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Tim morgan report_007
Tim morgan report_007
Tim morgan report_007
Tim morgan report_007
Tim morgan report_007
Tim morgan report_007
Tim morgan report_007
Tim morgan report_007
Tim morgan report_007
Tim morgan report_007
Tim morgan report_007
Tim morgan report_007
Tim morgan report_007
Tim morgan report_007
Tim morgan report_007
Tim morgan report_007
Tim morgan report_007
Tim morgan report_007
Tim morgan report_007
Tim morgan report_007
Tim morgan report_007
Tim morgan report_007
Tim morgan report_007
Tim morgan report_007
Tim morgan report_007
Tim morgan report_007
Tim morgan report_007
Tim morgan report_007
Tim morgan report_007
Tim morgan report_007
Tim morgan report_007
Tim morgan report_007
Tim morgan report_007
Tim morgan report_007
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Tim morgan report_007

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  • 1. thinking the unthinkable might there be no way out for Britain?Tullett Prebon Group Ltd155 Bishopsgate project armageddon – the final reportLondon EC2M 3TQTel: +44 (0)20 7200 7000 Dr Tim Morgan Global Head of ResearchFax: +44 (0)20 7200 7176www.tullettprebon.com strategy insights | issue seven
  • 2. the final report of project armageddonthinking the unthinkableexecutive summaryThe United Kingdom is mired in assumptions about growth, revenues Such an approach would drive thedebt, and her economy is flat-lining. and the deficit, the government public debt ratio to 100%2 by 2015 andEach side of the political divide has a concedes that debt ratios are set to 150% by 2021. The latter number isdifferent take on the best solutions rise further. irrelevant, because it is clear that, onto these problems. The Coalition any such debt trajectory, the UK wouldgovernment believes that the huge Official debt numbers exclude the be forced into some form of defaultfiscal deficit must be eliminated. net present value of unfunded public long before then.Its opponents argue that fiscal sector pension commitments andtightening will undermine the obligations under PFI contracts. Recognising the imperative need toprospects for growth. Together, these total an estimated reduce the deficit, the government has £1.35 trillion, lifting the total of set out a plan whereby modest real-Project Armageddon was established public debt and quasi-debt to £2.46 terms spending cuts, and a big increaseto examine the possibility that both trillion (167% of GDP). In addition, in revenues, will reduce the deficit fromsides’ warnings are correct but that the potential costs of financial sector 11.1% of GDP in 2009-10 to 1.6%neither side’s prescriptions will work. interventions total £1.34 trillion. by 2015-16.We conclude that Britain’s debts are The UK is a debt-saddled Europeanunsupportable without sustained peripheral country, a fact which forex The snag with this otherwise admirableeconomic growth, and that the markets alone seem to have recognised plan is that it depends upon someeconomy, as currently configured, is thus far. pretty heroic economic assumptions,aligned against growth. most notably the delivery of growth of Private debts, too, are huge. The 2.9% by 2012-13. At 2010-11 values,Radical solutions are required if a borrowing binge of the last decade and after allowing for an expecteddebt disaster is to be averted. All has lifted outstanding mortgage £25bn increase in debt interest, themacroeconomic options have been debt to £1.2 trillion, whilst unsecured government plan requires that the gaptried, and have failed. The only consumer credit exceeds £210bn. between revenue and expendituresremaining options lie in the field of be narrowed by £159bn. Increases insupply-side reform. Unfortunately, These levels of debt are manageable tax rates will contribute £31bn, andpublic opinion may be inimical to the if – but only if – the economy can spending cuts a possible £44bn (soscale of reform that is required. deliver growth. long as unemployment falls as the government expects), but the bulk ofmired in debt roads to nirvana? the deficit reduction is expected toThe general public are probably The government is undoubtedly right result from a growth-created £84bnunaware of the true scale of Britain’s to assert that the UK must achieve increase in tax revenues. If growth weredebts. Public debt, reported at 60% of a drastic reduction in the pace at to come in at half of the official target,GDP1, rises to 75% on the Maastricht which the public debt is rising. To interest costs and other spendingTreaty definition by which countries test this assertion, we have projected would rise, tax revenues would fall verysuch as Greece, Ireland and Portugal the implications of continuing to run far short of expectations, and the planare measured. Despite optimistic primary deficits at the 2009-10 level. would unravel.1 Public debt data as at the end of the 2010-11 fiscal year2 Debt ratio on the Maastricht Treaty definition strategy insights | issue seven 1
  • 3. thinking the unthinkable | might there be no way out for Britain?The deficit reduction plan, then as seems probable, growth in In addition to skewing the economy to zero for 28 months), devaluation, medium enterprises (SMEs) from theis critically dependent upon the retailing is precluded by falling towards debt and public spending, £390bn of fiscal stimulus and £200bn onerous burden of regulation whichrestoration of growth to pre-crisis real consumer incomes. Brown and his colleagues imposed of quantitative easing, all to no effect. blights their expansion.levels. Is this actually likely to happen? ever-increasing regulatory and a very British mess fiscal burdens on business, and The so-called ‘plan b’, which could Such reforms, whilst imperative if athe economy – aligned Together, the severity of Britain’s simultaneously transferred resources be better labelled ‘Brown lite’, is not full-blown economic crisis is to beagainst growth indebtedness and the challenging from private industry into a public worthy of serious consideration. In the averted, will be opposed by interestOur analysis indicates that the outlook for the economy mean that the sector whose productivity was subject years prior to the recession, Britain groups, and will also cut across muchBritish economy, as currently aligned, UK is now mired in a high-debt, low- to continuous decline. This weakened borrowed £2.18 for every £1 of growth. of the moral absolutism that wasis incapable of delivering growth at growth trap. Minimising the inevitable the overall productivity of the Continued high borrowing would be promoted so successfully by Labour. Inanywhere near the levels required by damage requires the clearest possible British economy. nothing more than a pain-deferral many instances, choices will have to bethe deficit reduction agenda. understanding of how this situation exercise leading inevitably to a full- made between economic efficiency on came about. Labour’s period in office was blown economic crisis. the one hand and spurious concepts ofIn the decade prior to the financial characterised not just by economic ‘fairness’ on the other.crisis, the UK economy became hugely Britain’s fiscal and economic problems and fiscal mismanagement but also As Britain’s debt-driven economicdependent upon debt. Taking public result from grotesque mishandling by the promotion of a culture of moral misalignment unravels, property The outstanding questions whereand private components together, of the economy under the 1997- absolutism centred around spurious prices can be expected to fall sharply, Britain’s economic future aredebts have increased at an annual 2010 Labour administration. Gordon and selective concepts of ‘fairness’. unemployment to remain high, sterling concerned lie less in the mechanicsaverage rate of 11.2% of GDP since Brown’s reform of the financial This culture, and the accompanying to remain weak, and real incomes to of reform than in the ability of2003. The two big drivers of the regulatory system, and his insistence sense of individual and collective continue to fall as inflation continues government to secure supporteconomy have been private (mortgage that the Bank of England determine entitlement, is the biggest obstacle in to out-pace earnings. for reforms which both challengeand credit) borrowing, and huge monetary policy on the basis of retail the way of effective economic reform. preconceived notions and offend An early objective for government vocal interest groups.(and debt-dependent) increases in inflation alone, resulted in a reckless damage limitation and the should be to put an end to the state ofpublic spending. escalation in mortgage lending. need for supply-side reform national denial over the true condition The best way for government to offset The ensuing property price boomReflecting the growth in debt-funded of the economy, and to undercut material pain would be to promote a spurred unsustainable growth in a Courtesy of massive and unsustainableactivities, three of the UK’s eight the delusory sense of individual and ‘liberty agenda’ which, whilst freeing plethora of housing-related sectors, public borrowing, the British public haslargest industries (real estate, financial collective ‘entitlement’ that was up SMEs to invest and to grow, would and underwrote a rapid expansion been shielded thus far from the painservices and construction), which fostered in the Labour years. Britain also begin to liberate the public from in consumer borrowing. Believing of recession. This exercise in damage-account for 39% of the economy, are has no automatic entitlement to high the results of Labour’s predilection for that this bubble was real growth, limitation was necessarily-timeincapable of growth now that net living standards or a welfare state. surveillance and coercion. Brown spent up to, and beyond, the limited. What comes next is going toprivate borrowing has evaporated. Rather, these benefits have to be apparent expansion in the tax base be unpleasant. At present, we see very little sign thatAnother three of the top eight earned, not borrowed. that had resulted from the property- the Coalition government is preparedsectors (health, education, and public driven boom. Real public spending The widespread assumption that the With all macroeconomic options to promote economic growth andadministration and defence) account increased by 53% in a period in which right blend of macroeconomic policies exhausted, the best way to restart individual liberty by tackling Labour’sfor a further 19%, and cannot expand the economy expanded by just 17%. alone can overcome Britain’s economic growth would be to implement supply- notions of morality, fairness andnow that growth in public spending As soon as the bubble burst, a chasm and fiscal problems is fundamentally side reforms designed to free small and entitlement.is a thing of the past. This means that rapidly opened up between excessive mistaken. Governments have tried low58% of the economy is ex-growth, a spending and falling tax revenues. interest rates (which have been closefigure that could rise to 70% if,2 strategy insights | issue seven strategy insights | issue seven 3
  • 4. thinking the unthinkable might there be no way out for Britain? contents executive summary 1 introduction: is this the end of the road? 7 part one: the scale of the problem: mired in debt 11 much worse than it looks 11 is bankruptcy possible? 13 part two: case studies: roads to nirvana? 17 let rip – route one to disaster 17 forget ‘plan b’ 18 showing resolve – the government plan 20 the achilles’ heel – dependency on growth 21 part three: the economic outlook – aligned against growth 27 a borrowed boom – the impact of debt addiction 29 the undermining nexus – high borrowing, low growth 31 the nature of addictive borrowing 31 what happens next? 35 part four: a very British mess – the delivery of failure 39 laying the foundations for failure 40 spend, spend, spend 41 declining productivity 44 the high price of moral absolutism 46 the gravest problem – the concept of entitlement 46 the distorted economy 48 nemesis – the squeezed middle 50 part five: the search for pain mitigation – no way out? 53 meanwhile, back in the real world… 55 limiting the pain, building the foundations for recovery 57 as others see us 58 fixing the obvious 59 the high value of low-cost reforms 62 do we want economic viability? 63 needed – a liberty agenda 644 strategy insights | issue seven strategy insights | issue seven 5
  • 5. introduction is this the end of the road? Earlier this year, when we began our Britain is truly mired in debt then. But research for ‘Project Armageddon’, the absolute scale of debt is far less the working title certainly wasn’t important than the ability to service it. intended for publication. The initial The United Kingdom’s debt mountain proposition was that, whilst the is manageable if – and only if – strong Coalition government was right about economic growth is to be anticipated. the imperative need to reduce the United Kingdom’s frightening fiscal The discovery which stripped any deficit, its opponents, too, might be remaining hyperbole from the right about the impact that fiscal ‘Armageddon’ title was our realisation tightening could have on growth. We that, far from delivering strong growth, expected to discover that Britain was in the UK economy is likely to do little for a protracted period of low (1.5-2%) better than mark time. Though we growth, and that the road to fiscal believe that we may have been the sustainability might, therefore, prove first to have spotted it, the logic behind to be a long and hard one. the implausibility of strong growth is pretty simple, and rests upon two Early research conformed to this calculations. picture, revealing that the debt numbers for the UK are frighteningly First we discovered, by combining larger than are generally realised. Public public and private borrowings, that sector debt, reported at £900bn, or the UK has, since 2003, borrowed an 60% of GDP at end-March, rises to £1.1 annual average of 11.2% of GDP. When trillion (75%) on the Maastricht Treaty the Labour administration ramped basis on which countries like Greece the fiscal deficit from 2.4% of GDP in and Ireland are assessed. The reported 2007-08 to 11.2% in 2009-10, all that number excludes the potential costs government was really doing was of the financial interventions (£1.3 replacing private borrowings, which trillion), and also excludes two big had dried up overnight. ‘quasi-debt’ obligations, which are the Second, sector-level analysis of commitments to pay public sector economic output reveals that pensions (about £1.18 trillion) and the commanding heights of the payments due under PFI obligations British economy are almost entirely (perhaps £170bn). Excluding the dependent upon private borrowing potential costs of financial intervention, and public spending, the latter also we estimate the true scale of British debt-dependent in that the massive public debt and quasi-debt at £2.46 ramp-up in government spending after trillion, or 167% of GDP. Outstanding 2000 was predicated on a tax base that private sector debt includes £1.2 trillion never really existed. of mortgage obligations and £210bn of consumer credit.6 strategy insights | issue seven strategy insights | issue seven 7
  • 6. thinking the unthinkable | might there be no way out for Britain? This report is concerned with past delivered by the economy as currently Logical though this is, we fear that The ex-growth lock-down – the commanding heights of the UK economy* events and trends only in so far as they configured. The opposition’s calls for such reforms could be blocked by Sector £bn %** Key factors reveal how Britain got itself into the a ‘plan b’ based on a more gradual vested interests and by the ‘must- 1 Real estate £299 23.8% Mortgage issuance has collapsed crippled periphery and may thereby approach to deficit reduction amount have’ entitlement culture built up suggest the possible outlines of a to nothing more than a recipe for on a foundation of spurious moral 4 Finance £126 10.0% Significantly linked to borrowing absolutism. reform agenda designed to minimise more denial and an accelerated lurch 5 Health £94 7.5% Public sector – spending flat the forthcoming pain and avert a debt into crisis. disaster. The conduct of the economy Is there a sufficient sense of realism 6 Education £77 6.1% Public sector – spending down The reality is that the cupboard is left in the body politic? If there is, a under ‘Team Brown’ was a tale of 7 Construction £73 5.8% Mortgage collapse, spending cuts grotesque incompetence which began bare where macroeconomic policy is return to viability might be possible in hubris and ended in blame-shifting. concerned. Massive stimulus, totalling even at this late stage. 8 Public administration and defence £65 5.2% Public sector – spending down Just as pertinently, where the future £590bn and equivalent to 40% of GDP, £733 58.4% has been tried, and has failed to deliver But if, as we strongly suspect, there is outlook is concerned, New Labour any growth at all. Interest rates are not, then this may be the end of the 2 Retail £140 11.2% Declining consumer incomes peddled a spurious moral absolutism already at rock-bottom. Fiscal stimulus road, and there really may be no way and created an almost surreal sense of £873 69.6% looks impossible with Britain boxed in out for Britain. individual and collective entitlement, and it is this blend of moralism and to a high-debt, low-growth trap. Source: * Tullett Prebon UK Economic & Fiscal Database Public sector ** Shares of the economy by GVA, 2009 Private sector entitlement which is the largest If an escape route does exist at single stumbling-block on any road to this very late stage, it lies not inThree of the eight largest sectors of the Now that private borrowing has A combination of high debt and low economic viability. macroeconomic strategy but in supply-economy – real estate, construction evaporated and the age of reckless growth means that the UK is a fully- Both the government and its side reform. Businesses in the UK areand financial services – have enjoyed expansion in public spending is over, fledged member of Europe’s debt- opponents seem to believe that the crippled by government interferencehuge growth fuelled overwhelmingly these sectors, accounting for 58% of shackled periphery, and this puts a Dr Tim Morgan delivery of recovery requires nothing and by the excessive demands ofby private borrowings. These three the economy, are poised to shrink, not wholly new complexion on the outlook Global Head of Research more than the selection of the right the state machine. The only way tosectors alone account for 39% of grow. Declining disposable incomes for what is still one of the world’s Tullett Prebon plc blend of macroeconomic policies. deliver growth would be to unshackleeconomic output. Another three of suggest that retailing, which accounts largest economies. Unless growth is This report seeks to demonstrate enterprise and transfer resources to July 2011the ‘big eight’ sectors (accounting for for a further 11% of output, may also restored briskly (which we regard as that no such magic formula exists. the private sector, a process whicha further 19%) are health, education, be poised to contract. All told, then, highly implausible), it can be only a The Coalition’s deficit reduction plan, would require reductions in publicand public administration and defence, the UK is in an ‘ex-growth lockdown’, matter of time before the markets and though laudable in its intent, is set spending which go much further thaneach of which has grown as public with as much as 70% of the economy the rating agencies start to put serious to fail because it is predicated upon anything thus far contemplated byspending has ballooned. incapable of growth and very probably upwards pressure on British debt levels of growth which cannot be the government. poised to shrink. yields. When that happens, sterling will be very much at risk.8 strategy insights | issue seven strategy insights | issue seven 9
  • 7. thinking the unthinkable | might there be no way out for Britain? part one: the scale of the problem mired in debt much worse than it looks economies such as Greece, Portugal and Ireland, it would be folly to assume • The real level of British indebtedness At different times, American is widely misunderstood. The 75% investment gurus Jim Rogers and Bill that this immunity can continue. reported public debt ratio excludes Gross have both expressed ultra- At first sight, fears such as those quasi-debt obligations which lift bearish views on the prospects for articulated by Rogers and Gross the total to 167%, and even this Britain, the former opining that the UK can seem melodramatically over- number excludes huge potential is “finished” and the latter commenting blown, since official public debt is a commitments created by financial that British public finances (and, by significantly smaller fraction of GDP interventions. Together, mortgage extension, sterling) rest on “a bed in Britain than in known basket-cases and consumer debt total a further of nitro-glycerine”. Allowing for the such as Greece and Ireland. According 97% of GDP. hyperbole in both statements, the to official figures, UK government debt reality is that the UK is indeed mired currently stands at £900bn, equivalent • These levels of debt are sustainable in debt, even though the true extent if, and only if, the deficit is brought to 60% of GDP. Government projections of British indebtedness is sometimes under control and strong economic (which assume that the deficit will less than obvious in published data. growth is achieved. A failure to be reduced from 9.7% of GDP last Though the hidden nature of much of deliver both of these objectives year to 1.6% by 2015-16) show the the British debt mountain has helped could result in a debt disaster. nominal level of debt continuing to prevent markets from bracketing the rise (reaching £1.28 trillion by 2016), UK with other European peripheral Fig. 1: Debt and estimated quasi-debt* Fig. 2: Evolution of public debt* £ trillion As % GDP £4 Interventions 200% PFI 2011, 167% PS pensions PS pensions PFI Treaty debt Public debt** Reported debt £3 150% 2006, 103% £2 100% £1 50% £0 0% Debt GDP 06 07 08 09 10 11 12 13 14 15 16 Sources: * Official data and Tullett Prebon estimates *Source: Official data and Tullett Prebon estimates. Excludes effects of financial sector interventions ** Debt on Treaty basis10 strategy insights | issue seven strategy insights | issue seven 11
  • 8. thinking the unthinkable | might there be no way out for Britain?though both inflation-adjusted debt The reality, moreover, is that published out of the contributions of current debt and quasi-debt stands at about of £390bn were incurred in the space which has recently reached new highs.and the debt/GDP ratio should top out numbers very materially understate workers with the Treasury making up £5 trillion (340% of GDP), and even this of three financial years, pushing the The trade deficit exacerbates thein 2013 at £1.1 trillion, or 70% of GDP. true indebtedness (fig. 1). For a start, any annual difference. The current understates the true scale of national reported debt ratio up from 37% to problem of servicing Britain’s hugeFor the foreseeable future, then, British public debt on the stricter Maastricht unfunded public sector pension indebtedness because it excludes 60% of GDP. external debts.public debt is expected officially to Treaty definition (on which the debts obligation stands at about £1,180bn, the very substantial corporate debtremain at historically high levels, but of Eurozone members such as Greece to which can be added perhaps £170bn incurred in the era of easy money, The third, equally-critical point is Britain’s greatest asset, in terms ofto stay well short of the 100% barrier and Ireland are judged) is already £1.11 of outstanding commitments under PFI ‘private equity’ and leveraged buy-outs. that national solvency is dependent earning the foreign exchange withat which, at least in theory, some trillion, or 75% of GDP. And, according (private finance initiative) contracts. upon generating sufficient economic which to pay for imports of food,form of bankruptcy begins to look to the ONS, debt including the effects Equally worryingly, UK external debt, output and government revenue to energy and other essential goods anda distinct possibility. of financial sector interventions now All told, then, we estimate total at 400% of GDP, is far higher than that service what are, by any standards, services, is the City of London, but stands at £2.24 trillion (147% of GDP). public debt and quasi-debt at of countries such as Portugal, Greece or uncomfortable levels of government the political climate for the sector isEven if the published debt figures were £3.6 trillion3, equivalent to 244% Spain (fig. 3), and equates to $143,000 and wider national debt. adverse. Bankers have been blamed fora realistic representation of public Nor is this all. The increase in the of GDP or more than £135,000 for for each man, woman and child in the financial crisis (for which the realsector indebtedness (which they are public sector wage bill over the last every British household. This, of Britain (fig. 4), again far higher than in For reasons which will be explored culprits were the policymakers whonot), alarm bells should be ringing at decade has caused a rapid escalation course, excludes private debts such most other developed countries. later, we very much doubt whether the crippled regulatory oversight), andthe sheer pace at which this debt has in unfunded pension obligations. The as mortgages (£1.2 trillion) or the real possibility of national bankruptcy criticised because they earn too muchbeen accumulating – 43% (£390bn) of British system of providing pensions consumer debt that escalated under Is bankruptcy possible? has yet entered the collective psyche. (which, as we have remarked before,all outstanding public debt has been for government employees has always the easy money conditions of the Even at the levels revealed here, debts But, and as we shall also see, the era is about as rational as supporters oftaken on in the space of just three been something of a Ponzi scheme, Labour years and currently stands at do not of themselves augur bankruptcy of comforting self-delusion is nearing a football club demanding the salefinancial years. the pensions of retirees being paid £210bn. Together, private and public or some form of default, because the its expiry date. Unless drastic action of their top goal-scorer because he absolute scale of a country’s debts is is taken – and, critically, unless a earns so much more than they do). The less important than the ability of the satisfactory level of economic growth emotional debate over banking tends economy to service these debts and to can be restored – markets are likely to to obscure the reality that for Britain Fig. 3: External debt to GDP* Fig. 4: External debt per capita* wake up to the reality that Britain has repay them when they fall due. to downsize its financial services more in common with Greece than industry would be about as rational as External debt as % GDP External debt per capita Even so, three things are already with Germany. And, when markets do Saudi Arabia downsizing oil, or Iceland 450% $160,000 abundantly clear. The first is reappraise Britain’s viability, a number downsizing fish. 398% $143,242 400% $140,000 that the UK economy and public of significant adverse factors are likely 350% finances have been managed with to be taken into account. As for selling assets, the state cupboard $120,000 300% staggering incompetence – for sheer is all but bare, and a huge swathe of $100,000 mismanagement, profligacy, and Britain’s external debt is a particularly private sector assets (such as water 250% $80,000 hubris, we know of no modern acute problem because of the UK’s suppliers, power generators and 200% persistent trade deficit, a problem $60,000 parallel for the trashing of the British airports) is already foreign-owned. 150% which has not been fixed by the sharp economy in the decade prior to the $40,000 100% financial crisis. devaluation of sterling. The cushion When considering the question of 50% $20,000 formerly provided by exports of North what is colloquially called ‘bankruptcy’, 0% $0 Second, it is equally clear that Sea oil and gas has long since gone, it is necessary to distinguish between UK POR FRA GRE ESP GER ITA AUS US CAN JP UK POR FRA GRE ESP GER ITA AUS US CAN JP government cannot go on adding to and energy imports are set to rise insolvency (when liabilities exceed its debt pile at anything remotely like further as domestic production tails assets) and illiquidity (when the the rate that has occurred in the period off. Britain is also heavily dependent borrower becomes unable to meet*Source: CIA World Factbook *Source: CIA World Factbook. Countries ranked by gross external debt as % GDP since 2008, when net new borrowings upon imports of food, the price of ongoing funding requirements, which 3 Treaty debt (£1106bn) + financial interventions (£1113bn) + pension obligations12 strategy insights | issue seven (£1180bn) + PFI commitments (£170bn) = £3,569bn strategy insights | issue seven 13
  • 9. thinking the unthinkable | might there be no way out for Britain? include interest payments and the British banks are able to operate in At present, these risks have been refusing to bear out this argument, the repayment of expired fixed-term debt). global markets because it is assumed averted, in no small part because of main outcome of devaluation thus far The concept of insolvency has little that they are viable, and it is further the change of government in May being a disquieting take-off in inflation. meaning in national terms, because assumed that government would bail 2010. There have, however, already most of any country’s asset base (such them out if it turned out that they been some disturbing signs, such Currency independence aside, the as its housing stock) is effectively were not. Businesses and citizens can as the creation in 2009 of £200bn single most significant difference unsalable, which means that assets undertake international transactions through quantitative easing (QE), the between Britain and these known are impossible to value. because international markets trust current euphemism for the printing basket-cases is the sheer scale of the sterling, which really means that of money. When QE was used, the public debt. The quantum of British National or government illiquidity, they trust the British government. Treasury vigorously denied that it was public debt dwarfs those of Ireland, however, is all too real a possibility Everything, then, hinges on belief. A monetising debt (which is forbidden Greece or Portugal. Many observers under certain conditions, and has in key assumption made by the current under the terms of the Maastricht believe that a Spanish debt crisis could the past impacted many countries government is that continuing with Treaty), but the use of virtually all of be a bridge too far for the bailout whose behaviour has been no more the debt trajectories of recent years the £200bn to purchase gilts from mechanisms, yet Spain’s public debt reckless, and whose governments have would put that belief into jeopardy. institutions which were bound to (of about £550bn) is very much smaller been no more inept, than those of the reinvest the proceeds in buying than that of Britain. UK over the last decade. The heralds of bankruptcy, though newly-issued gilts made the difference difficult to combat, are relatively easy Having established that bankruptcy between QE and debt monetisation When looking at the issue of illiquidity, to predict. First, we would anticipate is by no means inconceivable for a little more than technical fig-leaf. we need to bear in mind that national ratings downgrades if Britain fails country which has mired itself in debt Any repetition of QE could have economic viability is really an issue to deliver progress both on deficit whilst persistently living far beyond extremely serious repercussions in of credit, a matter of trust and belief. reduction and on economic growth its means, we need to look at some the bond markets. Currencies such as sterling are fiat within a timescale that may now have case studies of what might happen if money, which means that their shrunk to as little as twelve months. Perhaps the single most worrying the UK does, or does not, get its deficit value lies not in intrinsic worth or A second sign of impending illiquidity feature of the current situation is that under control. We start with the ‘route convertibility (into, say, gold), but in would be a ‘strike’ in both domestic persistent minimal growth may cause one’ journey to bankruptcy, which the faith that is placed in the ability and international debt markets, and a global market participants to gravitate would involve a policy of denial and an of the issuing government to meet third would be a further sharp fall in towards a new perspective in which unwillingness to stop piling up public its commitments. the value of sterling. Britain is seen not as a weaker version debt at the unsustainable levels of the of Germany but rather as a peripheral recent past. Much the same applies to national If this process were to occur, interest country in the mould of Greece, Ireland debt and, by extension, to private rates would climb rapidly (which would or Portugal. Thus far, Britain’s debt debt as well. The UK government is itself undercut economic performance yields have remained strong because it able to borrow from abroad because very severely), the cost of vital imports is assumed that the ability to devalue international lenders trust it to repay would soar, inflation would escalate can be used to promote economic what it has borrowed, and to do so and Britain could be subjected to a growth, but the facts are stubbornly in a currency whose value has not huge flight of capital. been ravaged by excessive inflation.14 strategy insights | issue seven strategy insights | issue seven 15
  • 10. thinking the unthinkable | might there be no way out for Britain? part two: case studies roads to nirvana? a 9.6% reduction which is equivalent Under this scenario, the total deficit • The Coalition government rightly to £134bn at current values. Before rises, because interest costs surge as believes that continuing to run deficits looking at how this might or might debt escalates (fig. 5). From 3% of GDP at anything remotely similar to recent not work, we need to consider the in 2010-11, interest absorbs 5% by levels would be a recipe for disaster. implications were Britain to go back 2014-15, 7% by 2018-19 and 10% by on this programme and, instead, to 2021-22. Needless to say, public debt • But the deficit reduction plan can only continue to run deficits at the reckless soars, rising from 75% of GDP today to work if the British economy achieves levels of recent years. 100% in 2014, 150% in 2020 and 200% very rapid real rates of growth. in 2025 (fig. 6). During 2009-10, the primary deficit let rip – route one to disaster (which excludes interest paid on public Long before the latter date, the Cognisant of the risks which would debt) was £125bn, or 8.9% of GDP. To government would have been forced be posed by any further escalation in evaluate the concept of sustaining into some form of default. On this public debt, the Coalition government growth by continuing to run large projection, by 2014-15 the DMO has laid out a programme of fiscal deficits, we have projected this primary (Debt Management Office) would be tightening which is designed to reduce deficit forwards. We further assume, trying to raise (at current values) a the budget deficit from 11.2% of perhaps somewhat generously, that net £250bn, of which £90bn would GDP in 2009-10 to 1.6% by 2015-16, growth conforms to the OBR forecasts. be required simply to pay interest on outstanding debt. Fig. 5: Recklessness – the deficit* Fig. 6: Recklessness – debt* Deficit as % GDP Debt as % GDP 45% 500% Interest 40% Primary deficit 35% 400% 30% 300% 25% 20% 200% 15% 10% 100% 5% 0% 0% 2006 2012 2018 2024 2030 2036 2006 2012 2018 2024 2030 2036 *Source: Tullett Prebon calculations *Source: Tullett Prebon calculations16 strategy insights | issue seven strategy insights | issue seven 17
  • 11. thinking the unthinkable | might there be no way out for Britain?Once debt begins to take off in this way, Various shifts and expedients deep negative equity. Britain’s publicthe borrower – in this instance, the would, no doubt, be employed in an debts are orders of magnitude largerBritish government – rapidly finds itself increasingly desperate attempt to keep than those Greece, Ireland or Portugal,being drawn into a vortex. Even without the fiscal ship afloat. The monetising which would in all probability make anincreases in interest rates, deficits and of debt through resumed QE would outside rescue impossible.total debt take off exponentially as a doubtless be tried, with an accelerationresult of the compounding effect of in inflation accepted as a necessary We have described here the implicationsaccumulated interest commitments. evil because it would destroy the real of sustained high primary deficits atThe reality is that this process would value of outstanding debt. The interest some length, but one word wouldbe exacerbated by rises in interest rates rates paid by government would suffice – catastrophe.which would inevitably be imposed by escalate, the pound would crash, and forget ‘plan b’the market as the vortex process gained so would property markets as soaringrecognition. As rates rose, the spending rates savaged affordability. A large Of course, the government’s opponentscapability of consumers would slump, proportion of Britain’s 11.4 million would argue, quite rightly, that theywhilst inflation would surge in response mortgage-payers would be reduced to would not for a moment suggestto a crumbling of sterling. penury by the resulting combination of prolonging a primary deficit of unaffordable monthly payments and anything like 8.9% of GDP. If the Fig. 7: Borrowing and growth – the impact of diminishing returns £bn at constant 2010-11 values £250 Debt change GDP change £200 £150 £100 £50 £0 97-98 98-99 99-00 00-01 01-02 02-03 03-04 04-05 05-06 06-07 07-08 08-09 09-10 10-11 -£50*Source: Tullett Prebon calculations18 strategy insights | issue seven strategy insights | issue seven 19
  • 12. thinking the unthinkable | might there be no way out for Britain?opposition were in office, we believe There is no point whatever in borrowing wholly unsustainable fiscal mess. This project has required us to assess fig. 8) and public debt falling rapidly issue of public spending, but we turnthat they would seek to reduce the £2.18 to create £1 of growth, which is Between 1999-2000 and 2009-10, the timescales that are a great deal longer thereafter. If this very rosy scenario next to critics’ accusations that thebudget deficit from the 9.6% recorded precisely what happened between Labour government had increased than those set out in official forecasts. were to eventuate, it is highly probable government’s fiscal policies are tiedin 2010-11 to perhaps 5% by 2015-16. 2001-02 and 2007-08. real-terms public spending by 53%, Where the official-basis outlook is that government would moderate to a growth scenario that, particularly from £440bn (at 2009-10 values) to concerned, we have assumed that the its plans to something closer to fiscal given the scale of retrenchment, is farThis, the so-called “plan b”, would The inability of the economy to respond £669bn. Once the financial crisis burst 2015-16 projections both for growth neutrality, gradually reducing taxes, too optimistic.not work, for three main reasons. to stimulus has been demonstrated in the ‘Brown bubble’, the result was a (2.8%) and for the nominal rate of and/or increasing spending, once theFirst, even the very modest real-terms spades since the onset of the banking deficit of £156bn (11% of GDP) and an expansion of GDP (5.6%) continue debt ratio started to decline (fig. 9). the achilles’ heel –spending reductions planned by the crisis in 2008. During 2008-09 and unsustainable surge in borrowings. throughout our forecast period. We dependency on growthgovernment have provoked hostile 2009-10, the Labour administration further assume that revenue remains Government argues that this Opponents of the government makeresponses based almost entirely on incurred deficits of £250bn and injected The Coalition plans to reduce the at the same (38.4%) proportion of GDP optimistic scenario more than justifies many different criticisms of thenaked self-interest, and a government a further £200bn through QE, but this deficit to 1.6% of GDP by 2015-16 projected for 2015-16, and that public a period of adjustment in which the budget tightening programme, butfollowing the opposition plan, having truly massive stimulus (equivalent to through a combination of significantly spending (other than interest expense) pain has, in any case, been exaggerated by far the most telling is that fiscalgiven way once, would be subjected to 32% of GDP) delivered extraordinarily higher tax revenues and slightly lower is held constant in real terms. by critics who are stretching credulity adjustment on the scale plannedsevere pressure from selfish interest modest returns in terms of growth. expenditures. With the exception of when they describe as ‘massive’ by the administration will undercutgroups. Second, a more gradual In the Coalition’s first year in power, a the planned job-destroying increase On this extrapolated basis, the fiscal planned real-terms spending growth because it will take far tooapproach to deficit reduction would further £140bn was borrowed, lifting in National Insurance contributions, deficit falls rapidly, with the budget reductions of just 3%. Later in this much demand out of the economy.create rises in interest costs over and the total stimulus to £590bn, but the the coalition has accepted Labour’s tax moving into surplus by 2017-18 (see report we look more closely at theabove those already anticipated, and economy is currently doing no more hikes and, in addition, has raised thethese costs would exert a crowding- than flat-lining. rate of VAT from 17.5% to 20%. Betweenout effect on other categories of public 2009-10 and 2015-16, taxation is showing resolve – the Fig. 8: Eliminating the deficit Fig. 9: Driving down debtspending. In any case, it is highly projected to rise from 36.8% to 38.9% ofprobable that a gradual reduction of government plan GDP, yielding an anticipated 22% real- Deficit as % GDP Debt as % GDPthe deficit to 5% simply would not be Given the potentially lethal terms increase in revenue.enough to head off ‘vortex risk’. characteristics of a ‘debt vortex’, the 15% 90% Budget extrapolated government’s decision to bear down Over the same period, total public 80% Budget moderated 10%Third, it is by no means certain that on deficits through big increases in spending is set to decline by 3% in real- 70%continuing with higher public spending terms, and to shrink from 48% of GDP 5% tax revenue and more modest cuts in 60%for longer would deliver the growth public expenditures obviously makes a to 40%. Nominal public debt (excluding 0% 50%that its advocates ritually claim. For financial interventions) will continue 2006 2012 2018 2024 2030 great deal of sense. The government is 40% -5%a start, a pattern which has emerged right in its analysis of the problem but to rise throughout the period, from Budget 30% Budgetsince 2001, and is discussed later in this wrong, we believe, in how it believes £1,000bn in 2010 to £1,530bn in 2016, -10% forecast forecast 20% periodreport, is for economic growth to fall that the numbers will actually pan out. but real-terms debt will be essentially period -15% 10%a long way short of increases in debt flat from 2012. Debt as a proportion(fig. 7). The debt data shown in fig. 7 The outlook, as presented by the of GDP will begin to fall very gradually -20% 0% 2006 2012 2018 2024 2030is a combination of private and public government, is for a period of painful after 2012, but will remain far higherborrowing but, as private borrowing has adjustment followed by much- in 2016 (80%) than in 2010 (71%), letnow dried up, government would have improved economic performance. alone 2008 (44%). *Source of charts: Tullett Prebon projections *Source of charts: Tullett Prebon projectionsto carry the entirety of any borrowing The Coalition administration argues,burden going forward. quite correctly, that it inherited a20 strategy insights | issue seven strategy insights | issue seven 21
  • 13. thinking the unthinkable | might there be no way out for Britain? Fig. 10: Contributions to planned deficit reduction £bn at constant 2010-11 values £250 £200 +£25 -£31 £160 -£84 £150 £100 -£44 £50 £26 £0 2009–10 Interest Tax rates Revenue growth Spending 2015–16 *Source: Tullett Prebon calculations It is certainly true that the £84bn) created by growth in the size To its lasting credit, the Coalition government’s fiscal calculations are of the economy and some declines government has created the hugely growth-dependent. In figure in ‘automatic stabiliser’ spending independent Office for Budget 10, we break out our estimates of resulting from lower unemployment Responsibility (OBR), so that contributions to the planned reduction and household benefits dependency. chancellors can no longer make in the budget deficit, expressed at the numbers add up by the simple constant 2010-11 values. Tellingly, the government plans to expedient of plucking the necessary increase the incidence of taxation by growth projections from the ether. In a The government’s plan is to reduce 1.9% of GDP (which is worth about report which accompanied the recent the real-terms deficit from £160bn £31bn) but expects revenues to Budget, the OBR set out its economic in 2009-10 to £26bn in 2015-16, increase by a total of £115bn at 2010- assumptions in considerable detail. a targeted reduction of £134bn 11 values, the balance of this increase which increases to £159bn when the being delivered by economic growth. Principally, the OBR expects real anticipated £25bn real-terms increase economic growth to reach 2.9% by in debt interest is taken into account. Since economic expansion is assumed 2012-13, with CPI inflation falling Our calculations suggest that the to deliver a majority of the resources back to the target rate of 2% over overwhelming bulk of this is expected for fiscal tightening, what levels of the same period. Supported by the to be delivered by growth. This growth are required, and how likely is assumed achievement of strong comprises revenue expansion (of it that these assumptions will be borne growth, unemployment is expected to out by events?22 strategy insights | issue seven strategy insights | issue seven 23
  • 14. thinking the unthinkable | might there be no way out for Britain?decline briskly, a factor which would higher in 2014-15 than in 2009-10, in 100% of GDP and, critically, would still be Fig. 11: Growth risk – the deficit Fig. 12: Growth risk – debtease the pressure on government comparison with the 16% assumed by increasing (fig.12), putting interest costswelfare spending. the government. on an upwards trajectory. Deficit as % GDP Debt as % GDPUnfortunately, these forecasts appear If this were to happen, the government’s Such a scenario poses a clear threat 14% 140% Budget Budgetto be extremely optimistic. We believe fiscal plans could indeed begin to unravel of ‘vortex risk’, which involves (a) Low growth Low growth 12% 120%(and explain in the next chapter of this in pretty much the manner that its borrowing to meet debt service costs,report) that the British economy simply opponents predict. Instead of expanding and/or (b) cutting other spending 10% 100%is not capable of growing at anything by a real-terms £115bn, tax revenues by more than is currently intended 8% 80%like the rates which are predicted by the would increase by only £50bn, putting in order to accommodate higher 6% 60%OBR and are critical to the government’s a £65bn hole in the deficit reduction interest payments within previously-deficit reduction calculus. objective. Higher-than-expected planned levels of expenditures. As debt 4% 40% spending on benefits could cost £11bn, escalates, the cost of borrowing canIn order to assess the deficit 2% 20% and higher interest expense could absorb be expected to rise, turning the debtimplications of lower growth, we an additional £13bn. Instead of reducing problem into a vortex. 0% 0%have assumed that annual rates of the deficit by £134bn, tightening of 2006 2011 2016 2006 2011 2016 2021growth are half of those projected by only £45bn would be achieved, leaving The government’s plan, then, dependsthe OBR. On this basis, trend growth is the deficit at over 8% of GDP (fig. 11). upon the delivery of robust growth. *Source: Tullett Prebon calculations1.4%, and real economic output is 8% Treaty debt would have risen to over Can this happen?24 strategy insights | issue seven strategy insights | issue seven 25
  • 15. thinking the unthinkable | might there be no way out for Britain? part three: the economic outlook aligned against growth The Coalition government and its What needs to be borne in mind from opponents differ on many issues, but the outset is that a return to satisfactory • Expectations for a return to strong growth ignore the fact that the they seem to agree over the general levels of growth is simply an assumption, British economy has become outlines of Britain’s parlous economic not a demonstrable fact. dependent upon private borrowing and fiscal condition. Conventional logic states that government deficits Assessment of purely public borrowing and public spending. Since 2003, only really took off in 2008-09, when seems to bear out the consensus annual additions to aggregate there was a very sharp downturn interpretation. During the period 1999- private and public debt have in economic output. The Coalition 2000 to 2007-08, when trend growth averaged 11.2% of GDP, whilst public and Labour disagree on why the was 2.8%, deficits averaged just 1.8% expenditures have escalated. downturn happened – was it domestic and only once exceeded 3%. Not until the economy deteriorated sharply • The combination of private mismanagement, or was Britain borrowing and public spending has battered by global events over which during 2008 did the deficit escalate. It skewed the economy to the point it had no control? – and they further looks like a classically Keynesian picture. where between 58% and 70% of disagree on the necessary pace and But this widely-accepted interpretation output is dependent on these inputs, scale of deficit reduction. But the is fundamentally flawed, because it both of which have now gone into general consensus seems to be that, leaves a critical component out of the reverse. This means that delivering whilst deficits at recent levels are equation. That component is private significant economic growth has unsustainable, a return of growth will in borrowing, shown in fig. 14 as secured become very difficult indeed. due course resolve Britain’s problems. Fig. 13: Keynesian? Deficits and growth, 1996-97 to 2009-10* As % GDP 12% Deficit 10% Growth 8% 6% 4% 2% 0% -2% 96-97 97-98 98-99 99-00 00-01 01-02 02-03 03-04 04-05 05-06 06-07 07-08 08-09 09-10 -4% -6% *Source: Tullett Prebon UK Economic & Fiscal Database26 strategy insights | issue seven strategy insights | issue seven 27
  • 16. thinking the unthinkable | might there be no way out for Britain? Even without the corporate domestic lending from international least 10% of GDP year after year, the Fig. 14: The bigger picture – government and private net borrowing since 1996* component, however, a key feature of wholesale markets, a process which not overwhelming bulk of which has been the British economy since 2003 has only contributed to a massive escalation sourced from overseas. Government As % GDP been the emergence of long-term in gross external debt (from £1.9 trillion debt escalation may have been a 16% dependency on borrowing at least 10% at the end of 1999 to £6.4 trillion by recent phenomenon, and one that the Credit 14% Mortgages of GDP, year after year. end-2008) but put the banking system Coalition is determined to eliminate, 11.2% 12% Government (deficit) into an immediate crisis when, in 2007, but national debt addiction has a longer Average 2003-10 Moreover, the overwhelming majority the supply of wholesale debt dried up history, and a much more worrying one. 10% Average 1996-2001 of this borrowing came from overseas, virtually overnight. 8% 4.9% because the domestic savings ratio The critical economic role played 6% collapsed under the double onslaught a borrowed boom – the economic by debt is reflected in divergences 4% of the pensions tax grab and interest impact of debt addiction between the performances of different 2% rates which remained far too low to What we have seen, then, is that the business sectors. By the 2007 high- provide any incentive to save rather UK has become debt-dependent over point of the ‘Brown bubble’, the 0% than to borrow. During the boom years, the last decade, with government and real-terms economic contribution of -2% 96-97 97-98 98-99 99-00 00-01 01-02 02-03 03-04 04-05 05-06 06-07 07-08 08-09 09-10 10-11 British banks customarily funded their individuals collectively borrowing at the financial services industry had -4%*Sources: Tullett Prebon UK Economic & Fiscal Database, Bank of England, ONS Fig. 15: A skewed boom – real output by industry, 2007 vs 2000* Changes in real GVA, 2007 vs 2000(mortgage) and unsecured (credit) What really happened in 2008, then, of GDP and, with the single exceptionborrowing by the public. was less a matter of intervention of the 2008-09 crisis year (7.8%), annual Financial services; +91% Health and social services; +34% per se but of government stepping borrowing never fell below 10.4%.When this private component is Construction; +47% in to sustain the aggregate level offactored in, a wholly new picture This dependency on borrowing would Education; +26% borrowing once mortgage and credit Real Estate; +31%emerges. Though government expansion collapsed. The expedient of be even more pronounced were it Public administration & defence; +23%borrowing did not escalate until 2008, replacing private with public borrowing possible to identify the purely domestic GDP; +19%aggregate (private and government) was always time-limited and has now component of escalating corporate Wholesale & retail; +14%borrowing was high throughout the reached end-point, but there has been indebtedness in the era of leverage and Transport & storage; +9%period beginning in 2002-03. During no recovery at all in private borrowing. private equity. The tax system favoured Electricity, gas & water; +15%the pre-crash years (2003-08), private debt capital over equity because Oil & gas; +6%borrowers added to their debts at an Taking government and private interest expense was (and remains) Agriculture, forestry & fishing; -16% Sectors in red are wholly or Manufacturing; -14% predominantly in the public sectorannual average rate of 9% of GDP. The components together, it becomes tax-deductible, whereas dividend Other mining & quarrying; -10%previously-abundant supply of private apparent that borrowing has become payments are not.lending was then cut off abruptly a way of life over the last decade. -40% -20% 0% +20% +40% +60% +80% +100% +120% +140%when the financial crisis hit, with net During 1996-2002, aggregate publicprivate borrowing falling from £114bn and private borrowing averaged 4.9% of *Source: Tullett Prebon UK Economic & Fiscal Database(8% of GDP) in 2007-08 to just £16bn GDP. Between 2003 and 2010, however,(1%) in 2008-09. aggregate borrowing averaged 11.2%28 strategy insights | issue seven strategy insights | issue seven 29
  • 17. thinking the unthinkable | might there be no way out for Britain? poses major problems given that the during 1996-2002 to 11.2% between If Britain’s economy had indeed Fig. 16: Disparate growth, 2000-09* government’s fiscal rebalancing plan 2003 and 2010), growth rates dropped become dependent upon annual is entirely dependant upon growth rather than improving. debt increments exceeding 10% of Real values indexed, 2000 = 100 reaching at least 2.8% in less than two GDP, why was there not at least some 50 years from now. The implication, which is that improvement in growth rates? The Construction, real estate & finance +42 Public sector borrowing-addicted Britain gained conundrum is one that asset managers Economy +28 If this doesn’t happen – and we are ever less growth from each successive call ‘returns on capital employed’ – All other industries 25 convinced that it can’t – the deficit increase in debt, is amply borne out by Great Britain plc has increased its +15 reduction plan will come apart at fig. 18, which shows a huge divergence capital (debt) base very markedly the seams. between real rates of growth in without generating any improvement 0 aggregate debt and in GDP. at all in income growth. Why? -5 the undermining nexus – high borrowing, low growth After 2000-01, and just as borrowing the nature of addictive borrowing In fig. 17, we revisit annual increments began to escalate, growth stagnated, To understand the conundrum posed 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 to government and private debt by showing no gains whatsoever over the by a growing capital (debt) base and superimposing real GDP growth rates preceding (1996-2001) period. Indeed, diminishing growth, we need to onto the chart. The disturbing feature trend growth was a lot lower during*Source: Tullett Prebon UK Economic & Fiscal Database. ‘Public sector’ = Education + Health + Public Administration & Defence distinguish between two types of debt. of this chart is that, just as incremental 2002-08 (2.6%) than it had been in the These are termed ‘self-liquidating’ and borrowing escalated (from 4.9% of GDP earlier period (3.5%). ‘non-self-liquidating’ debt.increased by 91% in just seven years, public spending sectors, from all other for 18.8% of the economy) are in thewhilst manufacturing output had industries, and indexes the real value public sector, and have been powereddeclined by 14%. Two other borrowing- of output between 2000 and 2009. by an era of spending growth which Fig. 17: Borrowing and growth #1 – opposite directions*related sectors, construction and real is well and truly over. Real estate andestate, increased their output by 47% Over that period, CREF output construction (29.6%) are leveraged toand 31% respectively. Tellingly, of the six increased by 42%, and the public sector net mortgage lending, which collapsed As % GDPfastest-growing sectors, the other three component by 28%, compared to a from £113bn in 2007-08 to just £3bn 15% 30%were all in the public sector – health 5% decline for other industries within last year. Financial services, though Credit Mortgages 25%(+34%), education (+26%), and public overall economic expansion of 15%. not wholly dependant on private 10% Governmentadministration and defence (+23%). As we explain later, we estimate that borrowing, are nevertheless linked to Growth (RH scale) 20% compound growth of 2.8% between private financial activity. Collectively, 5% 15%In practical terms, it is not possible 2000 and 2008 would have been this means that 58% of the economy isto draw a hard and fast distinction barely 1.4% in the absence of 0% 10% accounted for by sectors which are, atbetween ‘bubble’ and ‘non-bubble’ ‘Brown bubble’ borrowing. best, ex-growth. With real disposable 96-97 97-98 98-99 99-00 00-01 01-02 02-03 03-04 04-05 05-06 06-07 07-08 08-09 09-10 5%industries. But, in an endeavour to incomes declining, retailing – another -5%draw some very general ‘bubble’ More importantly when looking ahead, 0% 11% of output – will struggle evenand ‘non-bubble’ distinctions, fig. 16 six of the eight largest sectors of the -10% -5% to stand still, lifting the ‘ex-growth’strips out construction, real estate UK economy are dependant either proportion of the economy to 70%. Theand finance (‘CREF’), and the principal on private borrowing or on public mathematical implausibility of growth spending. Three of these (accounting *Sources: Tullett Prebon UK Economic & Fiscal Database, Bank of England, ONS30 strategy insights | issue seven strategy insights | issue seven 31
  • 18. thinking the unthinkable | might there be no way out for Britain?If the owner of a successful restaurant Government has been guilty of managed to delude themselvesborrows to invest in additional seating over-consumption, and very little otherwise. As average property pricesspace, the debt is self-liquidating has been invested in self-liquidating soared from £121,000 in 2002 tobecause it will be serviced and paid projects such the improvement of £197,000 in 2007 (a real terms increaseoff from the higher income that the the country’s road, rail, power or of almost 70%), escalating mortgageexpanded restaurant will generate4. telecommunications infrastructure. debt looked like an investment, and aBut borrowing to pay for a new But the biggest problems have been good one at that. But to believe thiscar or a foreign holiday is non-self- caused less by government than by was to overlook two critical points.liquidating, because it is a form of individual borrowers.consumption which does not leverage The first point that was generallythe borrower’s income. Though the The biggest single debt increment misunderstood was that propertyparallels are necessarily less than during the period between 2002 prices, whilst realisable on anexact, the sharp fall in Britain’s return and 2009 was mortgage borrowing, individual basis, are not realisableon capital reflects the fact that the which increased by £590bn between in the aggregate. Therefore, and asoverwhelming bulk of new borrowings those years. Many borrowers saw borrowers and lenders alike were tohave been non-self-liquidating. this as investment, a view which was discover, property prices, far from profoundly mistaken even though being an absolute, are an example of many policymakers and even bankers ‘notional value’. Fig. 18: Borrowing and growth #2 – a dangerous divergence* Growth rates as % of GDP 16% Debt growth Economic growth 12% 8% Decreasing return on incremental debt 4% 0% 96-97 97-98 98-99 99-00 00-01 01-02 02-03 03-04 04-05 05-06 06-07 07-08 08-09 09-10 10-11 -4%*Sources: Tullett Prebon UK Economic & Fiscal Database, Bank of England, ONS32 strategy insights | issue seven 4 We are indebted to Chris Martenson for this example of self-liquidating debt strategy insights | issue seven 33
  • 19. thinking the unthinkable | might there be no way out for Britain?The second reason why the escalation That the property market could not go The harsh reality is that the over- by equally reckless lenders. Now, and option. The critical issues, therefore, in 2009-10 to just 1.6% by 2015-16.in mortgages was not an investment on rising indefinitely was demonstrated whelming bulk of private borrowing although the public are not yet aware must be the probable outlook for Achieving this, of course, is criticallywas that a steadily diminishing in dramatic fashion when average during the Brown era was channelled of it, the bill for this era of unheeding borrowing, and the implications of that dependant on the assumption thatproportion of new issuance was prices fell by 19% between 2007 into immediate consumption. ‘Spending greed has turned up. outlook for the delivery of growth. tax revenues will be driven sharplyactually going into the purchase of (£197,000) and 2008 (£160,000). like there was no tomorrow’ showed upwards (by 22% in real terms) byhomes – by 2007, only 35% was being Despite this correction, property prices how the public had bought into the ‘easy To put it colloquially, many of the Annual borrowing averaged 11.6% of strong economic growth.used for this purpose, with the balance still look very exposed in terms of money’ mentality of the ‘Brown imported gadgets might already be in GDP between 2002-03 and 2007-08,going into buy-to-let (BTL) (26%) and earnings multiples, which remain far bubble’, but individuals can hardly be landfill, but the debt incurred to buy comprising mortgage borrowing of Private borrowing, which accountedequity release (39%)5. Whilst BTL above historic norms (fig. 19). criticised for this, since government them remains. 7.9%, credit of 1.0%, and government for 77% of the private and publicmight have looked like an investment, itself had done precisely the same deficits of 2.7%. To see what might aggregate during the boom years, With real disposable incomes falling, what happens next? happen to the economy going forward, has already collapsed. In 2007-08,the reality was that it was a low- or thing, increasing public spending bynegative-yield punt on property prices interest rates poised to rise and the more than 50%, in real terms, between As we have seen, a pattern has we need to look at where each of these net mortgage and credit borrowingcontinuing to rise ad infinitum. Equity spreads on mortgage lending far 1999-2000 and 2009-10. been established in which the borrowing levels may go in the future. totalled £114bn, but this crashed torelease, meanwhile, amounted to the higher now than they were before British economy has become hugely £16bn in the following year before the crisis, a bet on a property price The problems facing the UK today dependent upon borrowing, both The government has already set actually turning negative in 2010-11.direct leveraging of balance sheets recovery would require courage are the direct result of reckless private and public. But we have also out the trajectory of its own futureinto consumption. bordering on foolhardiness. consumption by individuals and established that borrowing at recent borrowing, determining that the government alike, the former funded levels is simply not a sustainable deficit will decline from 11.1% of GDP Fig. 19: Dysfunctional – property prices, 1996-2010* Fig. 20: The squeezed middle – how the price of essentials has outpaced incomes* 5.7x £210 6 Property prices** Gas £180 Earnings** 4.5x 5 Property +90% +131% Price/earnings multiple (RH scale) Electricity +69% £150 4 Council tax & rates +69% £120 3.2x Water +59% 3 Petrol price +41% £90 Food +36% 2 £60 Rent +30% Consumer durables -13% £30 1 CPI +23% £0 0 Wages (private sector) +40% 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 Wages (public sector) +46% £000s at constant 2010 values -20% 0% +20% +40% +60% +80% +100% +120% +140%Sources: * Tullett Prebon UK Economic & Fiscal Database, Lloyds Banking Group ** Halifax annual average property prices and earnings, converted to constant 2010 values *Sources: Tullett Prebon UK Economic & Fiscal Database and ONS. Compares 2010 with 200034 strategy insights | issue seven 5 Source: FSA strategy insights | issue seven 35
  • 20. thinking the unthinkable | might there be no way out for Britain?The likelihood of mortgage borrowing purchases) as real incomes decline. directly dependant either on private corner-stone of economic growth. But,increasing materially must be That this may well occur is implied borrowing or on public expenditures as we have also seen, Britain cannotrated at close to zero, at least until by the past rate at which the cost of – this outlook suggests that growth reduce its dependence on borrowingsproperty prices fall to a level at which necessities (such as utility bills and is likely to be very low indeed. This, in unless economic growth recovers. Inaffordability (which we regard as a fuel) has consistently out-paced both turn, implies that the government’s short, past dependence on substantialprice/earnings multiple of less than earnings and reported CPI (fig. 20). deficit reduction plan is unlikely levels of annual incremental borrowing3.5x) is restored. This would require to succeed, because it is critically has put Britain into a high-debt,prices to fall by a further 22% from A combined outlook for public and dependant on revenue expansion low-growth trap. Because growththeir 2010 average, which was itself private borrowing is set out in fig. 21, driven by strong economic growth. was feeble even when fuelled by the23% below the 2007 peak. which shows that borrowing is set to be continuous injection of debt-funded drastically lower over the coming five As we have seen in Part Two of this demand, the outlook, now that theUnsecured (credit) lending has already years than it was during the bubble. report, the UK cannot continue country’s borrowing capacity has beenturned negative, and is likely to remain to increase its public debt, so the maxed out, may be for extremely lowso unless consumers are sucked into Given that the UK economy is critically government cannot displace the economic growth.using credit to pay for necessities debt-dependant – with between five private borrowing which, prior to(rather than for discretionary and seven of the eight biggest sectors the financial crisis, had become the Before looking at what (if anything) might be done to get Britain out of its high-debt, low-growth trap, we need to understand how the country got itself Fig. 21: Running out of steam – the end of the debt-based economy* into this trap in the first place. As % GDP 20% Credit Mortgages 16% Deficit Average 1996-2001 Average 2003-10 11.2% Forecasts 12% Average 2011-16? 8% 4.9% 5.1% 4% 0% 96-97 98-99 00-01 02-03 04-05 06-07 08-09 10-11 12-13 14-15 -4%*Source: Tullett Prebon UK Economic & Fiscal Database36 strategy insights | issue seven strategy insights | issue seven 37
  • 21. thinking the unthinkable | might there be no way out for Britain? part four: a very British mess the delivery of failure and in particular ‘Team Brown’ at laws of cyclicality). With the laws of the Treasury, behaved with a blend economics conveniently abolished, • The responsibility for putting Britain into a high-debt, low-growth trap of recklessness, arrogance and Brown ramped up public spending lies firmly with the 1997-2010 incompetence for which we can find no by more than 50% in real terms, far Labour administration. ‘Team Brown’ parallel in modern British history. outpacing even the bubble growth of bungled the reform of the financial This, of course, need not translate into the period, let alone the much more regulatory system, mistook the a burden for the Labour party itself, modest growth in the tax base. ensuing property-driven bubble for so long as Ed Milliband and his colleagues disavow the Blair-Brown Together with this incompetence went real growth, irresponsibly ramped legacy completely. an almost messianic drive towards up public spending to unaffordable selective moral absolutism based levels, and throughout remained The indictment of the Blair-Brown on spurious concepts of ‘fairness’. blithely ignorant of its mistakes. government is comprehensive This moral fervour brought with it and, in sum, utterly damning. The ever greater arrogance in the upper • By pursuing policies based on selective moral absolutism and administration’s appalling conduct of echelons of the public sector, and spurious notions of ‘fairness’, foreign and defence policy lies outside also helped to create a dangerously the Labour government created the scope of this report, though the delusional belief in individual and a psychology of individual and party’s supporters were entitled to collective entitlement. collective entitlement which is the wonder why a Labour administration was tagging along with the overseas The real tragedy at the heart of biggest single obstacle on the route adventures of the most right-wing Labour’s disastrous conduct of the to economic viability. administration in modern British economy was that Brown and This report has been compiled from American history. his Treasury team remained in denial a pragmatic and politically-neutral even after the myth of their economic standpoint. We agree with the view of At home, Team Brown undertook a genius had exploded. Perhaps the Coalition government that deficit disastrously bungled deregulation of intoxicated by the concept of “neo- reduction is imperative, and that the banking system, thereby sparking endogenous growth theory”, and even Britain cannot go on adding to its debt a property bubble which could only with the economy crashing around his mountain in the reckless way that it has ever have ended in disaster. Along ears, Brown continued to believe that been doing for more than a decade. We the way, the UK economy became there had been “no return to” boom also share the view of the government’s debt-dependent – sectors driven and bust. Throughout his tenure at the opponents that lack of growth is likely either by private borrowing or by Treasury, Brown continued to preach to derail the Coalition’s plan. public spending prospered in an “prudence” and “golden rules” even as unsustainable way, whilst other he was creating the largest deficit in But we cannot concur with any industries withered. British peace-time history. When the analysis which endeavours to shift the banking crisis impacted in 2008, he blame for Britain’s current economic Far from recognising the bubble for continued to insist, ludicrously, that plight from the 1997-2010 Labour what it was, Brown proclaimed the Britain was “best placed” to weather administration. That government, abolition of “boom and bust” (together, the storm. Ministers seem to have presumably, with the general economic38 strategy insights | issue seven strategy insights | issue seven 39
  • 22. thinking the unthinkable | might there be no way out for Britain?been forbidden to refer to the financial failure since 1997. Opinions may differ Second, the Bank was required to look prudent practices. Lenders operating in “liar-loans” made top-end earnings spend, spend, spendcrisis without the obligatory word on whose economic plan (if any) is best only at retail price inflation when the UK, dependent upon the sanction multiples essentially unknowable. The Nowhere was Team Brown’s complete“global” being tacked on to it. fitted to create a recovery, but no one setting monetary policy. The concept of the Bank, had always toed the Bank was powerless to prevent this detachment from reality more evident should be in any doubt that the 1997- of asset price inflation, it seemed, had line, the traditional saying being that recklessness, and was also prevented than in public spending. DuringThe scale of the deficit, and Britain’s 2010 Labour government, at least from never even crossed Team Brown’s radar. a mere arching of “the governor’s – by its retail inflation mandate – from Labour’s first term, the governmentconsequent inability to use stimulus an economic and fiscal perspective, eyebrows” would be enough to bring raising interest rates to choke it off. had been constrained by an electoralto good effect, apparently had nothing was an unmitigated disaster. Since a number of factors (such as the recalcitrant into line. commitment not to exceed thewhatsoever to do with Team Brown’s generally benign commodity markets, In the space of nine reckless years, the spending plans of the outgoingreckless expansion of public spending laying the foundations for failure and an influx of cheap manufactured Not this time. Largely because of total amount of mortgage finance (Conservative) administration. Once thissince 2000. The crisis in the British In 1997, Gordon Brown embarked upon imports from emerging economies in the tripartite system, this informal outstanding increased by almost constraint had lapsed, Brown began topublic finances, it seemed, was entirely a reform of the financial regulatory Asia) were depressing retail inflation, restraint no longer functioned, and 150%, from £495bn in 1999 to £1.2 undertake the largest ever peace-timeof foreign origin, and the genius which system which was fundamentally interest rates were kept low even banks began to extend loans on terms trillion in 2008. This wall of easy expansion in public spending.had made Britain best placed in the bungled. Labour did this because when an unmistakeable asset bubble that would have given managers of an liquidity naturally drove the housingglobal economy could now be applied of a central belief that the financial began to emerge in the property earlier generation apoplectic fits. Loan- market sharply upwards so that, Although Labour’s conduct of theto “saving the world”. services sector, liberated to prosper, market. Any claim that the emergence to-value (LTV) mortgage ratios climbed when property prices finally peaked economy in the decade before the could pay for a welfare revolution. of a property price bubble could have to – and even, in reckless cases, beyond in December 2007, they had risen by banking crisis was fundamentallyThis is not simply a chapter of been neither observed nor countered – 100% of the purchase price, and 170% since December 1998. The government could be “intensely flawed, a combination of arrogance andhistorical regret, because one of the would be disingenuous, since rates of banks’ acceptance of self-certified relaxed” about a minority becomingmost striking features of the current price expansion, and the relationship “filthy rich” if these people’s taxeseconomic and fiscal mess is a national between property prices and average would fund a brand new welfare statestate of extreme denial over the earnings, supplied real-time evidence as a monument to the wisdom of the Fig. 22: Spending – the ‘Brown binge’* Fig. 23: ‘Cuts’ are modest in context*severity of the problems facing the UK. of unmistakable overheating in the New Orthodoxy.Politicians and the general public alike housing market.seem to believe that ‘everything will Labour also seems to have believed £bnturn out fine’, that growth will return, that debt doesn’t actually matter The bungled reform of financial £800 £800 £688 Nominalthat debt problems will go away, that very much, a view to which many regulation triggered a classic property £700 £668 Real £688life will go on as usual, and that Britain individuals and businesses also came market bubble. Hitherto, lenders had £700 £600will somehow ‘muddle through’. It is to subscribe. We now know better. worked to a set of long-established £669 £451clear that an individual and collective criteria. The purchaser of a property £500 £600sense of ‘entitlement’ plays a major In 1997, Labour made two disastrous had to produce a deposit, typically £400 Interest £451role in this state of denial, and the mistakes with its reform of the of 10% or 15% of the purchase price. £300 Other £500 Pensionsresponsibility for this, as for the sheer regulatory system. First, although the He or she also had to supply proof of Education £200incompetence and recklessness which Bank of England was given a degree of earnings, against which the building Welfare £400 Healthturned Britain into a debt-dependent independence, its regulatory role was society or bank would lend a multiple £100 Totaleconomy, lies firmly at the door of fatally undermined by the creation of perhaps 2.5x or 3.0x. £0 £300 of the tripartite system, which 2000 2002 2004 2006 2008 2010 2012 2014 2000 2002 2004 2006 2008 2010 2012 2014 2016Team Brown. handed many of the Bank’s previous Of course, periods of property priceIf we are to understand quite how responsibilities to the Treasury euphoria had happened many times *Spending at constant 2010-11 values. Source: Tullett Prebon UK Database, HM Treasury and ONS *Spending at constant 2010-11 values. Source: Tullett Prebon UK Database, HM Treasury and ONSsevere Britain’s problems are, we need and the FSA6. before, but the Bank had alwaysto recognise the magnitude of national been able to oblige lenders to stick to40 strategy insights | issue seven 6 The Financial Services Authority strategy insights | issue seven 41
  • 23. thinking the unthinkable | might there be no way out for Britain?ignorance prevented the government say, in the general cost of government resulting cynicism about the country’sfrom recognising the essentially illusory (+99%). (By contrast, planned spending political leaders will prove a majornature of the apparent growth of cuts by the coalition government are handicap as the Coalition governmentthat period. As a result, Labour made extremely modest, amounting to an endeavours to make the case fordangerously inept assumptions about overall reduction of just 3% between collective sacrifice. Even before thetax revenues, and about sustainable 2009-10 and 2015-16 (fig. 23)). Parliamentary expenses scandallevels of public spending. of 2009, there was unmistakeable The reckless expansion in public evidence of a growing rift betweenAll that was required to complete the spending had at least four very governing and governed – thedisaster was for government to believe unpleasant consequences. First, it government apparatus seemed to bethat the debt-fuelled bubble was real created unprecedented arrogance becoming relentlessly more arrogantgrowth – to believe, that is, that “boom in the upper echelons of the state as the power and resources of the stateand bust” really had been abolished apparatus, an arrogance which was expanded, and the ever-increasing use– and to spend up to it. The Labour reflected both in the pay and perks of of surveillance, not just at national butgovernment did even more than that. senior managers and in a relentless even at local government level, causedBetween 1999-2000 and 2009-10, encroachment on the rights and no less a figure than then Informationwhen reported real GDP increased by liberties of the individual. Second, the Commissioner Richard Thomas to warn17%, real public spending soared by seemingly endless flow of increases that Britain was “sleepwalking into a53% (fig. 22), creating an enormous in public spending (which rose by surveillance society”7.deficit which, at £156bn, equated to an average of 4% per annum, in real11% of GDP. terms, throughout the 2000-08 period) Laws which may have begun with was reflected in a steady decline in good intentions resulted in theDuring 1999-2000, the government public sector productivity – after all, banning of the traditional game ofspent £343bn. If this sum had simply who needs to budget carefully when conkers, a schoolgirl being banged upincreased in line with inflation, it there will always be more Treasury in a police cell for a purely technicalwould have reached £440bn by 2009- largesse coming down the line? transgression of the equality laws,10. In fact, spending in that year was parents being subjected to undercover£670bn. Such a spending hike had only Third, a mentality of individual and surveillance to ensure that they reallyever been affordable on the bizarre collective entitlement flourished in lived where they claimed they did,assumption that the economy could an environment in which, it seemed, the greatest density of CCTV cameracontinue its bubble-driven expansion public spending could provide the coverage in the world, plans to installindefinitely, and that tax revenues answer to all ills. Fourthly, and as we surveillance cameras in dustbins, andwould escalate on the back of super- have seen, the economy was distorted the arrest of opposition MP Damianheated growth. towards sectors driven either by debt Green for the supposed crime of or by public expenditures. receiving (not leaking) informationGovernment largesse was spread which, whilst embarrassing to theacross the board, with big real-terms Labour’s assumption of moral Home Office, had no relevanceincreases recorded in health (+89%), absolutism drove a wedge between whatsoever to national security.in education (+60%) and, needless to the state and the public, and the42 strategy insights | issue seven 7 The Times, 16th August 2004 strategy insights | issue seven 43
  • 24. thinking the unthinkable | might there be no way out for Britain?By 2010, more than 1,000 categories dramatic increase in spending took Since 2005, the ONS9 has put Second, some of the output measures Our recalculation of public sector real spending (fig. 25). The decline inof officials had an unrestricted right place. The decline in public sector commendable efforts into measuring seem extremely subjective. Perhaps productivity differs from the ONS productivity in sectors other than healthof access to individuals’ homes to productivity was bad news, of course, the outputs (and hence the the most striking of these measures version in two key respects. First, we was 15% (fig. 26), and the gap betweencheck on such vital matters of national both for taxpayers and for the users of productivity) of the public sector. This is the use of unqualified prescription use real spending data instead of productivity in the public sector (-20%)security as the cultivation of pot plants public services, but it also had adverse process seems to show that overall numbers, the assumption seemingly volumetric inputs and, second, we and the private sector (+24%) wasand the sale of squirrels8. implications for the overall efficiency of public sector productivity declined being that an increase in the number exclude the tripling in prescription particularly striking (fig. 27). the economy. between 1997 and 2007, but only by of prescriptions written by doctors numbers from our measurement ofdeclining productivity about 3%, the implication being that automatically correlates with an health sector output. Falling productivity meant, of course,At least, it might have been assumed, Because commercial outputs have a the quality of public services pretty improvement in public health. It is that taxpayer costs rose in relation tothe massive real-terms increase in market value, the measurement of much kept pace with the sharp increase at least arguable that a healthier On this basis, overall public sector the quality of services being enjoyed byspending must have resulted in a productivity in the private sector is a in inputs over the same period. population would require fewer productivity deteriorated by 20% the public, but it also meant that overallcomparable improvement in the relatively straightforward matter, but prescription medications, not more. between 1997 and 2007 (fig. 24), national productivity was underminedquality of public services. Available the same does not apply to the public Unfortunately, there are very serious Similarly subjective output measures because the increase in outputs (of in a period in which public sectordata very strongly suggests that sector, where outputs are not priced. shortcomings on both sides of the input/ include the use of GCSE results and 24%) fell far short of the expansion in spending climbed to 48% of GDP.this did not happen, because the Prior to 2005, virtually no attempt output equation as measured by the un-weighted prisoner numbers to real expenditures (54%). In the health was made to measure productivity ONS. For a start, inputs are measured sector, the decline in productivity was Together, then, the Labour era leftproductivity of the public sector calculate the output of the education in the public sector, the wildly naïve volumetrically, which excludes from the an alarming 31%, because outputs Britain with a debt-dependentseems to have fallen very markedly and prison services. assumption simply being that output calculation the very material rises in the (excluding prescriptions) increased economy and with a situation inthroughout the period in which the matched inputs. real unit costs of those inputs. by only 36% despite a huge rise in which overall productivity had been Fig. 24: Public sector productivity* Fig. 25: Health sector productivity* Fig. 26: Public sector productivity* Fig. 27: The productivity gap* 1997 = 100 1997 = 100 1997 = 100 1997 = 100 160 200 110 140 Public sector output Health output Public sector Public sector expenditures +54% Health expenditures +97% +24% 140 Private sector Public sector productivity Productivity 100 120 120 150 +24% 90 -15% 100 100 +36% 80 80 80 100 -20% -20% -20% 70 60 60 -31% -31% 60 40 40 50 Health productivity 20 50 Other public sector 20 Overall productivity 0 0 40 0 1997 1999 2001 2003 2005 2007 1997 1999 2001 2003 2005 2007 1997 1999 2001 2003 2005 2007 1997 1999 2001 2003 2005 2007*Source: Tullett Prebon estimates, see text *Source: Tullett Prebon estimates, see text *Source: Tullett Prebon estimates, see text *Source: Tullett Prebon estimates, see text 8 For more detail on the spread of surveillance, see The Rotten State of Britain, Eamonn Butler, 201044 strategy insights | issue seven 9 Office for National Statistics strategy insights | issue seven 45
  • 25. thinking the unthinkable | might there be no way out for Britain?undermined by the shift of national A selective concept of ‘fairness’ was in imposing rigid uniformity on extension, Britain as a whole, have an If accepted (as, by New Labour, it was), public spending increased by 53% andresources into a public sector whose at the very heart of Labour’s secular everyone, banning minority activities entitlement to these advantages, when this sense of ‘assumed entitlement’ public debt rose by 73% (not includingproductivity had deteriorated from a theology, so much so that an entire (such as fox-hunting), leaving the the reality, of course, is that they have leaves government free to burden financial interventions). Althoughprivate sector in which efficiency had chapter of the 2009 budget was income tax threshold a long way to be earned on an ongoing basis. industry in whatever way selective household consumption increased bybeen increasing. entitled “helping people fairly” (when below the minimum wage, enforcing moral absolutism dictates, confident 18% (thanks in large part to soaring helping them effectively might have multiculturalism as a secular religion Arguably the single biggest problem that the damage to output doesn’t personal indebtedness), governmentthe high price of moral absolutism been a much better idea). which no-one was allowed even to that the Coalition inherited from really matter because the world final consumption (which is not theIf the Labour administration failed question on pain of arrest, or granting Labour – more serious even than somehow owes Britain its current same as public spending) rose by 51%on two of its stated aims – economic The problem with this was (and is) national and local government ever the deficit, the national debt or the standard of living and its current level – again, dramatically outpacing GDPcompetence and ethical foreign that ‘fairness’ is an extraordinarily greater coercive and surveillance proliferation of wasteful agencies and of welfare provision. – whilst the value of manufacturingrelations – then it succeeded, rather vague concept, one to which everyone powers over individuals? quangos – is this belief in personal and, output slumped.horrifically, on the third, which was to can subscribe and then interpret as by extension, national entitlement. How this sense of entitlementchange ‘hearts and minds’. suits them best. For example, a rich Labour’s creed of moral absolutism Individuals, it is widely assumed, are translated into economic aggregates The scale of dependency is evident, too, person might argue that fairness had multiple negative spin-offs. But ‘entitled’ to claim perpetual benefits, is set out in fig. 32, which compares in the numbers claiming out-of-workPerhaps the most intractable part involves every working person paying from a purely economic perspective, and the country is ‘entitled’ to its real-terms changes between 1999 benefits. As of August 2010 (the latestof Britain’s economic problem is the the same amount of tax, or at any rate Labour pursued disastrous policies current standard of living, whether it and 2009. Although real GDP only month for which fully detailed data ismind-set engendered by Labour. paying the same percentage of his or (such as ‘light touch’ deregulation) to actually earns it or not. increased by 16% over that period, available), the claimant count totalledThis mind-set, which is a compound her income, whilst a person on a low the point of recklessness because itof entitlement (both personal and income might believe that the system believed that it had the moral inside-national), financial irresponsibility and should take far more from the better track on all issues.spurious moral absolutism, makes it off. The reality is that, beyond basic Fig. 28: Bubble growth* Fig. 29: Bubble swings*difficult for the public to perceive the rights as outlined in documents as the gravest problem – thenature of the national problem, let varied as the American Constitution concept of entitlement 1999 = 100 % change, 2007 vs 1999alone resolve it. and the European Convention on Despite the appalling mismanagement 130 80% Finance**; 75% Reported growth Human Rights, there are very few of the New Labour years, Britain Real growth? 70%Not since the days of William moral absolutes in a secular society. remains the world’s eighth largest 120 60% Construction; 57%Gladstone10 has a government come Labour’s solution simply was to economy (though it has now fallen to 50% 110 Real estate; 41%to power with a greater sense of moral declare ‘ex-cathedra’ principles and to 37th in terms of per-capita income)11. 40%fervour, and it is at least arguable that demonise those who had the temerity Reflecting this, British citizens enjoy 100 30% GDP; 24%Tony Blair and (in particular) Gordon to disagree. high quality health, education and 20%Brown were even more prone than ‘the welfare systems, combined with strong 90 10% Annual average growth rates**:Grand Old Man’ to treat the despatch Even by its own standards, Labour’s provision of other basic services. Reported: 2.74% 0% 80box as a pulpit. The essential difference secular morality was full of holes. Real: 1.35%? -10% Production; -7%between Gladstone and New Labour, Where, critics asked, was the ‘fairness’ The problem which has emerged -20% Manufacturing; -16% 70however, was that Blair and Brown in plundering private pension over the last decade, and can in large -30% 1999 2000 2001 2002 2003 2004 2005 2006 2007peddled an essentially secular moral schemes, piling gigantic debts onto part be traced to Labour’s doctrine ofabsolutism, albeit with at times a future generations, or invading moral absolutism, is the widespread Sources: * Tullett Prebon UK Database Sources: * Tullett Prebon UK Databasedistinctly nonconformist flavour. Iraq? Where was the ‘fairness’ assumption that individuals and, by ** Rates are compound averages, 2007 vs 1999 ** Financial intermediation 10 William Ewart Gladstone, 1809-98, Prime Minister 1868-74, 1880-85, 1886 and 1892-94. His moralistic logic for extending the franchise, as set out in a House of Commons speech in 1866, was destroyed by meritocratic logician Robert Lowe, who used “inductive reasoning” to demonstrate that carthorses and46 strategy insights | issue seven cats could expect to be allowed to vote under Mr Gladstone’s principles strategy insights | issue seven 47 11 Source: CIA World Factbook
  • 26. thinking the unthinkable | might there be no way out for Britain?4.9 million, including 1.4 million to run on the basis of escalating in 1999 to £230bn in 2008. Like latter equivalent to 430% of GDP. To construction (+43%) and real estate What, then, was the real growth track-receiving Jobseekers’ Allowance, 0.67 private borrowing and, latterly, of mortgage lenders, credit providers be sure, the UK’s external debts are activities (+30%), whilst manufacturing record of the British economy in themillion claiming single parent benefit unsustainable government borrowing behaved recklessly but, ultimately, it in part offset by substantial overseas output shrank by 19% and value added decade before the crisis, and what isand an astonishing 2.6 million on as well. This necessarily distorted was Labour’s dysfunctional regulatory investments, but the breakneck pace in the broader production category the economy’s current trend growthvarious forms of incapacity benefit. the economy towards sectors linked system which allowed them to do so. of expansion in overseas indebtedness declined by 11%. As a result, potential? If official figures were toThese are very large dependency either to private borrowing or to had no corollary in terms of increases manufacturing fell as a proportion be believed, the economy deliveredrates when compared with total public spending. Together, these factors injected in overseas assets. of the economy from 17% in 2000 annual real growth of 2.8% betweenemployment of 29.1 million (22.9 unsustainable expansion into the to 12% in 2008, whilst the share 1998 and 2009. And, if official (OBR)million in the private sector and 6.2 A gamut of trades ranging from economy. Meanwhile, the savings ratio The bottom line was that at least half attributable to the aggregate of real forecasts are to be believed, an evenmillion in the public sector). The construction to legal services via had virtually disappeared under the of all apparent ‘growth’ between 2000 estate, construction and financial higher (2.9%) rate of growth can berecently-introduced eligibility tests for estate agencies, white goods suppliers, triple onslaught of low rates, adverse and 2008 wasn’t genuine growth at services climbed from 32% to 39%. achieved within two years from now,incapacity benefits applicants revealed builders’ merchants, plumbers and tax treatment (notably the notorious all, because the apparent prosperity despite fiscal tightening.that three quarters of the applicants electricians benefited from the brisk 1997 tax “raid” on pension funds), and of that period was borrowed, not These trends were reflected, too, ineither failed the tests or withdrew their pace of expansion in the property a general perception that debt was generated intrinsically. employment patterns. Between 1999 The reality is that these numbers, bothapplications before taking them. market. Consumer spending surged not a matter of concern. Consequently, and 2007, employment in real estate historic and projected, are completely because inflated housing equity made the illusory growth of the period was The nature of the “Brown boom” can be activities and construction increased delusional. Stripped of bubble effects,the distorted economy consumers unduly relaxed about fuelled almost entirely by borrowings discerned from sectoral contributions by 58% and 22% respectively, whilst we calculate that annual average leverage, such that annual equity from overseas. Britain’s external debt to economic output. Between 2000 the number of manufacturing jobs growth during 1998-2009 was certainlyWhilst Team Brown presided over release peaked at over £50bn and climbed from £1.89 trillion in 1999 to and 2008, huge real-terms gains were fell by 28%. less than 1.5%, and may have been asa culture of moral absolutism and unsecured debt soared from £120bn a peak of £6.25 trillion in 2008, the delivered by financial services (+109%), little as 1.3%. And, as we have seen,entitlement, the economy continued Fig. 30: A classic bubble* Fig. 31: Skewed growth* Fig. 32: Spending, output and debt Fig. 33: Shares of the economy 1997 = 100 1997 = 100 2009-10 vs 1999-2000 at constant values 2009 vs 1999 at constant values 400 250 100% Health; +60% +89% Government consumption; +51% External debt Finance +50% Mortgage debt Construction Debt; Consumer debt 200 80% +40% Manufacturing +73% 300 Property prices Real estate Education; GDP Total GVA +30% Household +60% Spending; 150 60% consumption; +18% GDP; +18% Welfare; +53% +20% 200 +45% Pensions; +39% +10% 100 40% Defence; 0% +24% GDP; 100 -10% 50 20% +16% -20% 0 0 0% -30% 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 Manufacturing; -27% 1997 1999 2001 2003 2005 2007 2009 -40%*Indexed, 1997=100 *All items expressed at real values, indexed 1997=100 Source: Tullett Prebon UK Economic & Fiscal Database Source: Tullett Prebon UK Economic & Fiscal Database*Sources: Tullett Prebon UK Database, HM Treasury, ONS, World Bank and Lloyds Banking Group *Sources: Tullett Prebon UK Database, ONS and HM Treasury48 strategy insights | issue seven strategy insights | issue seven 49
  • 27. thinking the unthinkable | might there be no way out for Britain?dependency on private borrowing and by inflation-busting increases in food bills rose by 69%, gas bills by 131%, warring interest groups which gravely Fig. 34: Property price/earnings multiples*public spending renders the possibility and travel costs, electricity, water and council tax and rates by 69%, water by compromises Britain’s ability to findof the economy delivering growth rates gas prices, and the levies imposed by 59% and petrol by 60%, all of which are unified solutions to its problems.above 2% extremely remote. national and local authorities. far greater increases than the 42% rise in nominal weekly earnings. If Labour is to play a constructive role 7.0nemesis – the squeezed middle This trend played a major role in the in the quest for national economic 6.0The political sting in the tail for New overthrow of the Brown government. With the Brown era thankfully viability, Ed Milliband needs to disavow Real average earnings appeared to consigned to history, what remains is a the Brown legacy in its entirety, and to 5.0Labour was the emergence of the“squeezed middle”, roughly analogous improve by 15% between 2000 and country which is hugely indebted, has a turn the page on a deeply unedifying 4.0to the “middle England” which had 2010 – by 14% in the private sector and government which spends much more chapter in the history of the party. 3.0obsessed an earlier generation of by 19% in the public sector12 – but this than it can afford, and has an economy Potential further fall?political analysts. As a minority calculation rests on official measures geared towards low growth. 2.0prospered, people on second- and of inflation which do not seem to Worse still, the legacy of moral 1.0third-quartile incomes found that reflect everyday experience. Over the same period, for example, whilst CPI absolutism and entitlement has 0.0their debts had escalated whilst their 83 85 87 89 91 93 95 97 99 01 03 05 07 09 increased by 23%, average electricity created a political landscape ofspending power was being squeezed *Sources: Tullett Prebon UK Economic & Fiscal Database, Lloyds Banking Group50 strategy insights | issue seven 12 Public sector wages excluding financial services strategy insights | issue seven 51
  • 28. thinking the unthinkable | might there be no way out for Britain? part five: the search for pain mitigation no way out? total denial about the true state of the Official economic forecasts seem to economy and the public finances. The have been constructed on the basis of • There are no pain-free solutions to Britain’s economic and fiscal general assumption, and one which some kind of economic “flat earth” in problems, but supply-side reforms has been given official sanction both by which neither absolute debt levels nor can start to build the foundations for the government and by the OBR, is that the skewing of the economy towards longer-term revival. economic growth will return, regaining private borrowing and public spending the superheated levels of the ‘Brown are taken into account. • The biggest obstacles to recovery boom’ by 2013, when the official are spurious moral absolutism, an projection is that GDP will grow by A point which we have endeavoured unrealistic belief in ‘entitlement’, 2.9%. This being so, the argument runs, to make throughout this report is and the division of the economy into Britain’s hefty public debts are not a that both of these erstwhile economic warring interest groups. matter of major concern (although it drivers are dead. The government is conceded that they will continue to cannot continue to ramp up its Thus far in this report we have increase) and, with the exception of spending, and individuals cannot and, established, first, that Britain is gravely the official hope that banks will lend if they are wise, will not, continue to go mired in debt and, second, that the an extra £76bn annually to businesses, ever further into debt. levels of growth necessary to carry this there appear to have been no official debt are most unlikely to be delivered, This fundamental dislocation seems comments at all on private debt. because the economy has become far blithely to have been ignored in the too heavily skewed towards private Indeed, the authorities seem extremely framing of official economic and fiscal borrowing and public spending. ambivalent about the whole subject projections. Despite reductions in public of debt. The government accepts the sector employment, the total number What happens next can only be bad, need to reduce the deficit, but this of jobs in the economy is expected of course, but the critical questions does not amount to a plan actually to officially to increase by one million, have to be “how bad?”, and “what can reduce the public debt. The opposition with total employment climbing be done to minimise the damage?” does not even accept the need to go to 30.0 million by 2015, compared The answers to these questions will this far, seeming to see no necessity with 29.0 million today. The rate of depend less on policy choices than on to eliminate the structural deficit unemployment will fall from 8.2% to national cohesiveness, and this in turn over any realistic timetable. Where 6.4%, and the claimant count, after will depend upon ending the state private debt is concerned, the official rising slightly to 1.54 million next year, of denial that has gripped public and message, such as it is, seems to be that will fall back to 1.18 million by 2015. CPI policymakers alike since the onset borrowing can alone “get the economy inflation, though now at 4.5%, will fall of the financial crisis in 2008, and moving”, a view which does not take back to the 2% target by 2013. bridging the gap between warring self- into account the uncomfortable fact interest groups. Reflecting this optimistic economic that consumers are already burdened outlook, government tax receipts are by more than £1.4 trillion of secured One of the most striking characteristics expected to rise from £549bn in 2010- and unsecured debt. of Britain’s current economic and 11 to £735bn by 2015-16, a real-terms fiscal malaise is a sense of almost increase of 17%. The expectation that52 strategy insights | issue seven strategy insights | issue seven 53
  • 29. thinking the unthinkable | might there be no way out for Britain?both short-term and market gilts rates Once the sheer improbability of rapid needs to explain why sterling has meanwhile, back in the real world… but mostly in government borrowing The forex markets, it seems, are almostwill rise very sharply (from 0.7% to growth is recognised, the rest of the made no progress at all against the The real outlook, as we see, it – the state has borrowed £390bn, and alone in their immunity from this4.4%, in the former instance, and from officially-projected picture unravels euro or the dollar. What the forex begins with the observation that, printed a further £200bn, to plug the psychology of denial.3.8% to 5.1% percent in the latter) is like a badly frayed comfort-blanket. markets seem to be telling us is that by definition, there can be no such gap in the economy created by therecorded almost as a codicil to these With growth likely to average, at best, they place little or no faith in the recession. Banks seem to have been If, as we believe to be the case, Britain’s thing as a pain-free recession. Overgenerally buoyant projections. about 1.4%, the private sector cannot optimistic outlook as peddled by the loathe to foreclose on business debts psychology of denial about the true the last three years, Britain’s real conceivably create 1.4 million net British authorities. in order to avoid crystallising losses, state of the economy and the public economic output has fallen by moreThe problem with all of this is that new jobs (which is what an overall which very probably means that large finances is about to suffer a rude than 5%, but this, until very recently,neither the government nor the OBR 1.0 million increase amounts to once We share this view. Meanwhile, we numbers of ‘zombie companies’ are awakening, where is this likely to had had remarkably little impact onhas explained where all of this growth the probable level of public sector job suspect very strongly that both the UK being kept afloat artificially. become evident? When considering most members of the public. The riseis supposed to come from. As we have losses is factored in to the equation). authorities and international bodies each possible theatre of deterioration, in unemployment has been modest,seen, the real estate sector, which By the same token, the probability that such as the IMF13 and the OECD14 Whilst these short-term measures have we need to distinguish between business failures have been remarkablyaccounts for 24% of the economy, growth will fall a very long way short of are engaged in a process that might been necessary, they are, by definition, “bad” and “very bad”. We conclude few in number, and declines in realis incapable of further growth. The the official expectation means that the be termed either “jam tomorrow” time-limited. The pain of the recession this report by explaining how the disposable incomes have been offset,same surely applies to construction expected 17% real-terms increase in tax or “pas devant les enfants”. Near- has been deferred, not eliminated, and pain might be restricted to the former for millions of people, by sharp falls in(6%), because capital investment by revenue looks extremely implausible. term forecasts for growth are revised has now begun to turn up. One of the rather than the latter. monthly mortgage payments.government has fallen sharply whilst downwards, and predictions for problems with the deferral process isnet mortgage issuance has evaporated. We see no reason whatsoever for near-term inflation are raised, because that it has contributed to a general There are many possible theatres The explanation for the seeminglyDeclining real incomes are already inflation to fall back to 2%, and believe credibility demands nothing less, but sense of denial over the true economic for denouement, but let’s start with pain-free nature of the recession lies,exerting downwards pressure on that the combined outlook for jobs and longer-term optimism remains in and fiscal state of the United Kingdom. property. As it has been so often in of course, partly in low policy ratesretailing (11%), and the aggregate inflation emphatically points at further place. The promised land of strongoutput of health, education and public sharp declines in real incomes. Where growth and low inflation, the marketsadministration (19%) will be flat at the official forecasts may be on target and the public are told, has not been is over expectations for rises in interest Fig. 35: Net mortgage issuance* Fig. 36: Without the bubble #1best as a result of public spending mislaid, but simply pushed out intorestraint. The financial services sector rates. This implies a severe squeeze the future. The probable intention is(10%), too, may find growth very on the disposable incomes of Britain’s the bolstering of confidence in the face £bn £bndifficult to deliver. 11.4 million mortgage payers, many of of the clearest possible evidence that £120 £113 £700 £108 Spending whom may be barely keeping up with official projections are proving wildly £97 Actual revenue £96Official forecasts do not tell us where monthly payments as it is. optimistic. After all, the last thing that £100 £89 £88 Underlying revenuegrowth is going to come from, then, but £600 fragile international market confidence £80the calculations set out in this report In recent months, it has become needs at this time is to be told that oneidentify the 60-70% of the economy abundantly clear that there are very £59 of the world’s biggest economies is in £60 £500from which growth will not come. serious problems in the Eurozone, very deep trouble. £40£43 whilst American growth figures are £40 £29Our analysis suggests that real growth belied both by employment data and £22£20 £20£20 £400of 2.9% is pie-in-the-sky, and that £20 by escalating Federal debt. In thisanyone who believes in this forecast £3 context, anyone who believes in the £0 £0must also have unbounded faith in official, optimistic outlook for Britain 1996-97 1999-00 2002-03 2005-06 2008-09 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010Santa and the Tooth Fairy. *Source: Tullett Prebon UK Economic & Fiscal Database *Source: Tullett Prebon estimates 13 The International Monetary Fund54 strategy insights | issue seven 14 The Organisation for Economic Cooperation and Development strategy insights | issue seven 55
  • 30. thinking the unthinkable | might there be no way out for Britain?the past, the state of the property to just £3bn in 2010-11 (fig. 35). If the mitigation measures described is in negative equity would rise very years may be impossible to deliver if, as 1. The British public appears to bemarket is likely to be something of a Second, even the official forecasts later are put into place, the restoration sharply (though it is to be hoped that we believe to be the case, the growth unaware of the true scale of thebellwether for the broader economy. concede that interest rates are likely of normality in the property markets the banks would recognise the total assumptions upon which they are economic and fiscal malaise, theThough annual average house prices to rise, which will further undercut may take place over a relatively futility of large-scale repossessions predicated are far too optimistic. widespread belief seeming to behave declined by 17% since their 2007 affordability. Third, it is clear that protracted period. But if the psychology in such circumstances). The banking along the lines of “something willpeak, the ratio of prices to earnings real incomes are declining, which of denial continues, property markets system’s reserve ratios would suffer The way in which this process might turn up”. The public needs to be maderemains at 4.5x, far higher than is another adverse indicator for could be heading for a sharp fall, taking a battering, as, of course, would impact debt and the deficit is set out aware of the reality, which is that,historic averages in the 3.2x-3.5x range property markets. the price/income multiple down to consumer spending. in the table. If growth were to come unless radical corrective action is(fig. 34). Property market participants its 3.2x-3.5% baseline over a period of in at 0.9% this year, 1.3% in 2012-13 taken, what will “turn up” will be aare reporting extremely subdued levels Given this combination of factors – less than twelve months. Downwards Just as a sharp downturn in and 1.4% in subsequent periods, debt full-blown economic crisis.of activity, and this combines with minimal market activity, negligible momentum could cause the fall in property prices could be one form of will hit 100% of GDP by 2014, and willstill-very-extended price multiples to net mortgage issuance, declining real multiples to overshoot, involving a denouement for the collective denial continue to rise thereafter, whilst the As we have seen, the assumptionsuggest that further sharp falls may incomes and the probability of rate slump of at least 30% in average prices about the true state of the British deficit could still be close to 9% of GDP that, sooner or later, the economybe imminent. rises – it seems highly implausible that that would take the multiple down to economy, unemployment could be by 2015-16. will stage a brisk recovery is simply an the property price/earnings ratio can about 3.0x. another. As remarked earlier, the exercise in wishful thinking of whichThere are at least three further reasons remain about 40% above its historic official expectation that the private If this process were to gain Pollyanna would have been proud.to suppose that property prices may trend. One of the characteristics of Any such fall would, of course, sector can add 1.4 million net new momentum, it would become a vortexbe heading for a very big fall. First, net the unfolding downturn in the British have some pretty drastic knock-on jobs over the coming five years looks in which the UK’s economic situation 2. It needs to be appreciated that theremortgage lending has virtually dried economy, therefore, is likely to be a implications. The proportion of Britain’s pretty implausible. It is far more likely could very rapidly become perilous. If can be no such thing as a pain-freeup, declining from £113bn in 2006-07 sharp fall in property prices. 11.4 million mortgage payers which that, as public sector cutbacks enter the markets and the rating agencies recession. Together, low interest rates their stride, unemployment levels will decided that Britain was another and enormous fiscal deficits have, for rise. Quite how far these levels rise will debt-shackled, low-growth economy at millions of people, deferred the true depend upon the preparedness of the the periphery of Europe, interest rates cost of the downturn, but this was Fig. 37: Unravelling: How low growth could undermine the government plan* authorities to implement mitigating would rise sharply, exacerbating fiscal only ever a limited-duration delaying measures designed to make it more strains, and the government might tactic. Only now is the reality of 2009-10 2010-11 2011-12 2012-13 2013-14 2014-15 2015-16 attractive for businesses to take on even encounter significant difficulties declining living standards beginning Growth: in raising the huge and rising sums to bite. extra employees. Official -3.5% +1.8% +1.9% +2.7% +2.9% +2.9% +2.8% that it would need to borrow. Meanwhile, we also expect tax 3. It must be understood also that there Low growth +0.9% +1.3% +1.4% +1.4% +1.4% revenues to fall successively further limiting the pain, building the is no magic macroeconomic solution Deficit: adrift of official targets, not drastically foundations for recovery to Britain’s problems. Almost so this year (because the current- The question, then, is not whether all every possible macroeconomic Official 11.1% 9.6% 7.9% 6.2% 4.1% 2.5% 1.5% permutation has already been tried, year growth assumption is relatively pain can be avoided – that is clearly Low growth 10.2% 11.1% 9.8% 9.0% 8.8% restrained, and the VAT increase can be impossible – but whether the pain can to no avail. Specifically: counted upon to boost revenues), but be minimised and the foundations Debt ratio**: in subsequent periods. Allowing for the created for a subsequent recovery. • Interest rates have been maintained Official 71% 75% 83% 85% 85% 83% 80% at near-zero levels for 28 months, increases in tax rates (and most notably If Britain is to craft an eventual route yet no recovery has ensued. Low growth 86% 94% 100% 104% 108% in VAT), the target for 2011-12 revenue gains is not particularly demanding, out of the high-debt, low-growth trap, Source: * Tullett Prebon calculations but the increases forecast for future no less than six critical points need to ** Debt to GDP ratio on the Maastricht Treaty definition be grasped from the outset.56 strategy insights | issue seven strategy insights | issue seven 57
  • 31. thinking the unthinkable | might there be no way out for Britain? • Government (both Labour and 5. Politically, government needs to bankers, the public sector, and the massive (60%) real-terms increase of the regulatory burden imposed Whilst it will be equally obvious that the Coalition) has borrowed offer the public some offset to the virtually any interest-group they in education spending which occurred on businesses. The extent and effect correcting these faults could only help £390bn, or 27% of current GDP, generally depressing economic can think of, other, of course, than between 1999-2000 and 2009-10, of the taxation system sees the to improve economic performance, it over a three-year period, yet, again, outlook. The best way to do this, themselves. Continued self-interest Britain ranks 28th for the overall UK ranked 95th, worse even than may be less obvious that supply-side there has been no recovery in we believe, would be to promote and blame-shifting can serve only quality of its education system (behind Zimbabwe, let alone Guatemala or reform is the only remaining route economic activity. a ‘liberty agenda’ which strips to impoverish the UK as a whole if it Costa Rica, Lebanon and Malta), Angola. The overall tax burden on to economic viability now that all away much of Britain’s excessive acts as a block to effective reform. and fares even worse (55th, behind business is worse than in Pakistan or macroeconomic policy options have • A further £200bn has been surveillance, reduces the powers of Romania and Cyprus) in terms of the Nigeria or, for that matter, in 51 other been exhausted. pumped in through QE, again to national and local government to as others see us quality of maths and science education, countries. Very little of Britain’s huge no apparent effect (though it interfere in the lives of individuals, The scope for supply-side reform a weakness which is extremely public spending seems to go into the This poses the question which may have contributed to the removes many of the coercive is clearly visible in the 2010 Global detrimental to competitiveness. purchase of advanced technology ultimately could determine the fate of surge in inflation). aspects of government, and Competitiveness Report (GCR) issued products, where Britain ranks 53rd, the British economy – do policymakers promotes a greater degree of by the independent, objective and Anyone who is inclined to question behind such tech-driven economies as and the public actually want a viable • Sterling has remained at depressed consumer protection. highly respected Davos-based World the need for reductions in public Rwanda, Angola and Azerbaijan. economy, if this can be achieved only levels, clearly at an inflationary Economic Forum (WEF). Though still spending should consider such findings at the price of overcoming self-interest cost, but there has been no 6. Finally, it needs to be realised that the world’s eighth-largest economy in conjunction with the analysis The GCR survey’s ranking of the and abandoning many cherished ‘export-led recovery’. the government’s glib-sounding in terms of GDP, Britain’s overall of declining productivity outlined obstacles to business growth is a assumptions and prejudices? “we’re all in this together” is, in competitive position has declined earlier. In short, massive public telling one. First on the list is the If the macroeconomic policy these circumstances, literally true. spending has failed to deliver either overall rate of tax, followed by difficult fixing the obvious from 7th to 12th since 1997. The UK’s cupboard is demonstrably bare, then The financial crisis and its economic the infrastructure or the educational access to finance, the complexity Fortunately, many of the reforms which overall ranking is far less significant, it follows that any solutions which aftermath have revealed a culture of outcomes that might be expected of the tax system, the inefficiency are required if Britain is to restore however, than the detailed findings may be found must lie on the supply- self-interest and blame-shifting that in what remains one of the world’s of the government bureaucracy, competitiveness at the microeconomic of the report. side. The most positive finding of may only be overcome by a complete largest economies. policy instability, restrictive labour level are either low-cost or could this report is that there exists major explanation of what a debt crisis For a start, the effectiveness of regulations, an inadequately educated actually make a positive contribution scope for supply-side reform. would mean at ground level. Those government and its agencies is After the spectacles of bodged IT workforce, poor infrastructure, and a to the Treasury. Some aspects of the who believe that significant cuts in even lower than might generally be programmes, and critical data left on weak work ethic in the labour force. required programme, however, would4. The problem with this, and the trains and in cabs, it should come as no public spending (let alone in public assumed. Out of the 139 countries require the commitment of resources, fourth critical point which needs to surprise to anyone that the GCR finds This independently-established services, or in public sector terms and covered by the report, Britain meaning that savings need to be be grasped by policymakers and the that the process of government has assessment surely acts as an agenda conditions) are unacceptable need to ranks 72nd – behind such models made elsewhere. We believe that the public alike, is that the necessary been conducted in a less than efficient for reform. Whilst none of the GCR ask themselves exactly what might of efficiency as Ghana, Pakistan, government’s deficit reduction targets reforms will cut across many way. Of even greater significance are findings is particularly surprising, the happen to services, and to public Malawi and Egypt – in terms of are the minimum that are compatible vested interests and entrenched the findings of the GCR where they overall impression which emerges from sector pay and pensions, if the British the “wastefulness of government with continued market confidence, and prejudices. To a very significant concern the interaction between the survey is of an economy which economy followed the path already spending”. Perhaps reflecting this, the that there is no economic scope for extent, the ideology of ‘fairness’ government and business. is slipping down the international trodden by Greece and Ireland. quality of the overall infrastructure, further increases in taxation. Moreover, and ‘entitlement’ which has been competitiveness table because of a where the UK ranks 33rd, is worse our analysis suggests that a more absorbed into the public psyche over Led by the then Labour government According to the report, Britain government system which is costly, than that of Barbados, Namibia or realistic appraisal of the economic the last fourteen years constitutes (which, risibly, denied any culpability ranks 89th (behind Egypt, Paraguay, wasteful, inefficient and chronically Slovenia, and the quality of the UK’s outlook means that the government’s the single greatest obstacle on any at all for the financial crisis), different Zambia and Saudi Arabia) in terms prone to meddling. roads (35th) is worse than those of road to reform-driven recovery. interest groups have sought to pin Portugal, Namibia or Croatia. Despite the blame on international markets,58 strategy insights | issue seven strategy insights | issue seven 59
  • 32. thinking the unthinkable | might there be no way out for Britain? deficit targets will not be met unless transfers (£196bn). If, in addition to at these levels. But the number of since broken down, since asset tests spending cuts are taken a great deal ring-fencing health and overseas aid, recipients does seem excessive. alone mean that a high proportion of further than is currently intended. the transfer pot is left unchanged in Government plans to tighten the working people could not in practice real terms, a pretty small cut in overall criteria for incapacity benefit, a move access these benefits if they became Perhaps the biggest single problem spending is leveraged into very painful which clearly is highly desirable, but unemployed. with spending cuts is the way in reductions where unprotected services we believe that technology may make which leverage effects amplify are concerned. another solution attractive where out- To a significant extent, demographic comparatively modest reductions in of-work benefits are concerned. and economic change has divided overall spending into much bigger Within the context that overall public the population into those who inroads at certain levels. spending has become excessive, this We believe that government should receive benefits and those who, leads to the inescapable conclusion move towards paying benefits in kind whilst paying for them, have little Based on the government’s plans, the that transfer spending has to be cut. rather than in cash. Obviously, rent real likelihood of ever being able to maths work like this. The Coalition Within total transfers, interest expense can and should be paid directly to the claim them. We recognise that the plans to reduce real-terms public is outside the government’s control, landlord, not to the benefit claimant, elimination of universal benefits spending from £688bn in 2009-10 whilst the aim is to keep aggregate but the principle could be extended would strain this relationship even to £668bn by 2014-15, a reduction pension outlays broadly flat by raising by the use of smart cards which further, and we would not, in ideal of 3%. However, and resulting from the age of retirement. Within the the claimant could use to purchase circumstances, favour such a course. past increases in public debt, interest overall transfer pot, then, attention approved goods at participating But, with circumstances being very far expense is expected to rise by £24bn. has to be focussed on other payments, shops. The cash/kind proportion could from ideal, we believe that universal This means that ex-interest spending which comprise in-work benefits (such be varied over time, increasing the benefits need to be reduced and, in is set to decline from £657bn to as tax credits and universal benefits), incentive to find work. A card-based some instances, eliminated altogether. £612bn, a fall of 6.7%. Spending and out-of-work payments (such system could also work in favour of on health and on international as unemployment, lone parent and children by ensuring that a specified Within a general need to find further development has been protected and, incapacity benefits). This category of proportion of lone parent benefit economies, the issue of public sector with these also omitted from the expenditure increased by a massive would have to be spent on clothing funding needs to be addressed in a equation, all other spending is set to 87% in real terms between 1999-2000 and other items for children. strictly pragmatic and non-ideological fall by 9.4%, from £527bn to £478bn. (£105bn at current values) and 2009- manner. Though we believe that the 10 (£196bn). The case for looking at Universal benefits are a thorny issue. British state has become far too large But the really big leveraging effect On the one hand, paying benefits to as a proportion of the economy, we do out-of-work benefits is strengthened comes neither from interest nor people on comfortable incomes seems not advocate further marketisation by the widespread (if also widely from departmental ring-fencing, wasteful, but, on the other, these or privatisation of the public mistaken) public perception that but from transfer payments. benefits give the broader community services, since the evidence of the people who work can often seem to be Essentially, government outlays can a stake in the system. Historically, past two decades suggests that this worse off than those who do not. be divided between money which the working people were happy process does not boost productivity, government spends itself (in 2009-10, Despite widespread mythology to to contribute to, for example, tending instead to create top-heavy £339bn) and money which it hands on the contrary, it would be difficult to unemployment benefits, because administrative structures and a to others (£349bn). This latter figure describe out-of-work benefit payments they could be in need of such benefits duplication of functions. Competition comprises interest expense (£32bn), as “generous”, and anyone who believes themselves at some point in the within the public services is, in any state pensions (£121bn) and other otherwise should try living on incomes future. But this relationship has long case, intrinsically artificial. Rather,60 strategy insights | issue seven strategy insights | issue seven 61
  • 33. thinking the unthinkable | might there be no way out for Britain?management of the public services needs to further the public service be developed (presumably by HMRC) claimants. An adverse HSE inspection Fig. 38: Without the bubble #2*should rely instead on a rebuilt social ethic by narrowing the excessive gap to aggregate VAT, PAYE, business is a pretty unusual event, but legalethic, something which marketisation between senior and rank-and file rates and corporation tax into a action seeking compensation is farhas tended to undermine. We also remuneration. single-point system, a process which more of an everyday risk. This risk is by £bnbelieve that the PFI programme has could add value both to businesses no means confined to SMEs, but affects £180proved excessively expensive, and the high value of low-cost reforms and, conceivably, to the Exchequer large businesses and government £160 Deficit Underlying deficitshould be scrapped. Were circumstances more propitious, as well, by cutting out unnecessary departments as well. For example, it £140 we would have no hesitation in complexities. Under Gordon Brown, has been reported that as many as £120Marketisation has resulted in the advocating reductions in the tax Labour seemed to revel in adding ever 30,000 “road accidents” were staged in £100inappropriate aping of private sector burden on small and medium greater complexity to the tax system, the UK in 2010 alone, the aim being to £80practices in the public sector. Senior enterprises (SMEs), by raising the more than doubling the size of the tax make fraudulent insurance claims for £60public sector salaries are often set VAT threshold, exempting SMEs code and often tripping themselves up personal injury.using private sector comparators £40 from corporation tax, and creating in the process (as witness the 10p taxwhen the reality is that there is almost Our preferred solution to the problem £20 enterprise zones in which SMEs are rate fiasco). The Coalition should giveno overlap between the skill sets exempted from business rates as well. very high priority to unravelling this of opportunistic claims would be £0 2002 2003 2004 2005 2006 2007 2008 2009 2010required in the public and private We would advocate focusing any scope inherited mess. to outlaw contingent litigation,sectors. The payment of bonuses in for tax reductions on SMEs because colloquially known as “no win, no fee”.the public sector is inappropriate, as smaller firms are far more job-creative Where regulatory excess is concerned, Deregulation of the legal system has *Source: Tullett Prebon estimatesis the provision of the hefty expense (and, at least arguably, far more there are three main areas of difficulty. allowed this practice – long knownaccounts identified in Sir Philip Green’s innovative as well) than larger These are planning, health and safety, in the US as “ambulance-chasing”report. One of the key findings of the and employment legislation. Small – to feed into the development of a difficult matter, because the required forward, there is no mention of the businesses.Green report was the need for greater firms are at a disadvantage here compensation culture in Britain. The measures would cut across the UK’s weak economy or overstretchedcentralisation in procurement so that In practice, however, the UK’s fiscal because, whilst larger companies can abolition of this practice would need spurious moral absolutism and culture public finances; no mention of thegovernment can leverage its size and situation is so bad that little or no afford to employ specialists in these to be offset by increases to the Legal of entitlement that Labour did so much way in which private pension provisioncreditworthiness to extract greater scope exists for reducing taxation. areas, smaller companies can not. Aid budget in order to ensure that the to foster. has been battered by taxation and byvalue from its contracts with private SMEs often find themselves walking rights of those with genuine (rather low annuity rates; no mention of the Fortunately, a great deal can be done Industrial action over public sector fact that public sector earnings havesector suppliers. through a minefield of HSE and than purely opportunistic) claims are to improve the environment for SMEs pensions provides just one current overtaken private sector wages over employment regulations, all of which protected.Government needs to bear down on without spending much government example of the way in which the the last decade; no mention of the absorb scarce management resourcesmanagement excess both at national money. As the GCR shows, businesses At the same time, SMEs should be spurious values promoted over the fact that the taxpayer ‘top-up’ of the whilst often skewing decisions andand at local level. With the exception of in the UK are hampered by a hefty exempted from almost all labour last decade have created an economy public sector pension shortfall is set to deterring investment.certain highly technical scientific and regulatory burden and an excessively legislation, a move which would be divided by selfishness into warring double over the coming five years; andfinancial posts, there is in general little complex tax system. We should make it abundantly clear cost-free to government but would interest groups. no mention of the fact that final salaryneed for government to pay salaries here that strong health and safety make job creation very much easier. pension schemes have all but ceased to Let’s take fiscal complexity first. It If their representatives are to bein excess of £100,000, and there is standards are essential in a civilised exist in the private sector. should surely be possible to devise an do we want economic viability? believed, these public sector workersmost certainly no need to do so at local society, as are protections for workers. integrated small business tax system ‘will not accept’ plans which wouldauthority level. In addition to the But the risks that firms face arise less Where creating an enterprise culture which strips away complexities by result in working somewhat longersavings to be made from reducing both from the Health and Safety Executive, is concerned, the required reforms are combining all payments to the state and contributing more towards theirthe numbers and the pay and perks of or the Department for Work and pretty straightforward. Carrying them into a single system. Software could pensions. When this argument is putpublic sector managers, government Pensions, than from opportunistic out, however, could be a much more62 strategy insights | issue seven strategy insights | issue seven 63
  • 34. thinking the unthinkable | might there be no way out for Britain?Public sector unions are, of course, second requirement is to build a a process which has been in partexceptional only in their ability to social cohesiveness which can start a logical extension of the nationalbring large parts of the national to overcome the division of society disease of bureaucracy and in partinfrastructure to a stand-still. The into warring interest groups, and a a result of the doctrines of moralnaked selfishness implicit in their third is an imperative need to offer the absolutism and entitlement.intransigence over pensions typifies public some offset to the depressinga broader culture in which broader economic conditions that are now The public also needs to be freedsocial values have broken down in beginning to unfold. from exploitative practices in thethe face of self-interest and greed. private sector, most notably in theDavid Cameron’s advocacy of “the Big We believe that each of these form of “terms and conditions”Society” is targeted directly at this objectives can be furthered by the (known to a previous generation asself-interest ethic, but the big problem creation of a radical ‘liberty agenda’, “the small print”), and also in thefaced by this otherwise admirable getting government off the backs of the form of exploitation of the public’sambition, is that the conflict between public and administrators off the backs lack of understanding of banking andself-interest groups can only intensify of front-line public sector workers. other financial matters. In additionas economic conditions deteriorate. to strengthening existing consumer Where the general public is concerned, protection systems, governmentAnd this is where, we believe, the one of the most distressing features should create a Consumer Court,Coalition needs to offer the public an of Britain’s evolution over the last empowered to set aside onerous,offset to the economic hardship which two decades has to have been the unreasonable and one-sidedhas become unavoidable. relentless spread of surveillance and contractual terms. coercion. Britain is plastered withneeded – a liberty agenda warning notices, CCTV and speed The scale of Britain’s underlyingAs has been outlined in detail in this cameras, and other aspects of the economic weaknesses is such thatreport, the economic outlook for the surveillance state. Government needs David Cameron and Nick Clegg cannotUK is grim, and individuals can longer to start stripping away much of this realistically expect to make Britainbe insulated from this by government panoply of surveillance and coercion, a richer country, but they can most Disclaimerborrowing. One requirement that and to enshrine in law the primacy certainly make it a freer one. The information in this communication is provided for informational and demonstrational purposes only and neither is it intended as an offer or solicitation withhas been established here is to of individual liberties. The Coalition respect to the purchase or sale of any security nor should it serve as the basis for any investment decisions. In the UK, this material is intended for use only by personsfree up SMEs to invest and create cannot leave the electorate better off who have professional experience in matters relating to investments falling within Articles 19(5) and 49(2)(a) to (d) of the Financial Services and Markets Act 2000jobs, a requirement which means in 2015 than they were in 2010, but (Financial Promotion) Order 2005 (as amended), or to persons to whom it can be otherwise lawfully distributed.reversing much of the complication it can certainly leave them freer from Any reference to ‘Tullett Prebon’ refers to Tullett Prebon plc and/or its subsidiaries and affiliated companies as applicable.and bureaucratic meddling which the meddling of the state. Over the Neither Tullett Prebon plc, nor any of its subsidiaries (collectively, “Contributors”) guarantees the accuracy or completeness of the information or any analysis basedwas forced upon businesses by past twenty years, the “nanny state” thereon. Neither Tullett Prebon plc nor Contributors make any warranties, express or implied, with respect to the information (including without limitation anyLabour’s moral absolutism. But a has mutated into the “bully state”, warranties of merchantability or fitness for particular purposes) and neither Tullett Prebon plc, nor Contributors shall in any circumstances be liable for economic loss or any indirect, or consequential loss or damages including without limitation, loss of business or profits arising from the use of, any inability to use, or any in accuracy in the information. Tullett Prebon provides a wholesale broking service only. It does not provide services to private clients. Tullett Prebon (Securities) Limited and Tullett Prebon (Europe) Limited are authorised and regulated by the Financial Services Authority (“FSA”). This publication is produced and distributed in accordance with ‘COB 12.2 – Investment Research’ of the FSA Handbook. Recipients should note that all such publications are objective and impartial in their content unless clearly notified otherwise. The author(s) act in accordance with Tullett Prebon’s ‘Conflict Management Policy’, full details of which can be viewed on our website at www.tullettprebon.com.64 strategy insights | issue seven TPSI 007 | July 2011

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