Vericool Finance

It is considered a golden rule in politics that Budgets that look good on the day, start to look poor by the weekend and vice versa.  Last week’s Budget broke that rule.  Even the dreadful borrowing figures announced by the Chancellor of the Exchequer last week – pushing the national debt well beyond £1trn – were not dreadful enough to describe the reality, as became clear within days, when a set of shocking GDP figures recorded a contraction far worse than expected. Over half a trillion pounds of borrowing is scheduled over the next few years.

It could easily be more. On the Government’s own forecasts, the public finances will come nowhere near balance until 2018.  Some experts reckon we’re looking well into the 2030s or the 2050s.  “In the long run”, Keynes famously said, “we are all dead”.  But this is getting ridiculous.

The Chancellor has admitted the Government needs to borrow £220bn in the gilts market this year, just to keep finances afloat.  After that, he claims, things will start to get easier.  Really?  Darling’s expectation that the economy will shrink by “only”3.5% this year already looks out of date.  But this wildly hopeful assumption that this decline will somehow reverse into a growth rate of 3.5% in two years’ time seems preposterous.

Using the IMF’s more neutral economic forecasts, Monument Securities reckons Britain will have to tap gilt buyers for some £230-235bn this year and about the same in 2010/11.  At the moment, the Government is having little trouble finding lenders:  the increased supply of gilts is being soaked up by the Bank of England’s £75bn quantitative easing programme and by foreign buyers.  But if investors begin to doubt the Government’s ability to close the deficit, the market’s willingness to refinance sovereign debt could come to a sudden halt.  Epithets of “banana republic” and “sick man of Europe” may yet return to haunt the British.

Britain does have one advantage.  It entered the recession with relatively low levels of public indebtedness compared to other countries.  This means that, even with a dramatic surge in liabilities, it will end up with only a middling level of debt compared with G7 countries overall.  Yet we shouldn’t take refuge in that.  On some measures, Britain’s public finances are now the worst of any rich country: next year, we will probably have a bigger deficit, as a percentage of GDP, than the like of Italy.

Retaining market confidence calls for plausibility and willingness to forego overly optimistic forecasts.  The only way out is to confront the problem head on.  This dishonest Budget has done Britain no favours at all.

You’ve got to hand it to Alistair Darling.  Only this most emollient of politicians could manage to make this Budget seem boring.  Yet the content of the speech was, in many ways, explosive.  He told the country that British prosperity was, in important respects, as fraudulent as collateralised debt obligation; that the boasts of ‘no more Tory boom and bust’ are a joke; that the economic forecasts he gave only last November were nonsense, and the public finances are deteriorating at a rate never seen before in peacetime.  And all with a deadpan face.

Darling announced a rash of measure to steer Britain towards recovery, but the Chancellor’s efforts to offer a little to everyone failed to find approval in most quarters.  Indeed, he faced a chorus of disappointment.

Apart from the sheer mess of the economy, the big problem facing Darling was that hopes were perversely high.  This was one of the most anticipated Budgets in decades, with commentators on both the left and right urging dramatic action.  Be bold Chancellor, you could be our next Lloyd George,” said Polly Toynbee in The Guardian.  “Give voters a rock-solid reminder of what Labour is for”.  The Times was equally convinced that that Chancellor should follow the advice of President Obama’s chief to staff, Rahm Emanuel, and not let “a serious crisis to go to waste”.

With the weight of the public finances endangering the nation’s prospects for recovery, the Budget presented a perfect opportunity for ministers to change course away from ever-rising public expenditure and to profoundly change the shape of the government.  In the event, the Chancellor did announce a cut in public service spending growth:  it will fall from 1.1%, to 0.7% in 2001-12.  He also announced £15bn in “efficiency savings”.  But this is a little more than tinkering around the edges, £15bn over five years represents only a fraction of Britain’s annual interest payments on its public debt.  Far more profound changes are needed in a public sector that has grown out of all proportions to Britain’s ability to pay.

Darling’s Budget task was daunting enough to evoke pity. He had to reassure investors that Britain isn’t going bust, but to do so without taking too much money from the beleaguered taxpayer, or out of and economy in deep recession.  His response was a flight into fantasy. There was no bust Britain, he seemed to say, only a temporarily tripped-up Britain, which would soon be swanning along again.  He offered no meaningful explanation of how the deficit would be shrunk.  He acted like a fantasist – presenting the terrible news and pretending it didn’t matter.  Britain’s black hole required an adult response.  We didn’t get it.

“People didn’t want to deal with it while the party was in full-swing, but now the music has stopped.  We’ve lost a fortune,” observed U2’s guitarist, The Edge, in a trenchant piece of economic commentary.  He’s not the only one mourning the dead Celtic Tiger.  Ireland’s descent into the financial maelstrom – after more than a decade as, ostensibly, Europe’s most successful economy – has hit the country for six.

Economic activity appears to have ground to a halt:  a new McDonald’s outlet in the west of the country is said to have been “inundated with job applicants”, including bankers, accountants and architects.  Amid growing public anger, the government finally bowed to the inevitable and announced an emergency Budget.  The country is now steeling itself for “savage” cuts in public spending and hefty tax rises.

With growth predicted to plummet by 8% this year and a budget deficit of 18bn Euros, Ireland’s finance minister, Brian Lenihan, had little room for manoeuvre.  Without these tough measures, Ireland’s fiscal deficit could have reached 13% of GDP this year – more than four times the EU limit.  Even so, he may have pulled the wrong levers.  Lenihan sees the future of the Irish economy in exports. Yet, as a member of the eurozone, Ireland can hardly devalue its currency to stimulate demand.
Moreover, by pulling this hard on the tax lever, Ireland may only succeed in exporting its best hope of recovery:  its talent.

There’s also a risk that by tightening public spending, Lenihan will trigger a further downward spiral in property prices and bank solvency. Credit rating agencies are already casting doubt on the survival chances of Ireland’s biggest banks.  Britain is not there yet, but the similarities between our banking and property-dependent economics are striking.  Given a few more failed government debt auctions, this could be the future that awaits us.

Ireland’s short, sharp shock approach to putting its finances in order may, in fact, be preferable to the long, slow march back to fiscal rectitude that Britain faces once the crisis is over.  But don’t expect Alistair Darling to follow Lenihan’s lead next week: The British Government is far too wedded to its policy of fiscal stimulus.  Yet, given the black hole in our accounts, the main question at the heart of the Budget is surely “how close the nation is to bankruptcy”.  The Government’s accumulated losses may yet send Britain into the IMF’s embrace.  To hear Lord Mandelson saying there should be no ‘stigma’ in taking a begging bowl to the fund is to know how delicately balanced the public finances truly are.

Careless talk of green shoots can cost, if not lives, then certainly reputations.  Eighteen years after authoring the phrase, former chancellor Norman Lamont still feels obliged to defend it – protesting that he meant “shots not bushes”, and that the economy began to stabilise soon after.  We are not there yet.  But there are straws in the wind that suggest the economy may indeed start improving more rapidly than seemed possible even a few weeks ago.

There are signs of life in both the housing and stock markets, more optimistic news on the manufacturing front and – most significantly – evidence in the Bank of England’s latest Credit Conditions Survey that the money markets are easing.  It’s too early for green shoots, but there are “seeds of hope”.

Gordon Brown’s luck was certainly in.  He wound up the summit on a day when there was a raft of pleasing news around the world – and investors were determined to see the sunny side.  To be fair, the markets were also cheered by the G20 agreement itself (even if the figures owed something to Mr Brown’s talent for inflationary arithmetic).  The IMF cash boost was particularly welcome in alleviating fears of a further meltdown in emerging economies.

The hope in markets is that the worst of the crisis has passed.  The reality, of course, is that the world remains hostage to the health of the financial system. It is highly possible that the meeting might mark a turning point.  But the big fear the G20 didn’t address was the state of US banks.  Faith in Treasury Secretary Tim Geithener’s plan is paper-thin, and it may yet reveal that the banks’ balance sheets are still not telling the truth.  Moves to change the mark-to-market accounting rules may makes the values of toxic assets look better, but they won’t do much for investors’ faith in numbers.

The G20 hyperbole, complete with the “relief rally” on global markets, is pure escapism.  It’s the real-life equivalent of ‘soma’ - the mind-bending drug used for mass thought control in Aldous Huxley’s Brave New World. Our leaders need to snap out of this entrance and face reality.  UK growth fell 1.6% in Q4 last year.  We’re now looking at a possible 4% decline in 2009 and a further contraction next year.

It’s far too early to build up on hopes.  There are glimmers of light, but many dark indicators too - not least the worrying spectre of unemployment.  The pace of decline might be slowing, but we’re a long way from digging ourselves out of this slump.

The chief complaint about Davos this year was that there weren’t enough bankers to bash. “I’d like to congratulate Stephen Green,” said Tony Blair at one session, gesticulating towards the HSBC chairman. “We must congratulate him for being one of the few bankers willing to come out in daylight hours.”

Nonsense, if it was bankers you were after, Davos had them in spades. Over there, that grumpy looking chap, that’s Gordon Brown. He’s got three - or is it four? - big british banks. And that’s Angela Merkel. She’s got a couple, and that man over there from the US - he’s got stakes in loads of them…

If the humour was dark, so, too was the mood. The hope was that politicians and business leaders would come together at the World Economic Forum to forge a common approach to shaping the post-crisis world. The reality came closer to common abuse. The Russians attacked the Americans, Turkey had a bust-up with Israel, the globalisers took on the protectionists, casual dressers sneered at the tie-wearers, and everyone had a go at the bankers.

What else could you expect? The annual event has long been the epicentre of globaloney, and now that these self-styled global governors are faced with a major crisis, most of it their own making, they are clueless. The best they could offer were vague calls for “better” regulation, “improved” institutions and “more pulling together”.

The overall effect was of a crash inquiry into an airline that intends to keep flying. There was no serious intention to rebuild in a different way. Davos Man was subdued, but still partying.

The knives are out, but if you don’t like what you’ve seen from Davos Man, wait till you see Nationalist Man get to work. We certainly got a glimpse of him. In the absence of any strong delegation from the US, this year’s cast list was dominated by a mix of journalists, academics and authoritarian leaders. As Russia’s Prime Minister Vladimir Putin remarked: “This is Davos under the Russian flag.”

Neither he, nor the Chinese premier, Wen Jibao, could resist having a pop at an unnamed country’s inappropriate macroeconomic policies. And the Chinese delegation was visibly displeased and alarmed by the suggestion of Timothy Geithner, President Obama’s newly confirmed Treasury Secretary, that China has been manipulating its currency.

For all the drama on display elsewhere in Davos, the tensions between the Chinese and Americans look to be by far the most significant in the long term.

The year 2009 can be paired with 1931 as the second year after the start of a big recession, but the question facing the world now is whether we can avoid a repeat of the vicious spiral of depression that took root then and find an alternative way forward.

Some lessons appear to have been assimilated: notably that in a depression, too much and too early is safer than too little and too late. The Americans plan a $700bn fiscal stimulus, the Chinese are spending $584bn to shore up their economy, and policy-makers worldwide are at least paying lip service to the dangers of protectionism.

Yet no one should underestimate the extent of the threat. A year ago, we were looking at a US downswing, an occasional bank failure and rapidly increasing oil prices. Our economic worries now are much more deep-rooted.

Weakness can be seen everywhere - from China to Chile, from Switzerland to South Korea. It looks as if global output will shrink this year - an extraordinary development in the modern era.

This global downswing is partly trade-related: the manufacturing nations of the East have been hit hard by plummeting demand in the West. But it is mostly being driven by the spreading tentacles of the credit crunch.

Many emerging economies were dependent of inflows of loans from the Western banking system. Those flows are now drying up, as indeed are the emerging markets’ economic prospects. What happens in China may well determine the world’s prospects.

By Western standards, growth - projected to fall to 7.2% this year - is still licking along, but with factories closing and unemployment rising, there are signs of social unrest.

The big fear is that the Chinese government will choose to prop up its exporters by allowing the yuan to depreciate, thus bolstering its already huge surplus and aggravating existing imbalances with heavily indebted countries such as the US - with dire consequences for the world economy.

The danger is extreme. In Barack Obama, the US has a new president with vast political capital, but it is not strong enough to rescue the world economy on its own. It needs helpers, particularly in the surplus countries. If China pursues the depreciation route, the outcome could be a devastating round of beggar-my-neighbour devaluations plus protectionism, as was seem in the 1930s.

The world has changed and so must global policy - and quickly. Welcome to 2009, a year in which the fate of the world economy will be determined, maybe for generations.