No easy way out of the debt maze

A couple of things became clearer last week. One is that it will be some time before we have to worry about inflation again.

The other is that a consensus is building for drastic surgery on Britain’s budget deficit, focused on cuts in public spending, given the powerful backing of the International Monetary Fund in its annual health-check on the UK economy.

It was also the view of Standard & Poor’s, the ratings agency. I was less impressed with its analysis. More on that later.

Inflation and government debt are related. Some fear the government will seek to inflate its way out of its problems. Elected politicians, given the choice between, say 5% annual inflation for a few years, and the grinding task of trying to cut public borrowing through painful measures, would surely choose inflation. So would many individuals and businesses. Inflation is good for debtors and bad for creditors.

The trouble is that it is quite hard to generate inflation after a recession. Recessions are good at destroying inflation. That is what they are there for, most of them being deliberately engineered by governments and central banks for that purpose. Many feared that sterling’s post-1992 dive, combined with recovery, would lead to higher inflation. It did not. The early 1980s recession gave us years of low inflation. Even in the turbulent 1970s, with the wage-price spiral, recession was followed by three years of falling inflation.

Britain now has the lowest Bank rate since 1694, 0.5%. Sterling at its low point was nearly 30% down from its peak, and the Bank of England has embarked on a £125 billion programme of “creating” money through quantitative easing.

Yet inflation is falling on every measure. Retail price inflation, heavily distorted by falling mortgage rates, is negative by 1.2%. Consumer price inflation dropped from 2.9% to 2.3% last month and will drop below the 2% target in the next month or so.

There it will pretty much remain, barring a possible small blip from the increase in Vat back to 17.5% next January, until the end of 2011, according to JP Morgan. The old inflation target, retail prices excluding mortgage interest payments, is running at 1.7%, well below its old 2.5% target.

As the IMF put it in its statement on the UK, the outlook is subject to uncertainty but: “On balance the prospect is for inflation to fall and stay below the 2% target for an extended period. In this context, the Bank of England’s strategy of aggressive monetary easing is appropriate.”

Many people misunderstand the motives behind one aspect of that policy response, quantitative easing. When the Bank embarked on it in March it made no mention of deflation. When it talked about deflation in its February inflation report, it was to dismiss it as being likely in Britain.

Quantitative easing is intended to do what it says on the tin, boost the quantity of money and therefore money GDP (gross domestic product). In the unlikely event that it works too well, the Bank has a new weapon at its disposal — draining reserves from the system by exchanging them for Bank of England bills, until it can sell gilts back into the market.

So, inflation is unlikely to give the government an easy way out of its debt. What is the alternative? The nub of the IMF report was that it was right for the government to unveil a small fiscal stimulus during the recession but getting the public finances back on track should not be left too long.

It leans heavily in the direction of cutting public spending rather than raising taxes. “Expenditure-based consolidations are more durable,” it said. There are no numbers in the IMF’s report but the role-model is Canada, which over three years from the mid-1990s cut public spending by 20%. Yes, 20% of genuine reductions.

Achieving that in Britain would be asking a lot after a decade of annual real growth in public spending of between 4% and 5%. So far the Treasury is planning to freeze spending in real terms from 2011, as happened in the 1990s. Inevitably it will have to go further and impose real cuts.

That is recognised in the Treasury. The need for further action is acknowledged but officials point to practical constraints. This is not just that it will be easier to impose tough measures after the general election. It is also that, such is the fragility of the economy, announcing everything in the budget, even delayed measures, could have scuppered recovery hopes.

Officials say if they had 100% confidence that the economy will recover as they hope, such an announcement might have been feasible. But there is a chicken-and- egg argument here. There will be other opportunities, they insist, to take a scalpel to the public finances.

There is another point, not widely understood. It is quite possible for the Treasury to be both optimistic on its growth forecasts and pessimistic on its revenue and spending projections, because it is constrained by the assumptions it has to use. It has to assume, for example, unemployment does not fall even when growth resumes.

There are a lot of subtleties in this, which the IMF team explored in discussions with the Treasury, Bank and plenty of outside bodies on its visit here.

I did not detect subtleties in S&P’s report, which confirmed Britain’s AAA status but revised the outlook from “stable” to “negative”. In just over a third of cases, such a revision is followed by a loss of AAA status. Japan, the world’s second-biggest economy, has only AA status. Canada lost AAA status in 1992 but regained it after its radical fiscal surgery.

The problem with the S&P report, for all the headlines it generated, is that it is so thin. In three pages it suggests UK government debt will rise to 100% of GDP by 2013, something the respected Institute for Fiscal Studies thinks highly unlikely. It also appears to believe that any government losses on the banking rescues, which it thinks could be as large as £145 billion, will be crystallised over the next four years. Again, this is highly unlikely.

Nobody argues with the broad thrust of its conclusion, that further action will have to be taken to get the public finances back into shape. Everybody accepts that, including the Treasury. But S&P’s report provided no analysis to back up its verdict. Moody’s and Fitch last week reaffirmed Britain’s rating as stable. But S&P, I fear, did nothing to enhance the battered reputation of the ratings agencies.

PS: It is but a short flight to Dublin but there is a bigger gulf on economic policy. A few days ago I met Brian Lenihan, Ireland’s finance minister. In contrast to Alistair Darling’s budget in which pain was deferred, he gave it to the Irish economy straight, with large and immediate hikes in personal and capital taxes, alongside a squeeze on public spending.

Why the difference? Two of three ratings agencies, S&P and Fitch, have downgraded Ireland’s AAA status already and he argued Ireland did not have the luxury of waiting. The budget deficit was heading for an “unsustainable” 15% of GDP. His measures should hold it at 10.75% but if things get worse there will be no more emergency budgets this year. The economy, predicted to slide by 8%, would not be able to take it.

The other big difference is banking. Lenihan is setting up a “bad bank”, the National Asset Management Agency, to take on bad loans. Most are “conventional” bad loans, lending into an Irish property market characterised by cronyism, which is why getting the taxpayer to take them on is proving unpopular.

On this side of the Irish Sea, bank bad assets are more exotic, and could turn out to be worse for that. There were hints last week that the government is thinking of how it will sell its equity stakes in the banks. This must surely be a long way off.

The Anglo-Irish similarity is that public finances have proved so vulnerable in this recession. What politicians do to the economy is less important than what the economy does to them.


Originally published at David Smith’s EconomicsUK blog and reproduced here with the author’s permission.