Thinking the unthinkable - might there be no way out for Britain?

Page created by Margaret Goodman
 
CONTINUE READING
thinking the unthinkable
                           might there be no way out for Britain?
Tullett Prebon Group Ltd
155 Bishopsgate                     project armageddon – the final report
London EC2M 3TQ
Tel: +44 (0)20 7200 7000                    Dr Tim Morgan Global Head of Research
Fax: +44 (0)20 7200 7176
www.tullettprebon.com

                                             strategy insights | issue seven
the final report of project armageddon

thinking the unthinkable
executive summary

The United Kingdom is mired in                                  assumptions about growth, revenues        Such an approach would drive the
debt, and her economy is flat-lining.                           and the deficit, the government           public debt ratio to 100%2 by 2015 and
Each side of the political divide has a                         concedes that debt ratios are set to      150% by 2021. The latter number is
different take on the best solutions                            rise further.                             irrelevant, because it is clear that, on
to these problems. The Coalition                                                                          any such debt trajectory, the UK would
government believes that the huge                               Official debt numbers exclude the         be forced into some form of default
fiscal deficit must be eliminated.                              net present value of unfunded public      long before then.
Its opponents argue that fiscal                                 sector pension commitments and
tightening will undermine the                                   obligations under PFI contracts.          Recognising the imperative need to
prospects 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 increase
to examine the possibility that both                            trillion (167% of GDP). In addition,      in revenues, will reduce the deficit from
sides’ 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 European
unsupportable without sustained                                 peripheral country, a fact which forex    The snag with this otherwise admirable
economic growth, and that the                                   markets alone seem to have recognised     plan is that it depends upon some
economy, 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 expected
debt disaster is to be averted. All                             has lifted outstanding mortgage           £25bn increase in debt interest, the
macroeconomic options have been                                 debt to £1.2 trillion, whilst unsecured   government plan requires that the gap
tried, and have failed. The only                                consumer credit exceeds £210bn.           between revenue and expenditures
remaining options lie in the field of                                                                     be narrowed by £159bn. Increases in
supply-side reform. Unfortunately,                              These levels of debt are manageable       tax rates will contribute £31bn, and
public opinion may be inimical to the                           if – but only if – the economy can        spending cuts a possible £44bn (so
scale of reform that is required.                               deliver growth.                           long as unemployment falls as the
                                                                                                          government expects), but the bulk of
mired in debt                                                   roads to nirvana?
                                                                                                          the deficit reduction is expected to
The general public are probably                                 The government is undoubtedly right       result from a growth-created £84bn
unaware of the true scale of Britain’s                          to assert that the UK must achieve        increase in tax revenues. If growth were
debts. 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 spending
Treaty definition by which countries                            test this assertion, we have projected    would rise, tax revenues would fall very
such as Greece, Ireland and Portugal                            the implications of continuing to run     far short of expectations, and the plan
are 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 year
2
    Debt ratio on the Maastricht Treaty definition                                                        strategy insights | issue seven         1
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 the
is critically dependent upon the                  retailing is precluded by falling         towards debt and public spending,          £390bn of fiscal stimulus and £200bn        onerous burden of regulation which
restoration 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 a
the economy – aligned                             Together, the severity of Britain’s       simultaneously transferred resources       be better labelled ‘Brown lite’, is not     full-blown economic crisis is to be
against growth                                    indebtedness and the challenging          from private industry into a public        worthy of serious consideration. In the     averted, will be opposed by interest
Our 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 much
British 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 was
is 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. In
anywhere near the levels required by              damage requires the clearest possible     British economy.                           nothing more than a pain-deferral           many instances, choices will have to be
the 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 of
In 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 economic
dependent upon debt. Taking public                result from grotesque mishandling         by the promotion of a culture of moral     misalignment unravels, property             The outstanding questions where
and private components together,                  of the economy under the 1997-            absolutism centred around spurious         prices can be expected to fall sharply,     Britain’s economic future are
debts have increased at an annual                 2010 Labour administration. Gordon        and selective concepts of ‘fairness’.      unemployment to remain high, sterling       concerned lie less in the mechanics
average 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 of
2003. 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 support
economy have been private (mortgage               that the Bank of England determine        entitlement, is the biggest obstacle in    to out-pace earnings.                       for reforms which both challenge
and 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 of
public 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 boom
Reflecting 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 unsustainable
activities, 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 has
largest 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 pain
services 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-time
incapable 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 to
private borrowing has evaporated.                                                                                                      Rather, these benefits have to be
                                                  apparent expansion in the tax base        be unpleasant.                                                                         At present, we see very little sign that
Another three of the top eight                                                                                                         earned, not borrowed.
                                                  that had resulted from the property-                                                                                             the Coalition government is prepared
sectors (health, education, and public            driven boom. Real public spending         The widespread assumption that the
                                                                                                                                       With all macroeconomic options              to promote economic growth and
administration 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’s
for 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 and
now 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 low
58% of the economy is ex-growth, a                spending and falling tax revenues.        interest rates (which have been close
figure that could rise to 70% if,

2         strategy insights | issue seven                                                                                                                                                                                     strategy insights | issue seven   3
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                                       64

4   strategy insights | issue seven                                                                              strategy insights | issue seven   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
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 in
Three 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 are
and 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 interference
huge 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 of
by 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 to
sectors 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 unshackle
economic 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 2011
the ‘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 which
a 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 public
and 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 than
each 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 by
spending 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
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 basis

10        strategy insights | issue seven                                                                                                                                              strategy insights | issue seven                        11
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 the
in 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 huge
For 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 debt
remain 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 of
to 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 with
at 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 and
a 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 is
Even 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 for
a 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 real
sector 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 who
not), 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), and
the 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 much
been 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 of
taken 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 sale
financial 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 obligations
12          strategy insights | issue seven                                                            (£1180bn) + PFI commitments (£170bn) = £3,569bn                                                                                                strategy insights | issue seven       13
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
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 calculations

16        strategy insights | issue seven                                                                                                                                                 strategy insights | issue seven        17
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 public
the borrower – in this instance, the                      would, no doubt, be employed in an              debts are orders of magnitude larger
British 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 an
increases 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 acceleration
result of the compounding effect of                       in inflation accepted as a necessary            We have described here the implications
accumulated interest commitments.                         evil because it would destroy the real          of sustained high primary deficits at
The reality is that this process would                    value of outstanding debt. The interest         some length, but one word would
be 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 soaring
recognition. As rates rose, the spending                  rates savaged affordability. A large            Of course, the government’s opponents
capability of consumers would slump,                      proportion of Britain’s 11.4 million            would argue, quite rightly, that they
whilst inflation would surge in response                  mortgage-payers would be reduced to             would not for a moment suggest
to 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 calculations

18             strategy insights | issue seven                                                                                                      strategy insights | issue seven   19
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 turn
that 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 the
budget 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 tied
in 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 far
This, 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 the
First, 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 growth
government have provoked hostile                  2009-10, the Labour administration                                                      further assume that revenue remains                          Government argues that this                             Opponents of the government make
responses 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 the
naked 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, but
following 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 fiscal
given 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 planned
severe pressure from selfish interest             modest returns in terms of growth.          expenditures. With the exception of                                                                      when they describe as ‘massive’                         by the administration will undercut
groups. 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 too
approach 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 the
above those already anticipated, and              economy is currently doing no more          hikes and, in addition, has raised the
these costs would exert a crowding-               than flat-lining.                           rate of VAT from 17.5% to 20%. Between
out 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 debt
spending. In any case, it is highly                                                           projected to rise from 36.8% to 38.9% of
probable that a gradual reduction of              government plan                             GDP, yielding an anticipated 22% real-
                                                                                                                                                           Deficit as % GDP                                                                  Debt as % GDP
the 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%                      Budget
since 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%                      period
report, 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          2030
is a combination of private and public            government, is for a period of painful      after 2012, but will remain far higher
borrowing but, as private borrowing has           adjustment followed by much-                in 2016 (80%) than in 2010 (71%), let
now dried up, government would have               improved economic performance.              alone 2008 (44%).                           *Source of charts: Tullett Prebon projections                                      *Source of charts: Tullett Prebon projections
to carry the entirety of any borrowing            The Coalition administration argues,
burden going forward.                             quite correctly, that it inherited a

20        strategy insights | issue seven                                                                                                                                                                                                                       strategy insights | issue seven             21
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
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 – debt
ease the pressure on government                   comparison with the 16% assumed by           increasing (fig.12), putting interest costs
welfare spending.                                 the government.                              on an upwards trajectory.
                                                                                                                                                              Deficit as % GDP                              Debt as % GDP
Unfortunately, these forecasts appear             If this were to happen, the government’s     Such a scenario poses a clear threat                    14%                                           140%
                                                                                                                                                                   Budget                                        Budget
to 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 can
In order to assess the deficit                                                                                                                           2%                                           20%
                                                  and higher interest expense could absorb     be expected to rise, turning the debt
implications 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        2021
growth are half of those projected by             only £45bn would be achieved, leaving        The government’s plan, then, depends
the 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 calculations
1.4%, 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
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 Database

26        strategy insights | issue seven                                                                                                                                                strategy insights | issue seven        27
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 exception
borrowing 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 of
factored 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 sector
annual 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 public
private 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
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 the
whilst manufacturing output had                                   industries, and indexes the real value                        public sector, and have been powered
declined 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 and
estate, increased their output by 47%                             Over that period, CREF output                                 construction (29.6%) are leveraged to
and 31% respectively. Tellingly, of the six                       increased by 42%, and the public sector                       net mortgage lending, which collapsed                       As % GDP

fastest-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%
                                                                                                                                                                                                                  Government
administration 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 is
to draw a hard and fast distinction                               barely 1.4% in the absence of                                                                                       0%                                                                                                                                             10%
                                                                                                                                accounted for by sectors which are, at
between ‘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 even
and ‘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%. The
and 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, ONS

30           strategy insights | issue seven                                                                                                                                                                                                                                                       strategy insights | issue seven        31
You can also read