Thursday, January 14, 2010

Slow Death Or Amputation?

Not recommended

Yesterday, the credit rating agency Moodys opined that Greece and Portugal face a "slow death" caused by "bleeding" from the rapidly escalating cost of servicing their huge government debts:

"The risk of a 'sudden death' is negligible, but the likelihood of a 'slow death' high."
So how will this slow death feel?

Well, over the next 5-10 years, mounting debt interest costs exacerbated by investor flight will necessitate ever higher taxes. That in turn will cause prolonged and severe abdominal pain in the area of personal consumption, private sector investment, and unemployment. That will likely be followed by outbreaks of civil commotion with unforseeable political consequences. Unfortunately, the patient will not be in a position to receive further doses of pain-killing public expenditure because the drugs cupboard will be empty.

Doesn't sound too good. Is there no alternative?

Well, the traditional remedy was a good old-fashioned dose of inflation and currency depreciation, rapidly shrinking the government's debt in real terms, and shifting the problem away from the rioting workers and debtor businesses onto politically expendable pensioners and the rentier class. Unfortunately, the fearsome Staff Nurse Merkel has now taken personal charge of the Portugese and Greek cases, and she does not believe in inflation. So that's out*.

Which leaves just one other option - immediate amputation of the swollen appendage at the root of the illness - ie the bloated public sector.

According to the OECD, public spending in Greece is currently running at 50% of GDP, while in Portugal it's 51%. That's far more than the government gets in tax receipts, which are running at 40% in Greece and 41% in Portugal. Increasing taxes to cover such a yawning gap is a political non-starter (quite apart from the economic damage such increases would inflict), which means spending must be cut drastically.

How much? The OECD calculations of both countries' structural deficits (ie the bit of the deficit that will not automatically correct itself when the recession ends) suggests the cuts will need to be around 6-7% of GDP in both countries. Which equates to public spending cuts in the range 10-15%.

Well, you say, that's too bad. But you know, the PIGS*... the way they spend public money... frankly, they've always been dicing with fiscal death, as long as anyone can remember.

Which may be true. But right now, their cases do provide a most instructive comparison with that of the English Patient (OK, the British Patient).

Because on the same set of OECD figures, our public spending this year will be 53% of GDP - higher than both Greece and Portugal. But our tax receipts on 40% of GDP are no higher than Greece and Portugal's. Which means that our fiscal deficit - and in particular our structural deficit - is actually higher than theirs. In fact, at 10% of GDP, our structural deficit is the highest in the entire OECD:

Let's just repeat that.

The UK's structural fiscal deficit (ie the bit of the deficit that will not automatically correct itself when the recession ends) is the highest in the entire OECD.

And to correct our deficit with spending cuts will require cuts not of 10-15% but something closer to 20% - call it £130bn - £150bn.

So what do Moodys have to say about us?

Unfortunately their full report is not online, but we do have this quote:

"The current UK government may have started the crisis as "crass" Keynesians, the next one is likely to be Ricardian to its core."
Translation: Brown attempted to head off the recession with a crass dose of old-time deficit financed fiscal stimulus, but the next government needs to get real and recognise that government debt is simply deferred tax - it is not a sustainable fix for the fundamental problem of excessive government spending (see previous blogs on "crass Keynesianism" here, and "Ricardian equivalence" here).

Further translation: unless Cam/Os deliver serious spending cuts in their very first budget, plus a credible medium term fiscal strategy, the markets are going to get seriously pissed. And unlike Greece and Portugal who are at least currently tied securely to Staff Nurse Merkel's apron strings, the UK and its dodgy currency are exposed to sudden death any time the grim market reaper cares to drop by (see The day the pound nearly died for an account of his last visit in 1976).

So for us, a slow lingering death is rather less likely. For us, the choice is amputation at a time of our choosing and under proper operating theatre conditions, or a field amputation at a time of the reaper's choosing.

Your call.

*Footnote There is of course one way the Greeks and Portugese and maybe the Italians and Spanish (collectively the PIGS) might seek to escape the clutches of Staff Nurse Merkel - jump out the window and run away (aka abandoning the Euro). Watch this space.


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