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Tim morgan report_007

  1. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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