Britain’s debt time bomb is still ticking

Published in Business Spectator (Melbourne), 31 March 2011

It must have been a seminal event judging by the coverage it received in British newspapers. The tabloid The Sun dedicated seven pages to it. The Daily Telegraph provided 16 pages of reports and commentary, The Guardian 23 pages and The Financial Times, not to be outdone, a full 26 pages.

Few occasions would ever justify such journalistic lengths. So had Her Majesty abdicated? Were Martians about to invade Scotland? Had the English soccer team finally won a penalty shoot-out against Germany?

In fact, none of the above. All that had happened was the presentation of the 2011 UK budget to the House of Commons by the Chancellor of the Exchequer, George Osborne. And despite the media excitement around it, it was a dull budget in difficult times.

Perhaps the occasion was so sober because Osborne chose water as his drink despite parliamentary tradition allowing the Chancellor an alcoholic drink on budget day. Osborne’s motto for his fiscal plans was equally bland: “A budget for growth.” As if any chancellor had ever presented policies intended to manage decline.

Britain’s economic problems are well known. After a massive expansion of government spending in the Blair and Brown years, the financial crisis revealed the unsustainable business model of UK plc. Built on private and public debt, fuelled by rising house prices, buoyed by strong inward migration and increasingly dependent on financial services, the UK economy had become severely unbalanced. And in the budget there was a gaping hole of around 10 per cent of GDP.

The Conservative-Liberal Democrat coalition, which was formed after last May’s election, set out to correct this situation. Their plan, as announced in last year’s budget and the government’s Comprehensive Spending Review, was to balance the books over the course of the parliament. By 2015, the UK would have cut its deficit to zero, according to Osborne’s plans.

The Chancellor had previously emphasised the need for ‘austerity’. In last week’s budget speech of more than 8,000 words, the ‘a-word’ remained strangely absent however. One reason could be that it was meant to be a ‘fiscally neutral’ budget, which does not alter the balance between revenue and spending. But a more cynical analysis would conclude that there had never been much austerity in Osborne’s plans anyway.

Although anti-government protesters expressed their dismay about perceived ‘savage cuts’ at violent rallies over the weekend, the budget figures do not justify such anger. The UK government will spend £694.4 billion in the current financial year but £763.8 billion in 2015/16. That is a nominal increase of 10 per cent over five years. Of course, in real terms – particularly at rising prices – this will amount to modest cuts. However, it hardly qualifies as fiscal ruthlessness.

The UK budget made some headlines this year because of its revised growth forecast. Only last November, the government had predicted GDP growth of 2.1 percent for this year, which has now been reduced to 1.7 per cent. For the coming years, Osborne’s forecasters nevertheless remain optimistic. For the years from 2012 to 2015 they base their budget figures on a ‘steady as she goes’ scenario with growth rates ranging from 2.5 to 2.9 per cent.

This may soon turn out to be too optimistic if Britain does not manage to quickly get its inflation under control. The official inflation measure, the Consumer Price Index, stood at 4.4 percent in February. The Retail Price Index was even higher at 5.5 per cent. Britain’s alarming inflation figures will make it harder for the government to reach its deficit, growth and spending targets as outlined in Osborne’s budget.

Though the government may wish to blame most of the spike on external factors such as the Arabian uprising, it is hard to deny that the Bank of England’s loose monetary policy has played a role in price hikes. Since March 2009, the bank’s base rate has been at just half a per cent – a historic low. In addition, the Bank of England provided a total of £200 billion in quantitative easing. This policy may have stabilised the economy for a while. Yet it came at the price of rising inflation, and this creates a potential time-bomb for the Chancellor.

The yield for 10-year gilts stands at only 3.6 per cent – and thus substantially below the inflation rate. The spread between British gilts and German bunds has more than halved over the past year and now hovers around 30 basis points. Both statistics indicate that markets are still trusting the British government to solve the fiscal crisis. But for how much longer? And what would happen if markets became as nervous about the UK as they are about Ireland or Portugal?

Even under the government’s own forecasts, which may well err on the side of optimism, the UK would spend £66.8 billion on debt interest by 2015, equivalent to 8.7 per cent of expenditure. However, this would only work under the crucial assumption that by 2012 CPI inflation can be reduced to 2.2 per cent and then continues at 2.0 per cent until 2015. This is not impossible but it does not look very likely either.

All in all, Osborne’s budget tries to suggest that the UK economy has left the rocky road of the financial crisis behind and that a return moderate growth and low inflation is imminent. With all due respect, such goldilocks scenarios are reminiscent of Gordon Brown’s heydays when the figures were shaken long enough until the future looked rosy. In the end, it didn’t work out for Brown, who was regularly overtaken by reality, so why should it for Osborne?

Osborne has presented a budget containing some typical ‘rob Peter to pay Paul’ gimmicks, such as a cut of fuel duty funded by extra tax on oil companies. What it lacks, though, is an answer to the question when and how Britain will substantially lower its government spending.

That the budget does not leave room for manoeuvre is not an excuse for inaction. That is because under the projected debt trajectory Osborne’s successors will have even less leeway. In four years’ time, Britain’s debt interest will already exceed the combined government spending for defence, justice, domestic security, transport, energy, environment, work and pensions, climate change, culture, media and sport. If Osborne cannot bring himself to cutting spending now, future chancellors will have an even tougher job balancing the books.

Despite the enormous coverage the UK budget received in the British press, the main story was missing. A credible plan to cut spending and prevent excessive debt interest payments is nowhere in sight.

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