UK should brace itself for austerity


OVER the next few months the British electorate will wake up to the reality of what it means to live in a country with a budget deficit of £163bn. The bleak truth is that few will be immune to the tax hikes and spending cuts that will inevitably hit over the next year or so.

Whoever wins today’s election may indeed come to rue the day that he took on this gigantic task. But the decisions that he takes on the deficit will leave a legacy that will affect the performance of the UK economy for the next generation.

The spectacle of the Greek fiscal crisis provides a frightening backdrop for other governments that have been living beyond their means. General strikes and closed hospitals and schools are not events which promote stable governments. Greek workers cannot be blamed for objecting to the savage cuts in pay and benefits that have been announced this year, but the unions must recognise that the nation cannot afford to carry on without reform.

The escalation of Greece’s crisis meant that the country could no longer afford to issue debt on the open market because investors were demanding such a large risk premium to hold Greek paper. Without loans from the International Monetary Fund and the European Union to tide it over, Greece would be faced with no option other than to default on its debt and to potentially leave the Eurozone – events which may yet prove unavoidable.

Other countries have managed to turn around their fiscal affairs with less fanfare. For example, Sweden and Canada had considerable success in reversing their fortunes during the 1990s. At the start of 1990, Canadian 10-year bonds were yielding around 150 basis points more than their US counterparts. The spread is currently around -5 basis points; a change that was won after painful fiscal austerity.

The market is also currently rewarding Ireland’s fiscal prudence. Although Ireland has a budget deficit of 14.3 per cent of GDP – above Greece’s 13.6 per cent – 10-year bond yields in Ireland are around 390 basis points lower than Greek paper, reflecting expectations that a default is less likely. The Irish are swallowing the pill of austerity, perhaps not happily but far more pragmatically than Greece.

In May 2009, Standard & Poor’s revised its UK debt rating outlook to negative from stable. The markets reacted pragmatically and assumed that there was no real risk of a UK funding crisis. This attitude is still protecting UK government debt from any adverse fallout from the Greek crisis; in fact, yields have fallen slightly relative to their levels at the end of April.

However, this assumes the new government will tackle the deficit and the electorate will accept it. The risk of a hung parliament raises the prospect of lengthy coalition negotiations which could delay the tackling of the deficit. Worse still, a government without a clear majority may see its reform efforts jettisoned or watered down in parliament. If yields move higher, the cost of maintaining the public debt will grow at the expense of funding public services. A significant delay in deficit reduction could be paid for by a more extreme reduction in growth potential.

Assuming austerity bites soon, it is reasonable to fear another rise in unemployment in the second half of 2010. The recovery should hold its ground but economists are not optimistic about the pace of growth. According to the Bloomberg survey, UK growth this year will manage a modest 1.3 per cent. The next year or so will be tough but at least the UK can fall back on its flexible exchange rate. Poor fundamentals have chased sterling down around 20 per cent against both the euro and the dollar since the end of 2007.Data has been showing that export performance is strengthening. It seems that the euro sceptics are being vindicated.

This week’s rioting in Greece clearly reflects that the population is not swallowing the government’s austerity measures.

These conditions suggest that it is probably impossible for Greece to achieve its dual aim of slashing its budget deficit and also meeting all of its debt obligations, given the likelihood that yields will remain inflated for some time and that the €110bn loan will last around three years.

The fact that Portugal and Spain had far lower levels of debt going into the economic crisis suggests that they have managed their budgets better than Greece. That said, given the risk of a sovereign debt default in Greece, investors are simply in no mood to take any chances. If capital flight from Portugal’s bond market continues, then it too could require a loan from the International Monetary Fund (IMF). The markets have put significant pressure on Eurozone officials to stem the fear of default.

Therefore, it is increasingly likely that if Greece is to remain a member of the Eurozone then it will almost certainly have to write off some of its debt – the question is just who will take the haircut.

The sooner the EU officials answer this question, the greater the chances of preserving the Eurozone.