thinking the unthinkable
might there be
no
way out or Britain?
project armageddon – the nal report
Dr Tim Morgan
Global Head of Research
Tullett Prebon Group Ltd
155 BishopsgateLondon EC2M 3TQ
Tel:
+44 (0)20 7200 7000
Fax:
+44 (0)20 7200 7176
www.tullettprebon.com
strategy insights|
issue seven
1
strategy insights|
issue seven
1
Public debt data as at the end o the 2010-11 fscal year
2
Debt ratio on the Maastricht Treaty defnition
The United Kingdom is mired indebt, and her economy is at-lining.Each side of the political divide has adifferent take on the best solutionsto these problems. The Coalitiongovernment believes that the hugescal decit must be eliminated.Its opponents argue that scaltightening will undermine theprospects for growth.Project Armageddon was establishedto examine the possibility that bothsides’warnings are correct but thatneither side’s prescriptions will work.We conclude that Britain’s debts areunsupportable without sustainedeconomic growth, and that theeconomy, as currently congured, isaligned against growth.Radical solutions are required if adebt disaster is to be averted. Allmacroeconomic options have beentried, and have failed. The onlyremaining options lie in the eld of supply-side reform. Unfortunately,public opinion may be inimical to thescale of reform that is required.
mired in debt
The general public are probablyunaware of the true scale of Britain’sdebts. Public debt, reported at 60% of GDP
1
, rises to 75% on the MaastrichtTreaty denition by which countriessuch as Greece, Ireland and Portugalare measured. Despite optimisticassumptions about growth, revenuesand the decit, the governmentconcedes that debt ratios are set torise further.Ofcial debt numbers exclude thenet present value of unfunded publicsector pension commitments andobligations under PFI contracts.Together, these total an estimated£1.35 trillion, lifting the total of public debt and quasi-debt to £2.46trillion (167% of GDP). In addition,the potential costs of nancial sectorinterventions total £1.34 trillion.The UK is a debt-saddled Europeanperipheral country, a fact which forexmarkets alone seem to have recognisedthus far.Private debts, too, are huge. Theborrowing binge of the last decadehas lifted outstanding mortgagedebt to £1.2 trillion, whilst unsecuredconsumer credit exceeds £210bn.These levels of debt are manageableif –
but only i
– the economy candeliver growth.
roads to nirvana?
The government is undoubtedly rightto assert that the UK must achievea drastic reduction in the pace atwhich the public debt is rising. Totest this assertion, we have projectedthe implications of continuing to runprimary decits at the 2009-10 level.Such an approach would drive thepublic debt ratio to 100%
2
by 2015 and150% by 2021. The latter number isirrelevant, because it is clear that, onany such debt trajectory, the UK wouldbe forced into some form of defaultlong before then.Recognising the imperative need toreduce the decit, the government hasset out a plan whereby modest real-terms spending cuts, and a big increasein revenues, will reduce the decit from11.1% of GDP in 2009-10 to 1.6%by 2015-16.The snag with this otherwise admirableplan is that it depends upon somepretty heroic economic assumptions,most notably the delivery of growth of 2.9% by 2012-13. At 2010-11 values,and after allowing for an expected£25bn increase in debt interest, thegovernment plan requires that the gapbetween revenue and expendituresbe narrowed by £159bn. Increases intax rates will contribute £31bn, andspending cuts a possible £44bn (solong as unemployment falls as thegovernment expects), but the bulk of the decit reduction is expected toresult from a growth-created £84bnincrease in tax revenues. If growth wereto come in at half of the ofcial target,interest costs and other spendingwould rise, tax revenues would fall veryfar short of expectations, and the planwould unravel.
executive summarythe fnal report o project armageddon
thinking the unthinkable
strategy insights|
issue seven
strategy insights|
issue seven
23
thinking the unthinkable
|
might there be
no
way out or Britain?
The decit reduction plan, thenis critically dependent upon therestoration of growth to pre-crisislevels. Is this actually likely to happen?
the economy – alignedagainst growth
Our analysis indicates that theBritish economy, as currently aligned,is incapable of delivering growth atanywhere near the levels required bythe decit reduction agenda.In the decade prior to the nancialcrisis, the UK economy became hugelydependent upon debt. Taking publicand private components together,debts have increased at an annualaverage rate of 11.2% of GDP since2003. The two big drivers of theeconomy have been private (mortgageand credit) borrowing, and huge(and debt-dependent) increases inpublic spending.Reecting the growth in debt-fundedactivities, three of the UK’s eightlargest industries (real estate, nancialservices and construction), whichaccount for 39% of the economy, areincapable of growth now that netprivate borrowing has evaporated.Another three of the top eightsectors (health, education, and publicadministration and defence) accountfor a further 19%, and cannot expandnow that growth in public spendingis a thing of the past. This means that58% of the economy is ex-growth, agure that could rise to 70% if,as seems probable, growth inretailing is precluded by fallingreal consumer incomes.
a very British mess
Together, the severity of Britain’sindebtedness and the challengingoutlook for the economy mean that theUK is now mired in a high-debt, low-growth trap. Minimising the inevitabledamage requires the clearest possibleunderstanding of how this situationcame about.Britain’s scal and economic problemsresult from grotesque mishandlingof the economy under the 1997-2010 Labour administration. GordonBrown’s reform of the nancialregulatory system, and his insistencethat the Bank of England determinemonetary policy on the basis of retailination alone, resulted in a recklessescalation in mortgage lending.The ensuing property price boomspurred unsustainable growth in aplethora of housing-related sectors,and underwrote a rapid expansionin consumer borrowing. Believingthat this bubble was real growth,Brown spent up to, and beyond, theapparent expansion in the tax basethat had resulted from the property-driven boom. Real public spendingincreased by 53% in a period in whichthe economy expanded by just 17%.As soon as the bubble burst, a chasmrapidly opened up between excessivespending and falling tax revenues.In addition to skewing the economytowards debt and public spending,Brown and his colleagues imposedever-increasing regulatory andscal burdens on business, andsimultaneously transferred resourcesfrom private industry into a publicsector whose productivity was subjectto continuous decline. This weakenedthe overall productivity of theBritish economy.Labour’s period in ofce wascharacterised not just by economicand scal mismanagement but alsoby the promotion of a culture of moralabsolutism centred around spuriousand selective concepts of ‘fairness’.This culture, and the accompanyingsense of individual and collectiveentitlement, is the biggest obstacle inthe way of effective economic reform.
damage limitation and theneed for supply-side reform
Courtesy of massive and unsustainablepublic borrowing, the British public hasbeen shielded thus far from the painof recession. This exercise in damage-limitation was necessarily-timelimited. What comes next is going tobe unpleasant.The widespread assumption that theright blend of macroeconomic policiesalone can overcome Britain’s economicand scal problems is fundamentallymistaken. Governments have tried lowinterest rates (which have been closeto zero for 28 months), devaluation,£390bn of scal stimulus and £200bnof quantitative easing, all to no effect.The so-called ‘plan b’, which couldbe better labelled ‘Brown lite’, is notworthy of serious consideration. In the years prior to the recession, Britainborrowed £2.18 for every £1 of growth.Continued high borrowing would benothing more than a pain-deferralexercise leading inevitably to a full-blown economic crisis.As Britain’s debt-driven economicmisalignment unravels, propertyprices can be expected to fall sharply,unemployment to remain high, sterlingto remain weak, and real incomes tocontinue to fall as ination continuesto out-pace earnings.An early objective for governmentshould be to put an end to the state of national denial over the true conditionof the economy, and to undercutthe delusory sense of individual andcollective ‘entitlement’that wasfostered in the Labour years. Britainhas no automatic entitlement to highliving standards or a welfare state.Rather, these benets have to beearned, not borrowed.With all macroeconomic optionsexhausted, the best way to restartgrowth would be to implement supply-side reforms designed to free small andmedium enterprises (SMEs) from theonerous burden of regulation whichblights their expansion.Such reforms, whilst imperative if afull-blown economic crisis is to beaverted, will be opposed by interestgroups, and will also cut across muchof the moral absolutism that waspromoted so successfully by Labour. Inmany instances, choices will have to bemade between economic efciency onthe one hand and spurious concepts of ‘fairness’on the other.The outstanding questions whereBritain’s economic future areconcerned lie less in the mechanicsof reform than in the ability of government to secure supportfor reforms which both challengepreconceived notions and offendvocal interest groups.The best way for government to offsetmaterial pain would be to promote a‘liberty agenda’which, whilst freeingup SMEs to invest and to grow, wouldalso begin to liberate the public fromthe results of Labour’s predilection forsurveillance and coercion.At present, we see very little sign thatthe Coalition government is preparedto promote economic growth andindividual liberty by tackling Labour’snotions of morality, fairness andentitlement.
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