Growing euro crisis raises the stakes

 
Allister Heath
IT’s all starting to feel a little too much like we’ve returned to 2007. First a few little-known mortgage lenders, then Bear Stearns (Greece) in early 2008, then Freddie and Fannie (Ireland) – and then, eventually Lehman Brothers (Italy or Spain?) and the whole pack of cards came crashing downs. What at each stage seemed imminently containable soon enough turned into a financial and economic disaster.

Fortunately, we are not there yet. UK banks have substantial exposure to Irish assets. Nevertheless, so far investors have been relaxed about the UK, partly because there is a big difference between exposure and a loss. Britain is unlikely to be dragged down in any substantial way by Ireland, Portugal or Greece. Worryingly, it is tough to work out what is really happening in Spain or Italy. If those countries were to hit the rocks, an EU-wide double-dip recession and generalised calamity would be inevitable.

With Democratic-controlled California also teetering on the brink, and the Republicans in Congress in no mood for clemency, the spectre of sovereign defaults will be the greatest risk facing the world economy in 2011, above even the risk of China’s credit bubble going pop.

So far, the gilts markets have stood up well, largely because investors are convinced that the coalition won’t be turning on its plan to balance the budget. As analyst Michael Saunders of Citigroup points out, central government revenues are up 9.2 per cent year on year in the fiscal year to date, well above the Office for Budget Responsibility’s (OBR) forecast for the full year (6.7 per cent). Revenues have been fuelled by higher-than-expected nominal GDP growth (5-6 per cent year on year compared with the OBR’s forecast of 4.4 per cent growth for the whole year, in part because inflation is overshooting), the first VAT hike (back to 17.5 per cent, boosting revenues by about 2 per cent). Corporation tax receipts are up 28 per cent year on year in April-October.

The problem for the British government is that austerity is not fully being implemented, contrary to the rhetoric. Total central government current spending and net public investment rose 5.9 per cent year on year in April-October where the OBR projects a 4.2 per cent gain over the full year. Part of this overshoot reflects higher interest payments, including indexation on index-linked gilts. But public investment also has fallen less than expected so far, dropping 5 per cent in April-October whereas the OBR projects 21 per cent drop over the full fiscal year.

There is one more piece of good news, courtesy of Citigroup. Since May 2006, the monthly deficit has been revised down 41 times from the initial data, with only 12 upward revisions. For the last 12 figures, the deficit has been revised down 10 times and only twice upwards. For that 12-month period, the cumulative downward revision has been a massive £24bn.

Our public finances are improving and will make it easier to deal with small-scale sovereign crises. The rest of the EU has a much bigger problem, however: it has no solution to the fact that the euro is clearly not working and actually fuelling booms and busts. And its resolution procedures for failed states remain confused and opaque. It still seems as if the UK at least will be all right. But the chancesthat we won’t be have started to go up.
allister.heath@cityam.com