Tuesday, November 29, 2011

The Downwards Spiral: the UK

The headlines; the UK economy is sliding and government borrowing is not going to meet projections:

The Government is set to borrow £111 billion more over the next five years than previously expected, with borrowing peaking at £127 billion this year before declining to £53 billion by 2015/16.
The Office for Budget Responsibility (OBR) has now issued its latest review, and it makes interesting reading. Perhaps the most worrying aspect of the whole thing is that there is an assumption that (by some miracle) the Euro will somehow muddle through. This is from 'Economic Outlook', 1.16:

On the assumption that the euro area struggles through its current difficulties, we expect the economy to gain momentum gradually through next year. But the headline measure of GDP is likely to be broadly flat until the second half, partly due to various one-off factors. Consistent with this profile, we have revised down our central forecast for year-on-year GDP growth to 0.7 per cent in 2012, compared to the 1.2 per cent average forecast among external analysts.
And this is section 1.21:

Our central forecast assumes that the euro area finds a way through the current crisis and that policymakers eventually find a solution that delivers sovereign debt sustainability. A more disorderly outcome is clearly possible. This poses a significant downside risk to the central forecast, but one that cannot be quantified in a meaningful way given the numerous ways in which it might unfold.
There is an important point to note here. The central forecast assumes that there will be a Euro solution. It is hard to match this forecast with the events that are taking place. As we have seen over the past few weeks, the descent into crisis is accelerating, not slowing for the Euro. For example, today we have a headline that Italy has had to pay over 7% on ten year bonds at the latest auction. Last week a German bond auction was a worrying dud. Whilst there are arguments about the cause, it is still indicative of a wider 'loss of faith' in the Euro. In a recent post, I showed a diagram of risk exposures to sovereign debt crises, and the UK was just one of the countries with a heavy exposure to European sovereign debt defaults (also, see OBR report p.63 for details). And, of course, Europe is a key element in the UK's international trade.

Bearing in mind that the OBR forecast overall is therefore probably a work of fantasy, there are some interesting elements in the report. The OBR has belatedly started to recognise something that regular readers of the blog will already know; that the UK's problems are deeper than previously realised. This is a neat summary from the Wall Street Journal:

The OBR said the output gap--the difference between what the economy can potentially produce and what it is producing--is smaller than previously thought, reducing it to -2.7% for 2011 from the -3.9% estimated in March. This means that more of the deficit is structural, making Osborne's goal of eliminating it more challenging.
Regular readers will know that I have little time for the notion of the 'output gap', and have argued that it ignores the underlying structure of the UK economy that is based upon ongoing growing debt fuelled consumption. These figures are a finding of what should have been obvious, but the figures still flatter the situation. There are large sectors of the economy that are still largely distorted to service consumption based upon debt, and these are only just starting to contract.

The final point I want to pull from the OBR is the useful analysis of consumer disposable income, confidence and spending. The big picture is that consumers are not pulling out their wallets, and there is little prospect of doing so for a while yet. This should come as no surprise in light of rising unemployment in combination with  low wage growth versus inflation. The situation is just going to get worse, and this will lever the economy down, as the sectors of the economy that service consumer spending shrink back, and in turn this increases unemployment.

All in all, even without a Euro crisis, the UK economy was likely to be hit very hard as the government sought to reign in growth in borrowing. Also, it must be remembered that this dire economic outlook is set against a backdrop in which government borrowing levels are still outrageously high. So-called austerity still means supporting the economy through a huge stimulus from the government, and a stimulus that is funded by borrowed money (borrowing that is secured against future taxpayer income). Even using the OBR's optimistic forecasts, and bearing in mind that the off-balance sheet obligations are not included, the national debt will grow from 67% of GDP to 78%. However, I do not like these circular understandings of debt ratios. The net debt forecast is £bn; 2010-11 = 905, 2011-12=1044, 2012-13=1182, 2013-4=1300. This does not look very austere to me.

Some newer readers might be surprised at the word 'stimulus' used above. However, what else can we call such huge government borrowing (or rather taxpayer borrowing facilitated - signed for on behalf of taxpayers by the government). It is a massive stimulus to the economy but, despite this (and low interest rate) stimulus, there is only one way ahead for activity in the UK economy; it will shrink. The structural problems in the UK economy were built up as a result of years of debt-fuelled consumption, the government filled the gap in growth in debt based consumption, and is now trying to reverse this course. On top of this, there is the crisis in the Euro zone. The only direction the economy can go is down; there are no sources of economic growth. This is from Tullet Prebon's Dr. Tim Morgan, commenting on the autumn statement (distibuted by email):
The real problem which confronts the UK is that the economy has been skewed by a bubble-decade of private borrowing and public spending, a decade for which Osborne’s predecessors must shoulder most of the blame. Interest rates were kept too low, individuals ramped up their borrowing on the basis of unsustainable property price escalation, and the previous government spent not just up to, but far beyond, a boom whose real bubble nature it completely misunderstood. 
This is precisely correct. The fundamental problem is this. The UK is borrowing gargantuan amounts of money in the face of almost certain economic contraction. As such, it is borrowing ever more money with reduced prospects for income to service the borrowing in the future. It is not really as complicated as many would like to propose. Something must give. In recent times, the bond markets have been relatively kindly to the UK, but it can only be a matter of time before they start to work out the contradictions in the UK economy, or start to see the contradictions playing out in the statistics. The OBR's blated recognition of the structural nature of the deficit is just the start. The OBR have yet to recognise quite how terrible the situation is.

In a recent post, I discussed the way in which governments would piecemeal address the problems in their economy - a small cut here, an adjustment there. The only way out of the mess is for governments to confront the underlying problem that they simply cannot afford to continue spending on what I called 'luxuries'. The only route out, however painful is to have a medium term target of zero borrowing, however painful that might be. As it is, this is what I said for the countries that were debt laden:

As it is, each country that faces crisis will no doubt continue to nibble at the luxuries. As they do so, they will fail to address necessity versus luxury, and the crisis will continue as each nibble fails to achieve stability, and thereby forces a new nibble at yet another luxury. It is the way that Greece has gone, and the way ahead for the other overly indebted countries. Nibbling into oblivion. 
This is the current state of the UK. For all of George Osborne's good intention, he is nibbling in the face of a catastrophic downward spiral. It is not enough, and this will become apparent over time. Right now there may still be time to determine what is an absolute necessity and what has to be consigned to luxury. As it is, as Greece found out, if no action is taken soon enough, others may  well make that determination for the UK.

Note: Thanks for the comments on recent posts. One question that came up was to ask how a Euro break-up might develop, and what consequences. I have been giving a lot of thought to this, and the problem I am confronted with is this; any break up of the Euro would be an event that start a period of 'chaos'. By this, I mean that we cannot predict either government or market reactions to this kind of event in the short term, as there will be some kind of panic resulting from the crisis. The short term reactions will largely determine the nature of the medium term actions, so prediction is simply not possible. I can only say that in both the short and medium term (five years out), it will not be good.

In light of this, and the potential complexity of the situation, without even having comparable situation to draw upon, I am ever more puzzled at the confident assertions of those who predict x, y or z. Just for a start, think of the possibilities for core Euro zones versus complete break-up. What will finally determine the end game? What will Germany do if Greece defaults, or Spain, or Italy? What will France do, and how will that interact with Germany's approach. What about the ECB - will it ride to the rescue in the face of conflagration? Will that save the Euro, or just delay the day of reckoning? There are endless scenarios, and it seems that predicting one type of outcome would be extremely difficult. However, with the number of predictions out there, perhaps someone will get it right?


  1. With each passing week, Cynicus, your long-standing analysis seems to be substantiated further. Congratulations ... but commiserations too, for that can't be a pleasant feeling!
    I see democratic governments stepping in to prevent market mechanisms from working, and governing elites stepping in to prevent democratic mechanisms from working. I don't see any sign that governing elites, or elected politicians, or captains of industry [lovely dated phrase!] know how to run the place when the market and the ballot box are both out of commission...
    In a world of multi-storey fictions, where no-one knows what the real position is any more, events will be shaped by those powers that best combine force and unreason.
    On the plus side, there'll be some damned fine exam questions about this mess in 70 or 80 years time.

  2. Fellow "cynics" should enjoy this video lecture by Chris Martenson:


    Good fortune.

    Death to Bubble Addicts

  3. Thank you as always for another excellent article. They are always a great read; I'm so glad you're back again at this important time.

    The question of how the Euro may break up is an interesting one.

    My opinion is - it won't. Germany will buckle, and allow the ECB to print money. Now, I *know* Germany has fears (memories) about hyperinfation, and there's the moral hazard etc. etc., but the point is - and Germany knows this - it is the least worst option for itself (never mind the rest).

    Well, I say 'buckle'. So, is Germany in a lose-lose situation?

    Actually, no. Knowledge is power, so Germany - knowing the decision that will be made in the end "for the good of all", will spend the interim period pivoting itself accordingly. For example, bank shares will soar once Germany gives the green light, so maybe Germany will buy bank shares via some mechanism. And there will be other ways of clawing a bit of money, or influence back, of course.

    So, Germany has the consolation prize of knowing that she has not only done "the right thing" but quietly benefitting ahead of that decision. Shrewd stuff, and easier to sell to the electorate (who will be told that their nation's debt isn't as much as first thought, so they'll be some 'goodies' to give back).

    Watch out for a small stock market upwards adjustment just prior to the announcement as those in the know place their timely orders.

    Of course the Euro will sort itself out. It's all posturing whilst the behinds-the-scenes stuff is all finalised. The powerful & wealthy (turkeys) never vote for a haircut (Christmas).

    That's what I think will happen. Anyone fancy a wager? :)


  4. Hello Bob,

    Kyle Bass (the latest celebrity doomsayer) has arguments that convince me to take your wager.



  5. Hi CE

    Chris Dillow (a marxist!) has some interesting comments on the same OBR forecast and the fantastical assumptions underpinning it.


  6. I am trying to understand just what was announced by the central banks, FED, ECB, BOE, Japan, Switzerland and Canada yesterday.

    The media seems to be concentrating on the fact that the Central banks have made the cost of buying dollars cheaper by 0.5% and this is just fantastic! - it sounds no big deal to me.

    However, I think they also announced that the central banks would be providing liquidity in each other currencies against the collateral that they would normally accept.

    So in my lay mans understanding of this - they will accept Euro denominated assets and provide 'loans' not only in £ but in Euro's, Swiss Francs, Dollars and Yen.

    This sounds as though it is more significant, in the context of a collapse in the Euro currency. Presumably a stressed bank can swop it's dodgy Euro assets into other currencies which would remain liquid even if the Euro goes tits up. By the central banks agreeing to work together it means an US bank could go to any of the central banks and get any or all of the currencies it wants and dump its Euro's around the world.

    It seems that the central banks have agreed to underwrite the conversion of Euro's into other currencies.

    If I'm right I guess the exchange rate of the Euro will start to fall and may fall rapidly.

    Can someone, with more knowledge than me explain what's going on ?!!

    Many Thanks and Best Regards,



You are more than welcome to comment on the posts, but please try to stay on topic....I will publish all comments, excepting spam and bad language, and my moderation of the comments is just to exclude these.

Please allow up to two days for the comment to appear.

I have had a request for an email address for the site and have created the following:


I have ommitted the @ symbol to avoid spam....

For general purposes I would suggest using the comment form, but will occasionally look at this email account. Please be clear what is for publication and what is not, though I will also not guarantee publishing of email comments, unlike the comments through the form! Thanks.