#19. A grim tale

The UK Economy

This week, with the chancellor presenting the penultimate budget of this Parliament, we are going to be inundated with economic and fiscal analysis and commentary. I don’t know about you, but I’m usually put off by this deluge of comment, because most of it belongs in the realm of what I have called “flat-earth economics”.

As an antidote, I’m going to stand back and give you the big picture as I see it. Here’s a necessary warning for those of a nervous disposition – this isn’t going to be a fun read. In fact, it’s going to be very, very nasty indeed.

There’s really only one positive, so I’ll give you that right now. This positive is that George Osborne is a first-rate finance minister. There are those – myself included – who wish that he had cut public spending even further. But we need to remember that, with a single exception, Osborne is the only post-War chancellor who has reduced state outlays at all. The only other administration which has cut expenditures was Labour in the late 1970s, and this hardly counts because cuts were imposed by the International Monetary Fund (IMF). This aside, the trend in public spending has been a one-way street since 1945, and even Mrs Thatcher could do little more than stem this rise.

    *  *  *  *  *  *  *

The bad news, of course, is that Britain is going to need all of Osborne’s determination and more if a near-helpless economic situation is to be turned around.

In his budget, the chancellor will tell the public that, whilst the situation is improving, much more needs to be done, and that, by implication at least, this is no time to put the nation’s affairs back into the hands of the profligates of the Labour party.

In fact, the chancellor could hardly overstate the magnitude of the problems that remain to be overcome. The reality is that the British economy remains in very, very deep trouble, and that the public has virtually no idea at all about the real state of affairs.

Let’s start with the public perception, which, roughly speaking, is this:

       The British economy grew strongly between 2000 and 2008;

       Output slumped in 2008-09;

       The economy flat-lined after that; but

       A recovery is now under way.

This perception is wrong in virtually every particular. Properly understood, the economy did not grow at all during 2000-08; the 2008-09 slump inflicted far more damage than is usually recognised; and the recovery that we are supposed to be experiencing now is almost entirely illusory.

To understand why, we need to appreciate, first, that gross domestic product (GDP) is an extremely misleading measure of prosperity. As a measure of income, GDP is analogous to a company’s profit and loss account, and no sensible person would assess a company’s performance on this basis alone. The shrewd investor looks not just at profits and losses, but at cash flow and the balance sheet as well. What this in turn means is that you cannot arrive at a realistic analysis of Britain’s economic performance without taking debt into the equation.  

    *  *  *  *  *  *  *

Let’s start with some debt numbers. At the end of 2000, Britain’s debt totalled £2.99 trillion, or 307% of GDP, comprising government debt of £328bn (34% of GDP), household indebtedness of £677bn (69%) and corporate (including financial sector) borrowings of £1.99 trillion (204%).

Move forward to the end of 2008 and the debt-to-GDP ratio had risen from 307% of GDP to 501%, where it remains today. Whilst nominal GDP had grown by £466bn (from £975bn to £1.44 trillion), there had been a vastly larger increase in debt, which had risen by £4.22 trillion (from £2.99 trillion to £7.22 trillion).

Just think about this for a moment. Adding £4.22 trillion of debt to achieve a GDP increase of £466bn means that each £1 of economic “growth” had been purchased at a cost of more than £9 in new debt.

That isn’t growth.

It isn’t even, stricto senso, an economy.

It’s a Ponzi scheme.

Of course, the subsequent slump made these ratios look even worse. Between 2008 and 2012, nominal GDP increased by £120bn, but debt expanded by a further £600bn.

Now, let’s consider the “growth” that we’re likely to experience in 2014. If the optimists are right, GDP will grow at a real rate of perhaps 2.5% this year, a nominal increase of 4.5% if we add back inflation of 2%. In money terms, this would add about £70bn to GDP, which is less than the government alone is likely to borrow. Add in the probable increases in private debt as well (as mortgage funding expands) and you can see that the “recovery” is a case of “same old same old”, with each £1 increment in economic output purchased at a cost of far more than £1 in additional borrowings.

Nor is this all. As things stand, Britain is running a current account deficit of about £60bn, because our exports no longer cover the cost of essential purchases such as food and fuel. Our “growth”, then, is being financed not just by lenders but by trade creditors as well.

    *  *  *  *  *  *  *

Before finishing this grim litany, there are two other points to consider.

The first of these is that the absolute scale of British indebtedness is even worse than the formal number (of 501% of GDP, or £7.8 trillion). This number includes government debt on the domestic definition, rather than the more demanding Maastricht one. It excludes potential exposure resulting from the banking bail-out. It also excludes quasi-debt commitments such as public sector pensions (about £1 trillion), PFI contracts, nuclear decommissioning and the debts of state-owned corporations.

Second, any impression of economic normality is surely countered by interest rates which, at 0.5%, are far lower than inflation. Five years of negative real interest rates have been terrible for savers, of course, but the implications go much further than that. Without positive returns on savings, a country cannot invest. And, without investment at levels which at least match depreciation, a country’s asset base deteriorates in a process that is tantamount to cannibalisation of the economy.

    *  *  *  *  *  *  *

So there you have it. Debts are astronomical, the “growth” of the last decade and more has amounted to nothing other than the spending of borrowed money, the asset base is deteriorating through a lack of investment, and creditor forbearance is keeping us in food and energy.

Good luck, Mr Osborne.

You’re going to need it.   

18 thoughts on “#19. A grim tale

  1. Many thanks for that Tim – this is a fine example of the kind of thing those of us who pass on your enlightened news need. The only way the powers that-ought-to-be will ever get to see the light, before everything is more obviously falling to pieces, may be as a result of those of us, with no vested interest in keeping quiet, using all kinds of networking to spread the word. More please ….

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  3. My response to the situation you describe is to stress test my personal finances to a repayment mortgage interest rate of 8%. I am therefore liquidating any debt as fast as possible in preparation for likely storms ahead probably including rapid interest rate rises. These fears are clearly not in the minds of property enthusiasts, who are witnessing bubble like gains taking place, at least in London and the South East, and are more frightened now of missing out on this. Your often made point that the average earners are continuing to see a decline in their disposable income after paying for essentials is likely to put many budgets under considerable strain to the point that they can hardly withstand any interest rate rise at all. Maybe fixed rates will protect them for a bit. Some of the financial media is now forecasting the return of real income increases, but they never seem to support this with any evidence. I haven’t yet been able to spot anything coming along to save the situation, but I think estimating the timing and nature of future events is very difficult. Your suggestion of 1-2 years feels about right. We live in interesting times!

    • First of all, I’m sure you’re right to do that stress test. What we have now clearly isn’t normal. It doesn’t look sustainable either. Like you, I’m evaluating my personal plans, too.

      What I’ve tried to do here (amongst other things) is to point out quite how abnormal negative real rates are – hardly anyone seems to get the point, which is that, without real returns, people don’t save, and without saving there is no net investment. That means we’re living off accumulated assets, hence my comment about cannibalising the economy. It’s a bit like, say, an airline keeping some planes flying by stripping spare parts off others – the airline stays in business, but it’s fleet (and its business) shrink.

      I’ve not changed my view about 1-2 years. A key factor will be the scale of the run-up in property prices over the coming year. If it’s a big bubble, the effect of it bursting will be correspondingly large.

      Another point that I didn’t have space for was risk exposure. In my view, Britain’s ability to withstand external shocks is now very fragile. These shocks are more than possible. Energy prices could spike. A major economy could trip over (Japan, for instance, though Britain’s own position is at least as precarious). There could be a global re-pricing of risk, and even a 1% rate rise is nasty when you’re £7 trillion in debt. The biggest single danger, though, has to be a loss of global investor confidence in the UK.

    • I think it is a bigger bubble already than official statistics indicate. For example – Nationwide index 2005- present day +14%. I am aware of cases of +120% or so.

    • I don’t see any chance in the near or mid term of rates rising to 8%

      Any significant rise in rates in UK would trigger a cascading default of consumers, home-owners, banks and ultimately the government, As the BoE and the government ponzi up yet another debt bubble the ability to withstand any rate rise vanishes towards zero..

      Significant interest rate rises are no longer an option for the UK or for that matter much of the developed world and ergo for the global financial system. A sovereign default on the scale of the UK would cause an uncontrollable chain of defaults through the Eurozone, Japan and the US. It would trigger the financial armageddon they dodged in 2008.

      The debtor nations simply won’t let it happen – they will act in unison to prevent it. The creditor nations are locked in a death embrace with them – via globalisation (and in Germany’s case via the Eurozone). The debtors will use QE (or the threat of) to keep rates low in perpetuity – the creditors will have to swallow it and more importantly their wealthy elite will want to – in order to protect their capital.

      This crazy global imbalance of credit/debt and production/consumption will grow and grow – until it doesn’t.

      As Tim says, it will end with an external shock – not from the monetary economy – but from the real economy – almost certainly an energy shock The central bankers can’t print oil.

      When it happens we won’t be discussing interest rates, deficits and GDP – rather the breakdown of global trade, food shortages, civil disorder and war.

      I reluctantly find myself hoping that the central bankers can keep this train wreck of a global economy on the rails for as long as possible – I hope longer than we might think – maybe a decade.

  4. Tim,

    Heres my pennyworth then – most of which we have agreed on anyway

    1. Your Council House Building plan
    2. Credit controls on mortgages & an end to tax relief on BTL Mortgages
    3. bringing defence spending into line with the European Average (saves about 1% GDP)
    4. ‘Cost Recovery’ – a levy on firms employing low wage workers to get the Social Security costs back
    5. Cutting back the bloated police/security/prison system – for example higher alcohol prices would cut public order problems at no cost to the taxpayer
    6. Clampdown on tax evasion/avoidance including possibly a turnover tax
    7. Recover the cost of the bail out from the banks and curbs on proprietary trading

    And that’s for starters!

    • Thanks John. I like your list – here’s mine.

      (Perhaps this deserves a blog of its own?)

      1. A programme of building council houses (any sane recovery plan would start with this one).

      2. Finance this by scrapping HS2.

      3. Make non-doms pay tax on worldwide earnings

      4. An integrity agenda (see below)

      5. Abolish business rates (this is such a massive disincentive to enterprise that I’ve called it “the economic equivalent of strychnine”)

      6. Pay for this by introducing a minimum tax threshold, basically your turnover tax, so foreign corporations pay a minimum, of, say, 10% of UK turnover.

      7. Re-centralise the NHS (because the “internal market” and fragmentation into Trusts clearly hasn’t worked).

      8. Stop all outsourcing in the criminal justice system.

      9. Widen prudential controls to limit mortgage lending (impose loan-to-income and loan-to-value limits) and cap consumer interest rates (to stop exploitative practices).

      10. Strengthen consumer protection.

      11. Start breaking up companies with excessive market shares.

      12. Restrict tax relief on corporate debt interest, and restore pension fund dividend tax exemption.

      The integrity agenda is necessary to rebuild world market trust in the UK, especially in financial services. Instead of fining innocent shareholders when things go wrong (in banks, utilities and so on), punish those executives responsible. Restore our reputation for probity by introducing severe penalties for malfeasance.

  5. Dr Morgan,
    Interesting to note that MoneyWeek’s estimate of debt is much lower.. “By the next general election in 2015, our national debt is estimated to stand at almost £1.36 trillion, or 80% of our entire national output”. That was scary enough but your analysis analysis is paints a much darker picture.
    Excellent article although I don’t share your view that George Osborne is an excellent finance minister. In my view he had a clear mandate to cut public spending substantially – but has failed. His CV includes a period ‘folding towels’ and has little relevant real world experience. John Redwood would have been a much better choice but he doesn’t fit into Cameron’s clique.

    • To explain, the MoneyWeek number is just government debt. I’m including debt owed by individuals and businesses, including banks. At the end of 2012, the totals were;

      – Households – £1,147bn
      – Non-financial corporations – £1,479bn
      – Financial corporation – £3,683bn
      – Government – £1,182bn
      – Total of above – £7,816bn

      …..which is about 500% of GDP.

      I take your point about George Osborne, but, in fairness, his efforts to cut spending have been hampered by the steady escalation in the interest payable on government debt (so yes, this is a vicious circle).

      My choice of PM would have been David Davis………….

    • Thanks for your reply Dr Morgan it was most useful and interesting.
      I believe that any company that had a debt of over 500% of it’s turnover would be very quickly wound up. I just wonder how close the day of reckoning is in your view ?
      I find the level of Non financial corporation borrowing surprising when we are often told that companies are sitting on large amounts of cash that they cannot spend in the present economic climate.
      My understanding is that George Osborne hasn’t cut spending in cash terms at all – he has merely decreased the rate of the increase in spending. He just seems to have bought himself a few years in the sun avoiding any really difficult decisions. Just another mediocre politician, out of his depth ‘kicking the can down the road’. Had he put personal popularity before country then I would be congratulating him.

  6. I know it is pretty hard to specify dates for the massive change to the average Brit that is coming.

    But you have mentioned previously that you think 2018 will be the year when “Shale” is shown for what it really is. Could 2018 be the absolute last date when change/reset/depression happens? Or do you think there could be further “can kicking” after that?

    • A fascinating question, and probably worth a blog article of its own…

      Let me summarise how I see things. The global economy is being undermined by weakening energy economics. Meanwhile, debt has escalated, much of it built up on the assumption of never-ending growth.

      The first shock came in 2007-08, when the financial system panicked over how much debt had been created. Governments got us through that – by bailing out the banks, taking a lot of the debt on to their own balance sheets, printing money and manipulating interest rates downwards.

      But nothing has really changed. Debt (and other financial “claims” on the future, such as pension and welfare promises) remain wildly excessive. Banks’ capital ratios remain far too slender. There has been no return to real growth. The energy cost screw continues to tighten. The economy remains extremely abnormal – for example, negative real interest rates prevent capital-formation through saving. QE has distorted the system. And there are wild cards (such as Russia-Ukraine) in the deck as well.

      For me, we’re “falling over a cliff in slow motion”. First it was the US (sub-prime) and the UK (debt-addicted). Then it was the eurozone (the euro is an idiotic, political currency). Now it’s emerging countries, such as India, South Africa, Turkey, Brazil, Indonesia and others, that are suffering. Next, I think, could be China, where debts of US$ 24 trillion have been reported. Japan and Britain are clearly in existential trouble. I don’t think the Fed will continue to taper, i.e. QE will become a fixture, not a “temporary” expedient. Thanks to QE, asset classes around the world (including equities and bonds) are way over-valued. Some currencies have plunged, and others (including the yen and sterling) are defying economic gravity. Shale is buoying up sentiment in the US. Privileged elites aside, most individuals are getting poorer.

      End result? Something exposes “the emperor’s new clothes”. Runners and riders, in no particular order, are:

      1. Chinese debt
      2. Market recognition that one or more big economies are debt-dependent basket cases (Japan and Britain the front-runners here)
      3. Collapse of one or more currencies, causing spike in interest rates
      4. Loss of faith in asset valuations, causing spike in interest rates
      5. Escalation in cost of fuel, food or both
      6. Contagion from emerging countries
      7. Political shock (Ukraine?)
      8. Major blow to confidence (exposure of shale myth?)

      Now, ANY ONE of these could be the trigger. So, the idea of the system carrying on unscathed for, say, five years looks extremely unlikely. Of the above, a loss of faith in asset valuations looks the likeliest, though the Fed would try to counter it with QE. My best bet would be a crash in one or more economies or countries, triggering defaults which undermine the financial system. The economies and currencies at greatest risk are Russia and the rouble, Japan and the yen, and Britain and sterling. Russia could run out of time very quickly, if sanctions are extended. That may not happen, because other countries may have too much to lose.

      So my money is on Japan, which has huge debts (at least 400% of GDP). The failure of Abenomics is obvious, so watch out for yields on Japanese government bonds (JGBs) escalating, the yen collapsing and/.or the BoJ raising rates to protect the yen. How long will this take? I stick to my 1 or 2 year time horizon – but risks seem to be multiplying, which could shorten this horizon.

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