World Economy

We need to talk about Britain

23 Feb 2010

"Having its own currency may have spared the UK the full wrath of the bond markets so far, but it may turn out to be a curse-in-disguise."

Over the past couple of months, there have been unprecedented levels of interest in Greek economic affairs and the likely impact they might have on the entire euro project. Among those smirking from the sidelines have been those in the UK who have always looked on the euro project with scepticism and who point to the current fiscal difficulties within the eurozone as proof, if it were needed, that the UK did the right thing in not joining the euro.

Having your own currency decisions and your own interest rates decisions, this conventional wisdom suggests, is just what macroeconomic policymakers need when a once-in-a-lifetime economic crisis comes knocking.

My artistic skills are pushed to the limit

Seamless photo-shopping!

There is another way to view this, though. Countries like Ireland and Greece would, in previous decades, have taken a look at their debts and deficits and decided there was nothing for it but to devalue their currency and start all over on the growth cycle. And there’s no denying that competitive devaluations played a large part in Ireland’s economic successes after 1987. However, there is downside to pulling that trigger: it severely reduces the need to address the underlying problem, namely the government’s errant spending path.

In other words, the eurozone gives countries like Ireland and Greece something new and highly desirable – the (almost) irrevocable clarity of purpose to keep proper control of public finances. Other countries with similar boomtime growth stories but with their own currencies still don’t have this purpose of mind. For example, with Ireland and Greece pulling out the stops to get their deficits back to 3% by 2013/14, the UK has much more limited aims: a deficit perhaps twice that size by the same time.

This is not just pointless picking on the UK either. Sometimes it’s easy to forget in all this talk of PIGS but the UK government finances are in a very shaky position and, with no annoyed Germans on the other side of the table, do not look like improving any time soon. Four points:

  • The UK’s fiscal deficit is projected to be larger than any PIGS country both this year and next. (For those curious, Ireland [not Greece] takes second place.)
  • Linked to this, the UK will move into the developed world’s heavily indebted club pretty quickly, while interest payments on national debt will be larger than Spain, Portugal or Ireland by next year. (Its gross debt will be between Ireland and Portugal next year, the OECD estimates.)
  • Government spending as a proportion of the economy is rising faster than any other developed country apart from perhaps Finland.
  • Lastly, assuming they stay safe within their currency union, Ireland, Spain and Portugal are expected to undergo competitive devaluations (through consumer price channels). Like Sweden, through higher inflation, the UK will pay the price for having its own currency.

Various different indices exist giving an insight into pressures on particular countries and currencies. I’ve taken four key state finance metrics, deficit, debt, interest payments and total government spending (all as % of GDP), and using OECD projections ranked 24 developed countries in terms of both where they will be in 2011 and how much they’ll have changed between 2007 and 2011, eight metrics in total. To these, I’ve also added three macroeconomic variables from the European Commission’s detailed economic forecasts: GDP growth, unemployment and inflation.

Taking the simple rank in each of the 11 metrics as that country’s score, the sum gives each country a number between 0 (top rank on all metrics) and 253 (worst rank on all), which is then normalised into a number between 0 and 100, a higher number representing a worse state of government finances, taking into account the health of the economy. The result is below, with the “two-Ied PIGS countries” in red and their eurozone neighbours are in blue.

An Index of the Health of Various Governments' Finances

An Index of the Health of Various Governments' Finances

Some pre-emptive methodological comments:

  • Australia, New Zealand, Canada and Korea are omitted due to their exclusion from European Commission projections.
  • Current accounts are not included because they reflect many things and this is essentially a measure of Government finances, not private finances.
  • Composite indices like this are a function of what goes in – in particular here, ranks hide gaps between, say, 19th and 20th placed countries.
  • The inclusion of the level of Government spending in 2011 as a variable is of course potentially ideologically charged. Then again, more than likely so are bond markets.
Pound/euro exchange rate, Feb-2008 to Feb-2010

Pound/euro exchange rate, Feb-2008 to Feb-2010

The UK saw its currency depreciate strongly in late 2008 (see graph to the right). As an adjustment, though, that marked the start rather than the end, because it threw purchasing-power parity between the two currency areas out of whack.

With the UK as a major reserve currency worldwide, further devaluation and inflation (i.e. making foreigners and children pay) does not seem an ideal solution to its economic woes. Instead, it should look to take the bull by the horns and bringing back into balance tax receipts and public spending.

Having its own currency may have spared the UK the full wrath of the bond markets so far, but in allowing deficits and debt to grow, it may turn out to be a curse-in-disguise.

(Needless to say with the two-armed science that is economics, one can find UK economists that have been out in force in favour of current UK fiscal policy and against.)

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3 Comments

  1. Ben said on February 23, 2010 | Permalink

    Great article… Seems to have 2 points: a) Euro is great, b) Britain needs to get its finances in order.

    It perhaps overstates the benefits of the Euro/ of having a benevolent German central banker with a suitably long stick. 3 points:

    1. Greece is already at ~100% debt/GDP and its government still looks errant as it plays chicken with Germany. This clarity of purpose for public finance clearly hasn’t got through the heavy red wine to those leaders in Athens either now or during the last 8 years.

    2. Forced competitiveness sounds a bit like the UK’s experience in the 20′s with the Gold Standard.

    3. I’m not sure the Government and all those overindebted consumers are too upset about ~4% inflation: an example of where they are clearly not paying “the price”.

  2. Rob said on February 26, 2010 | Permalink

    As an Irish person living in London for the past five years your analysis is interesting. The problem for the U.K. is that it is carrying a large feckless welfare-dependent underclass which increases government spending. The advantage over Ireland is that the public sector is leaner and less overpaid.

    I note that the Irish figures relative to the U.K. do not reflect the cost of NAMA, which is being kept off the state’s balance sheet by a manoeuvre that would but to shame the swap that Goldman Sachs did for Greece.

  3. Ronan Lyons said on February 26, 2010 | Permalink

    Hi Ben, thanks for the comment. A couple of quick points in reply. I wouldn’t argue for a minute that the euro has been an unqualified good thing (cf. inappropriate interest rates), however for countries with a history of currency volatility and speculator bullying, it did bring straight away an environment of stability that can only be a good thing in the medium/long term.

    Secondly, I would make an important distinction between “can’t learn” and “won’t learn”. The Irish economy, for example, got itself into all sorts of hot water in the late 1970s and the 1980s, because it thought it could spend (i.e. borrow) its way out of recession. The lesson has been learnt and learnt hard – very few commentators are arguing that we can borrow our way out of the current mess, which is a product of another lesson Ireland (and the UK) must learn: we can’t spend our way through a boom/spending can’t be acyclical (cf. Gordon Brown’s now risible rule of “balanced books”).

    I would agree with you that were the UK in the eurozone, they would probably have stared down any Franco-German calls for better budgets in the good days, due to economic/political clout, but you would have to think that it would have had *some* ameliorating effect and that the UK wouldn’t be heading for 100% debt/GDP by 2014, but instead perhaps 80%.

    On Greece, I actually think the Finance Minister in Greece is very much on top of his game, he’s an ex-OECD pro and can definitely see the bigger picture. Politics comes into play though, so they can’t be seen to be rolling over to international capital markets for political reasons. They need to be seen to be playing some sort of middle ground.

    Lastly, on inflation – I think you and I are in agreement, but just on opposite sides. Someone has to pay, and while debtors and exporters may be happy to see inflation, but ultimately bondholders, future generations, consumers in a year’s time, etc., will not be very grateful if the pound in their pocket is worth, say, 15% less through inflation and devaluation. This is particularly relevant for the UK, as part of the reason its debt is well-regarded is because it has a role as a reserve currency. No-one likes gradually weakening reserve currencies.

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