Will the Debt Crisis Spread to the UK?

There is a concern that the EU sovereign debt crisis will spread to the UK.

• Firstly, this year the UK budget deficit is forecast to be higher than both Spain and Greece. The OECD predict UK's debt will be 13.3% of GDP this year compared to 9.7% for Greece and 8.5% for Spain.
• Confidence in the government bond market is plummeting. It means there is going to be extra scrutiny from investors; with market sentiment so fragile, foreign investors especially may be reluctant to hold bonds in any country with double digit annual borrowing.
  
• A Hung Parliament is not Going to Help. The general election could well create a hung parliament with wrangling over coalition governments and how to deal with deficit. It would be hard enough to cut spending with a strong majority, but, with coalition partners it will be more difficult

Hopeful Points of UK

1. We have More Longer Term Bonds. The UK has one of the highest percentages of long term bonds. The average debt maturity is over nine years. This means we need to refinance bonds less frequently. Long term bonds give greater stability in times of crisis. Though, we still have to sell many new bonds coming onto market. (see: National debt ceiling)
   
2. Flexible Monetary Policy. At least we have an option of depreciating the exchange rate and pursuing quantitative easing if necessary. This should ensure we have greater flexibility in avoiding deflation, which would be very bad for bond market and economy. However, the UK economic recovery still looks fragile. It is not clear our monetary policy has delivered strong growth yet.
3. Recovery in Finance Sector. The recovery in bank profits may be galling for many. But, it has left the Treasury with a paper profit on bank shares. When we bailed out the banks last year this looked hard to imagine. But, it definitely helps make our fiscal position look more attractive.
4. No history of defaulting on debt unlike Greece.
5. We have been through worse (national debt over 200% in late 1940s - see: Historical national debt). Though, I'm not suggesting we could cope with anywhere near those debt levels now. Many factors are different e.g. lower private sector saving rate.
   

• UK National Debt
• Facts about National Debt
  

Economics of Elections

'It's All About the economy stupid'

Although this is often a refrain at election time, it often isn't about the economy. In 1983, the incoming government had just presided over a deep recession and a rise in unemployment to 3 million, but it won a landslide. By 1992, the Lawson boom and turned sour and the economy again faced a recession largely of the government's own making. Yet, despite the dire economic situation, the government were re-elected.

So maybe there is hope for the incumbent Labour government. The longest post war recession may have ended, but, it is not going to fade from people's minds. Unemployment remains high, and just for annoyance, we have recent bad news on inflation and the pound.

Unlike 1983, and 1992, the government may have a better claim when they say it wasn't their fault. The causes of this economic crisis are many and varied, only some can be laid at the door of the present government. However, voters are not always rational in deciding the precise causes of the recession.

Perhaps the more important factor is will voting for any particular party make any difference to the difficult period after the recession? The first problem is actually finding out what the parties policies are. There are vague talks of spending cuts all round, but, this mainly involves promises of what they won't cut. When one hears the campaigning of parties, one cannot help but remember the immortal Shakespeare:

Told by an idiot, full of sound and fury,
Signifying nothing. (Macbeth 5.5)

One potential difference is the speed of deficit reduction. Labour and Lib Dems have promised to wait longer into 2011 before implementing spending cuts and deficit reduction policies. The Conservatives have said this may be too late and threaten the UK's credit rating.

Both sides have reasonable arguments - The fear of pushing the economy back into recession, versus the fear of losing confidence in the market - the recent travails of Greece is no laughing matter.

However, I would err on the side of ensuring economic recovery, even at the risk of delaying medium term deficit reduction. Economic growth is essential to reducing the deficit and we should not threaten this through over-eager deficit reduction.

Where Should The Axe Fall?

You might imagine that the different parties would have much different targets for spending cuts. However, the main parties seem to have done the same market research and are saying some areas like Health care and education are 'untouchable' and will not be cut.

This is a shame because although health care and education is a noble public service, it doesn't mean it should be a sacred cow. The number of health care administrators has mushroomed in past decade. There are no reason why this could not be an area for potential cuts. What it means is that less politically popular areas like defence and transport will be the target. In the case of transport this could be a shame. If we have potholes in roads, a creaking train system and underinvestment - it will be the economy which suffers in the long term.

There was a time when I would get very excited at election time. I think I was once even a member of a political party. These days I'm more concerned with developing strategies for avoiding canvassers who come knocking on the door. As far as economics is concerned it would be mainly a relief when election is over - preferably without interminably wrangling over a coalition government.

Related

• Politics and Economics of the Budget

Volatile Economy and Inflation

A few weeks ago I might have been more excited at the volatility of CPI inflation which recently rose to 3.4% (CPI). The RPI figure is even higher at 4.4%. However, somehow this kind of volatility pales into insignificance when you are stuck on the wrong side of the Atlantic tentatively praying a small Icelandic Volcano may become less volatile in its outpourings of ash.

CPI Inflation in UK

Source: ONS

Why Has Inflation Risen in the Middle of Recession?

• Cost Push factors. Rising petrol prices have caused transport costs to rise 11%. The highest rise since 1997.
• Part of the rise is due to the fact, this time last year prices fell for household services.
• One reason analysts are not concerned about the rising inflation is that the inflationary pressure is likely to be temporary. It is similar to the inflation spike in September 2008. The rise in inflation is definitely not due to excess demand in the economy.
  
• The Bank of England have maintained a very loose monetary policy - 0.5% interest rates, quantitative easing. There has been no premature tightening of monetary policy.
  

How Much Should We Worry About Inflation Being Above Target?

• Given state of economy, the positive inflation rate is better than deflation or a very low inflation rate. Deflation would increase the real value of debt - making it more likely people spend less.
• Moderate inflation helps reduce government borrowing as a % of GDP.
• The inflation gives the government more room to tighten fiscal policy (higher taxes and lower spending) to reduce government borrowing.
• These days inflation above 3% feels high, but, it is a far cry from 1970s and 1980s when inflation often reached double figures.
  

Who Loses From this Inflation Rate?

• It is a bad time to be a saver. Inflation at 3.4% is much higher than base interest rates. It is a negative real interest rate, reducing the real value of savings.
• If this inflation continues, bond investors will require higher interest rates to compensate for the decline in the real value of interest payments.
• There is a danger inflationary expectations may change and it will become more difficult to keep low inflationary expectations.

Related

• What is Optimal Inflation Rate?

A Little Volcano and an Extended Holiday

Fortunately or unfortunately I am stuck in New York awaiting a flight back to UK.

After spending several hours phoning Airline companies to rebook the motivation for writing Economic posts somewhat dissipates. But, I should have time now for writing.

Economic Recovery in UK

By nature I'm an optimist, I'm always looking for the light at the end of the tunnel and suspicious of the tendency to magnify the doom and gloom which surrounds the economy. (economics of fear)
However, even the bravest optimist would have to admit defeat at the tide of bad news that has surrounded the economy in the past two years.

Yet, it might be that after the unprecedented stimulus to the economy, (months of 0.5% interest rates, quantitative easing, biggest peacetime fiscal deficit) the economy is finally beginning to return to strong growth. A recent report by the OECD suggests the UK could have the second highest growth rate in the OECD at 3.1% in 2010.

This would be very beneficial for the economy in many respects. The chancellor's recent forecast for deficit reduction was based on such an optimistic growth forecast. A few months ago this kind of growth forecast appeared to be more wishful thinking rather than based on reality. If the UK does grow this strongly, it will take some pressure off the bond market. Markets would have greater faith in our ability to pay off the record debts. The UK could well hang on to our valued AAA rating and it could give any government greater time to deal with the scale of the fiscal deficit.

Of course, one year of 3% growth is still going to leave a structural deficit of very significant proportions. And whilst growth of 3% would help to reduce unemployment, there is still a long way to go before the level of spare capacity is overcome.

The economy is still threatened by prospect of tax rises, spending cuts, oil price increases, recession in Eurozone. But, the job of any chancellor would be an awful lot more difficult if we had a growth forecast of 0%. Spare a thought for Greece, stuck in recession and facing a sell off in bonds despite an attempt to tackle the budget deficit.

Impact of a Weak Euro

It's been a bad week for the Eurozone. Growth in the last quarter of 2009 has been revised downwards to 0.0%. Markets show no sign of letting up on the Greek Bond Market. Continued sell offs have pushed interest rates on Greek bonds to 'unsustainable levels'

The impact of this bad news has been to weaken the value of the Euro. What will be the impact of a weaker Euro on the EU economy.

A weaker Euro would make Eurozone exports more competitive and increase the cost of importing goods into the Eurozone. It is bad news for exporters to the Eurozone (though it will not really hit UK exporters as the weakness of the Euro is being matched by weakness in Sterling)

A weaker Euro would make exports cheaper and could provide a boost to EU growth and employment. This is particularly important for Eurozone countries who rely on export led growth such as Germany.

However, the impact of a weaker Euro may be limited. Evidence suggests that demand for exports is often inelastic, a weaker currency is no guarantee of strong growth. The UK has had a weaker currency but, recovery has been weak. The impact of a weaker Euro will have a different impact within the Eurozone. I can't image a 10% devaluation in the Euro currency solving the lack of competitiveness within the Greek and Spanish economy. Much more is needed than a depreciation in the Euro. It is also important to bear in mind, the majority of trade in the Euro is within the Eurozone. For example, a depreciation in the Euro would not restore the competitiveness of Spain's exports with regard to EU partners such as France and Germany.

Inflation and A Weaker Euro

The ECB may be concerned that a weaker Euro could lead to inflation. A weak currency may cause inflation for three reason.

• Price of imports rises (cost push inflation)
• Demand for exports rises (demand pull inflation)
• Less incentives for exporters to cut costs and increase efficiency.

Given the state of the EU economy, I feel inflationary pressure is very limited. But, the ECB are apt to give great importance to inflation (even when not justified). Therefore, it could raise the prospect of early interest rate rises for the Eurozone area.

Overall

Given state of Eurozone economy, a weaker Euro is no bad thing at the present moment. Overall, economic growth is sluggish, and a weaker Euro may help to boost recovery. However, a weaker Euro will do nothing to redress the imbalance within the Eurozone area. The depreciation is likely to be too little for the south (Greece, Spain e.t.c) It may prove too much for Germany. Far more is needed to solve the pressing problems in many Eurozone economies.

Forecast for Euro

It is hard to see any end in sight to the problems of sovereign debt prospects. If markets become fearful of countries like Italy and Spain the Euro could come under much greater sustained pressure.

Problems Facing Eurozone Economy

At the start of the global recession, the Euro appeared to be faring relatively well. Germany and France were two of the first major OECD economies to emerge from recession. The collapse of Iceland had many people suggesting the Euro as the solution to global instability. However, in the past few months, the growing problems of Greece and other peripheral Eurozone countries have highlighted some of the problems with the bold Single Currency experiment.

The first problem facing the Eurozone is the prospect of a deep and persistent recession in the southern Eurozone economies. Greece, Spain and Italy already have falling GDP, but, current economic policies make it hard to see how they will recover.

Debt and Default

The Maastricht Criteria was supposed to limit government borrowing to 3% of GDP. However, this has been ignored. Greece is borrowing 12% of GDP. Italy and Spain are not far behind. Eurozone economies facing crippling national debt burdens. The irony is that the strength of the Euro enabled Greece and Italy to borrow for a long time at low interest rates. If they had not the strength of the Euro, markets may have charged higher rates earlier - there may have been market pressure to contain borrowing at an earlier stage.

However, the level of debt has raised the prospect of a sovereign debt default. This has worried markets causing the recent sell off of Greek gilts. The problem is not just confined to Greece, but, also the much larger economies of Italy and Spain. Prospects of debt default or just higher interest rates will undermine the strength of the Euro.

The problem is that the EU doesn't like the idea of bailing out profligate countries. There is not just the political problem of using German tax revenues to pay for a bloated Greek civil service. There is the real problem of Moral Hazard - where is the discipline to contain borrowing if the pain can be shared by your neighbours?

The other problem is that very stringent policies to reduce borrowing (tax rises, spending cuts, wage cuts) will damage the economies GDP. Yet, there are no other policies to fall back on to boost Aggregate Demand. They have to pursue tight fiscal policy, but, cannot loosen monetary policy or depreciate the exchange rate.

Unequal Labour Costs

One of the underlying problems in the Eurozone is the increased divergence of wage costs and competitiveness. Rising wage costs in Greece, Italy and Spain have made them uncompetitive, leading to large current account deficits, falling exports and higher unemployment. In the past, this would have caused a depreciation in their exchange rate and their competitiveness would have been regained. But, of course, this can't happen in the Eurozone.

Non Optimal Currency Area

Why does a single currency work in the US but not Eurozone? An unemployed person in California can relatively easy move to Texas to get a new job. But, the unemployed Spanish worker faces much more geographical immobilities to moving north (to say Germany or France). The lack of Geographical mobility and the geographical divisions means the Common Monetary policy can't meet the varying needs of different Eurozone Economies. see: Is Eurozone optimal currency area?

One Monetary Policy Doesn't Fit.

If Germany is growing strongly, due to rising productivity and exports, the ECB will wish to pursue a tight monetary policy - higher interest rates (certainly no quantitative easing). However, an economy like Greece is facing deflationary pressures - wage cuts, falling prices, rising unemployment. However, the south of the Eurozone needs the expansionary monetary policy the UK implemented - quantitative easing, prolonged zero interest rates. But, in the Eurozone, you can't have different monetary policies.

Related

• Problems with Greek Economy
• Problems with Spanish Economy
• Difficulties of leaving Euro