By William Green
June 30 (Bloomberg) -- The state of the U.K. economy fillsBritish financial historian Niall Ferguson with foreboding.
“The probability of a real sterling crisis is around one inthree and the probability of major tax hikes and cuts in publicspending is roughly one in one” the Harvard Universityprofessor says.
Ferguson’s concern stems from the deterioration in theU.K.’s public finances which prompted Standard & Poor’s to warnon May 21 that the country could lose its AAA debt rating. Thefirm estimated the cost of propping up Britain’s banks at 100billion pounds ($166 billion) to 145 billion pounds and saidgovernment debts could double to almost 100 percent of grossdomestic product by 2013.
Chancellor of the Exchequer Alistair Darling said on April22 that this year’s government deficit would hit 12.4 percent ofGDP. Alan Clarke a London-ba
“We’re not Iceland or Ireland but we’re closer to themthan we are to the U.S.” says Ferguson author of “The Ascentof Money: A Financial History of the World” (Penguin 2008).Iceland had to borrow from the International Monetary Fund toavoid default after its banks collapsed in October; Ireland thisyear may have the steepest economic contraction of anyindustrialized nation since the Great Depression.
Britons can expect to face spending cuts in coming years inall areas including social security and health care says NigelLawson who was chancellor of the Exchequer under MargaretThatcher from 1983 to 1989.
Expenses Scandal
Political chaos is complicating the financial crisis. InMay the Daily Telegraph reported that lawmakers had beenreimbursed for expenses such as moat cleaning and massagechairs leading at least 15 to say they won’t stand forreelection. With his popularity plunging Labour Prime MinisterGordon Brown then suffered the indignity of six cabinetministers quitting in one week in early June including twocaught up in the expenses scandal.
Brown now trails Conservative leader David Cameron by 8 to22 points according to 21 polls in May and June. By law Brownmust call an election no later than June 2010.
“Our public finances are easily the worst we’ve ever had inpeacetime” Lawson 77 says. “The amount of borrowing thegovernment will have to do as a result of the deficit is veryworrying.” He says yields on U.K. debt will have to climb toattract buyers.
The government must sell about 900 billion pounds of giltsover five years Clarke says. He estimates that the Bank ofEngland will buy a third of these gilts to pump money into aneconomy mired in its worst recession since World War II. Thegovernment may struggle to find buyers for the rest he says.
Warning Signal
Ferguson cites as a warning signal the rise in the yield on10-year gilts which was 3.6 percent yesterday up from 2.9percent in March. “Bond investors have real doubts about thefiscal stability of the U.K. and they want some kind of riskpremium” he says.
Andrew Bosomworth a fund manager in Munich at PacificInvestment Management Co. agrees with Ferguson that a weakeningof the pound is likely. “In a worst-case scenario there couldbe a run on the currency” he says.
The U.K.’s expansionary fiscal and monetary policy -- it issimultaneously boosting spending and buying its own debt --bothers Bosomworth. So does the possibility the government willhave to help pay for further bank losses. “I’m not panickingbut those are real material risks” he says. “It’s a veryfragile situation.”
Not a Safe Haven
Ferguson takes no solace from the pound’s recent rallyagainst the dollar. While it climbed to $1.66 yesterday from$1.37 in March it’s still down 22 percent since November 2007.
“The big difference between the two countries is that theU.S. issues the world’s No. 1 currency and is regarded partlyfor that reason as a safe haven” Ferguson says. “The U.K. usedto be but we’re not anymore. That means we have much morecurrency risk here.”
The U.S. is one of the 18 countries that S&P rates AAA. TheU.K. is the only country on that list with a negative outlookfrom the firm.
Bad as it is the fiscal mess is unlikely to end indisaster says Ben Broadbent U.K. economist at Goldman SachsGroup Inc. “We had debt of over 200 percent of GDP after WorldWar II and we didn’t default” he says. “I don’t look at thepublic borrowing numbers alone and think there’s a big risk ofdefault or a currency crisis.”
Broadbent is less concerned about looming bank losses thanabout the recession’s impact on government tax receiptsparticularly from the battered financial and housing industries.
Debasing the Currency
The price of credit-default swaps on U.K. sovereign debthas surged as investors try to protect against a deteriorationin creditworthiness. The cost of the five-year contract rose to81 cents per $100 of insured debt on June 26 from 14 cents ayear earlier.
“I don’t think thebdb U.K. is going to default” Fergusonsays. Still debasing the currency has some of the same effectsas defaulting on interest payments he says because it erodesthe value of the money the government uses to repay itscreditors.
The current crisis has stirred memories of 1976 whensterling collapsed and the U.K. had to borrow from the IMF.Meghnad Desai emeritus professor at the London School ofEconomics and a Labour member of the House of Lords says thesituation is far less perilous this time because many othercountries have heavy debts and face similar recessions.
‘Policy Vacuum’
“In the 1970s the British economy was out of kilter withother economies” Desai says. Given the size of the U.S. fiscaldeficit he says the dollar could prove more vulnerable than thepound.
That may be little consolation for Brown. The Labour leaderis loath to make himself more unpopular by cutting spending andraising taxes to tackle the deficit says George Magnus senioreconomic adviser at UBS AG. “This government has got itself intoa policy vacuum until the next election” Magnus says. “I don’texpect them to do anything of significance to stabilize publicfinances.”
Lawson who expects Cameron to succeed Brown urgesBritain’s next leaders to make deep cuts. “It’s essential theytake very tough action straight away” says Lawson who slashedspending in the 1980s. “The question is: How tough are theyprepared to be? How much initial unpopularity are they preparedto ride through?”
Historian Ferguson sees no alternative to such stringency.“It has to happen” he says. “This kind of red ink implies bothspending cuts and tax hikes that could make the 1980s look likea teddy bear’s picnic.”
To contact the reporter on this story:William Green in London atwgreen6@bloomberg.net.