Tuesday, January 3, 2012

Is UK at Risk from Eurozone Crisis?

In his New Year's message, David Cameron declared Britain can only gain 'some protection' from the Eurozone debt crisis. Despite deep spending cuts, Cameron admits it might not be enough to prevent problems from Europe spreading to the UK.

I'm not a great fan of credit rating agencies, but it was interesting that Moody said the threat to the UK's debt position came from prospects of a double dip recession (and not a failure to cut spending more).

In other words, the fall in economic growth that has occurred since the start of 2011, is the biggest threat to the ability to satisfactorily reduce debt to GDP ratio.


UK public sector debt is currently 62% of GDP. How did the UK deal with its public sector debt of over 200% which occurred in the early 1950s - Debt which was a legacy of the Second World War and bold spending on the Welfare state post 1945?

One reason was a loan from the US (who were fearful of a Communist governments springing up in Europe). Today, there is no chance of similar loan from the US. But, the US loan is only part of the story. The main reason is that the UK were enable to maintain two decades of fairly constant economic growth. The rise in GDP, meant that the government could steadily reduce debt to GDP, without resorting to spending cuts. It is a similar story in the US, whose large national debt post 1945 was steadily reduced over next few decades.

An elected government of 1945 could easily have panicked at levels of national debt in the aftermath of Second World War. They could have used these debt levels as an excuse to cut spending (rather than setting up NHS and Welfare State). But, spending cuts in the 1940s, would have caused a very different economic recovery. With aggressive spending cuts, the UK economic growth would have been much lower, tax receipts would have been smaller, it would have been much more difficult to reduce debt to GDP ratio.

The mistake the UK made in 2009 was to consolidate too fast. Outside the Eurozone, the UK never had a surge in bond yields. Countries which pursued austerity with vigour singularly failed to prevent surging bond yields. As Oliver Blanchard of IMF said (Four hard truths):
To the extent that governments feel they have to respond to markets, they may be induced to consolidate too fast, even from the narrow point of view of debt sustainability.

They (markets) react positively to news of fiscal consolidation, but then react negatively later, when consolidation leads to lower growth—which it often does.
Not all is negative. In 2012, falling inflation will reduce the squeeze on living standards. But, with a renewed slowdown in Europe, it will be much harder to boost economic growth and reduce unemployment.

Yes, the UK is at risk from the Eurozone crisis. A fall in exports to Europe would reduce economic growth, when it is already stagnant. Also, prolonged crisis in Europe can only adversely affect UK confidence.

2012, will be a tough year.


QP said...

I struggle to understand why all the focus is on government debt (particularly when it is monopoly issuer of currency) when this pales into insignificance when you look at private debt.

I find this assessment more enlightening:

The UK is most at risk from itself.

Health and Safety said...

In my opinion we are safe enough and it does help that we are not in the Euro and we have kept the Pound. This also means we can keep a distance from many of the problems being felt elsewhere.