It is my fear that the UK economy is likely to recover more slowly over 2012 than market commentators have previously forecast.
That’s because the outlook for global growth has deteriorated substantially in recent months, due both to policy errors and the prospect of further fiscal tightening in the US and Europe. This is likely to weigh on the UK’s “export led recovery”. Forecasts will likely be chopped in aggregate to around 1.5 per cent, but while exports remain a key driver of the recovery, they do now make a smaller contribution and the main reasons to expect weak growth are fiscal consolidation and a weak recovery in investment.
Despite this apparent gloom, we can still expect a small acceleration in activity in the UK over 2012. There are modest grounds for optimism on growth in real disposable income owing to less weakness in real wage growth, and there may be a small fall in the savings rate, as households deleverage and credit constraints ease. The Olympics should also provide a one-off boost to activity.
As for the monetary policy backcloth, lingering concerns over growth are likely to discourage the BoE (Bank of England) from a near-term rate rise. But what of Quantitative Easing (QE)? Certainly the BoE’s medium-term outlook for weak growth does not appear inconsistent with further QE. If the UK economy did slip back and growth contracted, then this would substantially raise the chance of further QE. We expect inflation pressures to persist.
But there are much bigger issues for the economy, in particular a strange sense of xenophobic triumphalism circulating in the London markets as peripheral Euroland debt has been priced lower. The mood is one of yet ‘but for the grace of God go I’, with the UK mired in debt, and our economy clearly weak.
FINDING A SOLUTION
Each side of the political divide has a different take on the best solutions, with the coalition government believing the huge fiscal deficit must be eliminated and its opponents arguing fiscal tightening will undermine growth prospects. Clearly growth is important but so too is constraining the build-up of debt, and there is a realistic chance that both sides’ warnings are correct but that neither side’s prescriptions will work.
Although we observe and manage assets rather than indulge in political positioning, it is apparent and important that radical solutions are required if a debt disaster is to be averted in the UK.
The key options for policy lie in supply-side reform. Unfortunately, public opinion may be inimical to the scale of reform required and the general public are probably unaware of the true scale of Britain’s debts. Public debt, widely reported as 60 per cent of GDP, rises to 75 per cent on the Maastricht Treaty definition by which countries such as Greece, Ireland and Portugal are measured, and even with optimistic assumptions about growth, revenues and the deficit, the government concedes debt ratios are set to rise further.
Of more immediate concern, official debt numbers exclude the net present value of unfunded public sector pension commitments and obligations under Private Finance Initiative contracts. Together, these total an estimated £1,350bn (€1,600), lifting the total of public debt and quasi-debt to £2,460bn (167 per cent of GDP). In addition, the potential costs of financial sector interventions total £1,340bn, and taken altogether, the UK can be seen as a heavily indebted European peripheral country.
The government is undoubtedly right to assert the UK must achieve a drastic reduction in the pace at which public debt is rising. This is not a political statement, but simply reflection of what would happen if the UK continued to run primary deficits at the 2009-10 level. In recognising the imperative to reduce the deficit, the government has set out its plan whereby modest spending cuts in real terms coupled with a big increase in revenues, reduces the deficit from 11.1 per cent of GDP in 2009-10 to 1.6 per cent by 2015-16.
The problem with the plan is that it depends upon ‘heroic’ economic assumptions, most notably delivery of growth of 2.9 per cent by 2012-13. At 2010-11 values, and after allowing for an expected £25bn increase in debt interest, the government plan requires that the gap between revenue and expenditures be narrowed by £159bn. Increases in tax rates will contribute £31bn, and spending cuts a possible £44bn (so long as unemployment falls as the government expects), but the bulk of deficit reduction is expected to result from a growth-created £84bn increase in tax revenues.
If growth were to come in at half of the official target, interest costs and other spending would rise, tax revenues would fall very far short of expectations, and the plan would unravel.
