rated 'AAA' by Fitch, meaning the agency has the highest confidence in their ability to repay borrowings.

Fitch said in a report published on Tuesday that "all major 'AAA' sovereign governments need to articulate more credible and stronger fiscal consolidation plans during the course of 2010."

Fitch added that such action was necessary "to underpin confidence in the sustainability of public finances over the medium-term and the commitment to low and stable inflation."

Should the UK be alarmed? According to an article on the BBC, the UK should not:

No wonder leading credit ratings agencies have expressed concern and suggested the UK's AAA rating - reserved for only the very safest borrowers - is under threat, sparking widespread hysteria in the media that UK debt is spiralling out of control.

Reading some headlines, you might even be forgiven for thinking UK plc is on the verge of going bust.

But are the UK's debt levels really that bad when compared with other leading developed economies?

The article goes on to show a chart, which identifies the high level of debt in other developed economies, as if this were to suggest that UK debt levels are OK. It is a curious argument that is put forward in various forms by many commentators. It is like a person who is about to go bankrupt pointing to their neighbour and suggesting that their neighbour has borrowed even more than themselves, so that means that they will not themselves go bankrupt. Of course, their neighbour might be earning more in relation to their debts, might be better able to cut their expenditures, might have borrowed from family rather than the bank and so forth. Also, there is the possibility that their neighbour will go bankrupt too. It is, in other words, a simplistic and complacent point of view.

The concern for this post is that the growing fiscal deficit goes alongside the ongoing fall in GDP.

Britain's economy shrank by 0.2pc in the three months to September, more than the 0.1pc decline expected, as stronger construction output was offset by a weakening in the services and industrial sectors.

This leaves Britain officially mired in recession, unlike most of its major trading partners, even though the previous estimate had shown a bigger 0.3pc GDP contraction.

Regular readers will be aware of the fact that GDP includes debt based activity, so it is apparent that the record levels of government borrowing are still insufficient to prop up the GDP figures. Such an outcome is quite shocking, and suggests that the underlying state of the economy is truly dire. The key question is to ask what GDP might look like without the government's huge borrowing, and the word 'ugly' comes to mind.

As for the policy of Quantitative Easing (QE - printing money to finance government borrowing), there is considerable discussion of the policy coming to an end:

All but one of the 53 analysts in a Reuters poll reckon the Bank of England will halt its quantitative easing programme when the current 200 billion pound ($320 billion) asset purchase fund, intended to help keep credit flowing, runs out in the next few weeks.

I am not so confident. As I have previously asked, who exactly will pick up the slack if the Bank of England ceases purchases of gilts? The Bank of England has expressed concern about the state of the fiscal deficits, but that is a long way from a decision to throw the gilt markets to the wolves. This is not to excuse the Bank for an irresponsible policy, but rather an acceptance of the dilemma that the Bank is facing. On the other hand, with the fig leaf of the deflationary fear receding, how might the Bank justify an ongoing policy of QE? I would guess that there are some strained meetings taking place between Alastair Darling and the Bank of England.

The scope of the problems of QE and the fiscal profligacy of the government are now having an impact on the gilts market, with yields on gilts moving to levels that are now comparable with Italy. Even mainstream economists are starting to accept that the policy of QE increasingly looks like a method of monetization of government debt, and that this will eventually lead to a crisis:

In a letter to The Sunday Times, the economists, including Tim Congdon, Patrick Minford and Gordon Pepper, warn of “heightened risk” of a downgrade of Britain’s sovereign debt rating.

The signatories, several of whom are on the “shadow” monetary policy committee, say that the integrity of UK fiscal and monetary policy is at stake because of the huge budget deficit.

They warn that international investors could see the Bank of England’s £200 billion quantitative easing programme, mainly the purchase of UK government bonds (gilts) as “driven by a politically-motivated desire to ease the government’s funding difficulties”

Regular readers will know that I have been making the argument that the QE policy is a method of funding massive fiscal deficits, and that I argued even before the commencement of the policy that the response to a growing fiscal hole would see either printing money or sovereign default. The most incredible part of the entire story is that economists, analysts and commentators have accepted the Bank of England spin on the policy for so long. I suspect history will not be kind to those that have accepted the Bank's line on this policy.

Then there is the 'real' economy. Starting with the banks, they are facing major headwinds, with losses on lending stretching out to the horizon. Commercial property is looking a particular risk, with loans in breach of agreement doubling in the first half of 2009, and expectations for the situation to become worse. Residential mortgage arrears, already at a high rate, also increased in the third quarter of the year by 3%. Some positives might be seen in the figures, even though they are still terrible:

A total of 13,987 properties were repossessed by lenders during the three months to the end of September, according to the Financial Services Authority.

But the figure was 6% lower than during the first quarter of the year, as a combination of low interest rates, Government schemes and lender forbearance helped people to stay in their homes.

The Government has launched a raft of initiatives to help people struggling with their mortgage stay in their home.

[and]

The combination of of Government support, low interest rates and lender forbearance has caused the CML to slash its forecast for repossessions for 2009 by more than a third to 48,000, although this would still be the highest number since 1995.

Of course, the question about such schemes is to ask how much they will cost, and whether they are sustainable, or simply putting off the day of reckoning for both the banks and the mortgagees. With regards to interest rates, if inflation picks up or there are problems rolling over government debt, then it is quite possible that the Bank of England will be forced into interest rate rises.

As for consumer credit, the losses in the coming year are expected to be horrendous, with the following from the Telegraph:

"Economic indicators and feedback from our collections clients suggests that the first quarter of 2010 could be the busiest period ever seen."

Experian is anticipating the worst due to the 771,000 job losses in the first nine months of the year, a 94pc increase on 2008, and the record quarterly personal insolvency rate of 41,390 for the three months to September.

There are a few points to highlight from these indicators. The first is that, with consumers saving and restricting in their spending, it is not clear where the shops, bars, restaurants, and all the other consumption based businesses are going to get their income (the puzzle of growth in spending mentioned earlier). This lack of income will in turn impact upon employment and commercial property, and this will in turn feed into more mortgage and credit defaults, and this will then impact upon the banks. The truth is that, now consumers are trying to live within their means, and are prudently saving, the adjustment can not be stopped. The move of consumers to living within their means can only mean a downward spiral, until the point is reached where businesses supported by excessive borrowing are gone.

Even the government's massive borrowing, acting as the consumer of last resort, is insufficient to hold back the inevitable adjustment - at best it is an expensive mechanism of delay.

Then there is manufacturing. Output is down by 8.4% according to the Economist of 12th December. Bearing this in mind, I read an interesting article in the Times, which was still harping on about the much vaunted theme of the knowledge economy:

The primary question, though, of where the money comes from in the future, is difficult. In 1975 55 per cent of the British economy came from services. Now 75 per cent does. Manufacturing was more than a fifth of the economy 20 years ago. Now it is less than one eighth. But this, in itself, does not mean the economy is “unbalanced”. Manufacturing is roughly the same share of the economy in the UK as it is in France and the US. In any case, outside the aerospace, defence and biotechnology industries, manufacturing is stuck in a trap of low value and low skills. These jobs will migrate to anywhere that adds low wages to the mix.

They still do not get it. This is the bankrupt model that led the UK, and other economies into the mess we are in. A quick look at the current account balance for the UK shows that this has not, and is not, working. Again, according to the Economist, the UK's trade balance is $US -126 billion, and the current account balance is $US -50 billion.

The article in the Times presents the aspiration for a future built upon "biotechnology, pharmaceuticals and sophisticated engineering", but we have heard this mantra in the past, and it is not paying the UK's bills. That winning in these sectors would be a good thing is not a matter of dispute, but the reality remains that the UK has, over a long period of time, failed to achieve this miracle.

Whilst it is possible to point to many successes in the creation of jobs from these industries, it has become clear that the UK also needs to compete in old fashioned manufacturing. The added value in the output in the 'creative' and high tech sectors has not been paying the bills, and this has been hidden by debt based growth. In order for the UK to succeed in manufacturing, the reality is that it must accept the necessity to compete with lower wage countries, a critical element is to remove the burdens on the UK economy associated with excessive government expenditure and debt creation.

A reduction in the size of the state is not the whole solution. A more efficient state is necessary, as is the necessity of pushing for fairer free trade, for example addressing the currency manipulation of China, or the inequities of state intervention in industry in the EU. In addition, there are many areas of the UK in need of reform, and it is beyond this post to detail all of them (see links to my suggested reform at the top left of the page). The point is that the one thing not being addressed by government is the underlying problems at the heart of the UK economy.

Talk of success in high tech and creative industries is easy. Actually generating enough to support a high standard of living in the UK are entirely different matter. History to date has shown us that it is not enough, and there is no reason to think that this will (as if by magic) change simply because people wish it to. The UK has been living on borrowing for too long, and something must change if the UK is to achieve economic success.

For those that point, for example, to the success of countries like Germany, and that we should emulate their policy, I have a simple question. If it was possible to achieve, why is it we have so stubbornly failed to do so? We have had industrial policy and it failed, we have had high government expenditure, and massive state intervention and it failed. Why will it be different this time? Economists might argue about what are the key elements of German success, but can another country - with so many structural and cultural differences - ever hope to reproduce the success? I would argue that the success of one country can not be easily transferred to another country with an entirely different structure and culture. In other words, the UK must enact policy that will work for the structure and culture of the UK.

I read an article recently (sorry, I forget where) which suggested that ongoing falls in the £GB will see trade eventually return to balance. Currency devaluation is often seen as a solution to economic problems, which is partially true. If the value of a currency falls, then the competitiveness of businesses does indeed increase. However, it does so at the cost of relative impoverishment of everyone who holds the currency. In simple terms, if you are paid in £GB and enjoy Belgian beer, then the price of the beer will go up - you are literally poorer in terms of your Belgian beer purchasing power.

As such, devaluation is a solution to a poorly performing economy, but it is a solution in which everyone in the economy is quite literally poorer. It is a mechanism of re-balancing an economy, but it always puzzles me that it is proposed as a 'successful' solution by some economists. It is just a wage cut for everyone, and the erosion of the purchasing power of savings. It is a form of achieving competitiveness that is punitive, in particular for those who have worked hard and saved.

Although devaluation might eventually lead to a re-balancing of the economy, at cost to everyone, the problems of such a devaluation are numerous. As has already been detailed, there is considerable nervousness about the UK's fiscal policy. If a government and the Bank of England seeks the devaluation solution, then there is a real possibility of a gilts strike. If investors believe that there will be an ongoing and substantial devaluation, then it will become ever more difficult for government to borrow, which means printing more money to fund deficits. In addition, inflation will continue to increase, as imports become more expensive. As inflation increases, the cost of government will increase, requiring higher levels of borrowing. I think you can see where this is heading...an inflationary spiral.

Devaluation is therefore a very, very high risk solution. It leaves only one viable solution, which is that the UK economy must just stop consuming more value than it produces. That means that government must follow the lead of consumers and stop borrowing to spend. That the solution will be very hard does not remove the necessity. Yes, the economy will go into a tailspin. Yes, it will need cuts in expenditure in every sector of the economy, even in the NHS.

The basic question to be asked is what is the alternative? A government that lives on printed money, crippling inflation and massive interest payments? Yes, the UK economy might get away with the policy of printing money and massive fiscal deficits for a little longer. But what will happen when this finally unwinds? How much worse will it be then?

As 2009 comes to a close, the deep seated problems in the structure of the UK economy are harder and harder to hide. The (neo) Keynesian solutions that so many supported are now being seen as what they are - a progression towards disaster. The idea that government can borrow and spend to infinity is being tested, and it is apparent that this can only work if people are willing to lend. This small detail escaped the Keynesian economists, who seemed to assume that governments could indeed borrow with no restraint or consequence.

You do not need a PhD in economics to know that people will only lend money if they think they have a reasonable chance of having that money returned to them. You do not need a PhD in economics to know that, if your finances are in a mess, lenders will demand ever more reward for the risk of lending you money. You do not need a PhD in economics to know that you can not continue to live beyond your means forever, and that one day the borrowing will have to stop and paying back the debt will need to start.

Perhaps the most interesting aspect of the coming year for the UK will be the election. It might be that Gordon Brown will seek an early election, hoping for re-election before the economy becomes any worse, or in fear of a coming gilt strike. The likely winner of the election is the Conservative Party, who will inherit an economy and fiscal situation that is on the brink of disaster. To date, the Conservatives have failed to persuade me that they have either the will or the courage to tackle the deep seated problems of the economy head on. Perhaps they are hiding their plans from the public, and do intend a more radical policy than they are currently proposing. This can only be speculation, but in all cases the Conservative Party should be honest with the public.

As the world enters a new year, it is time for honesty. The party is over, and the hangover must now start. When surveying the news, there are still only hints from the politicians of the severity of the situation. The time has come for the politicians to come clean, and tell people about exactly how bad the situation actually is. It is only then that people can actually accept what is an absolute necessity, and that is wholesale restructuring of the UK economy.


Note: That restructuring the UK economy alone is not enough should not stop the process from starting. The more difficult and intractable problems of the world economy must also be addressed, but the UK government can not by itself address this problem. Currency manipulation by China, for example, requires action from the US an the EU.