Sunday 5 April 2009

Is the UK Heading For Meltdown?

Wiht all that G20 nonsense out of the way, and no doubt forgotten about in a few days, we can get back to looking at the UK economy. And the prospects remain pretty dire. In my MoneyWeek column this week, I've been looking at the potential for meltdown. Here's a taster....

Take A Deep Breath, and Examine The Meltdown Options For The British Economy:


Disaster Planning is meant to be a core discipline for any responsible organisation. If you were running an airline, you’d want to know what would happen if both engines on a plane failed, in freezing fog, on the same day some terrorists decided to launch a bomb attack on the airport. If you were running a hospital, you’d want to know how you might cope if there was an outbreak of bubonic plague, then an earthquake, and all in the middle of a flu epidemic.
None of those events are very likely, and certainly not at the same time. But, all the same, it’s good to have some idea of what you might do if they did. After all, there won’t be much time for thinking about it when a catastrophe strikes.
Has anyone in the Treasury been sketching out disaster scenarios for the British economy? Given the lamentable state of preparedness for the recession – it’s not long since we were being told our economy was the best placed in the world to withstand the downtown – it seems unlikely.
They should be. True, the chances are that it won’t happen. A mixture of a devalued pound, historically low interest rates, and the Bank of England printing money, should pump enough demand into the economy to keep it on its feet.
But there are three meltdown scenarios for the UK. And we should be thinking about them now – if only to concentrate our minds on how to avoid them.
One, an attack by the bond vigilantes.
We got a taster of what the bond markets can do a government last week, when an auction of gilts failed. Finding buyers for the mountains of debt the British government is going to have to issue will be a huge task. Capital Economics estimates that the budget deficit will run as high as £200 billion annually over the next five years. In fact, even that might turn out to be too optimistic. “It is not implausible that annual borrowing rises towards £300 billion,” it concluded in its most recent analysis of the public finances.
Whether the markets are willing to finance deficits on that scale remains to be seen. Of course, the Treasury might think the problem is fixed. The Bank of England’s new policy of ‘quantitative easing’ means that if it comes to a crunch, the Bank will simply print fresh money to buy up the gilts and pay for the government’s debts.
The real pain will come in the currency markets. If the government starts printing money to the tune of 10% to 15% of GDP annually, the pound can be expected to plunge. Britain imports the majority of its food and manufactured goods. Our ability to do that depends on people abroad accepting sterling as hard currency. If confidence in the pound collapses, there will be no choice but to jack up interest rates to whatever level is necessary to get foreign investors buying into sterling again. A base rate of 15% would probably be the minimum necessary – a rate that would crucify businesses and mortgage holders. In the worst case, we might even need import controls.
The chances? Probably about 10%.
Two, a return to hyper-inflation.
Forget all the chatter in the City about deflation. There are a couple of thousand years of economic history to show that once you start printing money the result is usually inflation. Cynically, policy-makers probably know that perfectly well, and have decided to accept it. A burst of inflation – say 30% over a period of five years – will effectively wipe out much of the debts of consumers and companies. It will be de-leveraging by stealth.
The trouble is, a bit of inflation is bit like having a smidgen of cocaine. It is a lot easier to start than it is to stop. The assumption right now is that all the freshly printed money can be quickly withdrawn once the economy has steadied. If it can’t be, the UK could be heading for hyper-inflation, a 20% to 30% annual increase in the price level. Savers will be wiped out, industrial unrest will be rampant, and the currency will start to lose any reliable value.
The chances: About 30%.
Three, stag-flation.
Much of the commentary on the British economy right now assumes that it was in pretty good shape until a collapse in the credit markets caused a sudden drop in demand.
Of course, that isn’t really true. The UK has been on a downward trajectory for several years. Taxes have been raised to levels incompatible with rapid growth. All the historical evidence suggests that once the state consumes more than 40% of GDP growth stagnates. The burden of red-tape and regulation has grown steadily year by year and remains the only part of the economy that shows no signs of slowing down.
In short, there were plenty of problems already – on top of which the credit markets have collapsed. So even when we fix that, the underlying economy will still be a lot weaker than it has been for the thirty years or more.
The net result will be stag-flation: a combination of moderate, persistent inflation and sluggish growth, probably never more than 1%. Interest rates will have to remain high for many years, business confidence will remain weak, there will be little incentive to save or invest, and unemployment will rise steadily because growth is too weak to create new jobs.
The chances: About 80%.
We keep being told that this recession is so threatening , governments and central banks have to throw everything they can at it. But it is worth keeping in mind that the UK now runs the risk of meltdown – and the cure might even turn out to be worse than the disease.

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