Disaster planning is a core discipline for any responsible organisation. If you were running an airline, you’d want to know what would happen if both engines on a plane failed, in freezing fog, on the same day as terrorists bombed the airport. If you were running a hospital, you’d want to know how you might cope with an outbreak of bubonic plague, then an earthquake, all in the middle of a flu epidemic. None of those events are very likely, and certainly not at the same time. But it’s good to have some idea of what you might do if they did happen. After all, there won’t be much time for thinking about it when a catastrophe strikes.
Has anyone in the Treasury been sketching out disaster scenarios for the British economy? Given the lamentable state of preparedness for the recession – not long ago we were being told our economy was the best placed in the world to withstand the downtown – it seems unlikely. But they should be. Sure, the chances are it won’t happen. The devalued pound, historically low interest rates and the Bank of England printing money should pump enough demand into the economy to keep it on its feet. But there are three meltdown scenarios for Britain. And we should be thinking about them now – if only to focus our minds on how to avoid them.
1. An attack by the bond vigilantes
We got a taster of what the bond markets can do to a government last week when an auction of gilts failed. Finding buyers for the mountains of debt the British government has to issue will be a huge task. Capital Economics estimates that the budget deficit will run as high as £200bn annually over the next five years. Even that might be too optimistic, they say. “It is not implausible that annual borrowing rises towards £300bn.” Whether the markets are willing to finance deficits on that scale is still to be seen. The Treasury might think this isn’t a problem. ‘Quantitative easing’ means that, if it comes to a crunch, the Bank will simply print fresh money to buy up the gilts and pay for the government’s debts. But the real pain will come in the currency markets. If the government starts printing money to the tune of 10%-15% of GDP a year, the pound would plunge. Britain imports the majority of its food and manufactured goods. Our ability to do that depends on people abroad accepting sterling as hard currency. If confidence in the pound collapses, there will be no choice but to raise interest rates to whatever level is needed to get foreign investors buying sterling again. A base rate of 15% would probably be the minimum necessary – a rate that would crucify businesses and mortgage holders. In the worst case, we might even need import controls.
• The odds: about 10%.
2. A return to hyper-inflation
Forget all the chatter in the City about deflation. A couple of thousand years of economic history demonstrate that once you start printing money the result is usually inflation. Policy-makers probably know that perfectly well, and have accepted it. A burst of double-digit inflation will effectively wipe out much of the debts of consumers and companies. It will be deleveraging by stealth. The trouble is, having a bit of inflation is a bit like having a smidgen of cocaine – it’s a lot easier to start than it is to stop. The assumption right now is that the freshly printed money can be quickly withdrawn once the economy has been steadied. If it can’t be, the UK could see hyperinflation, a 20%-30% annual increase in the price level. Savers will be wiped out, industrial unrest will be rampant, and the currency will start to lose any reliable value.
• The odds: about 30%.
3. Stagflation
Much of the commentary on the British economy assumes it was in pretty good shape until a collapse in the credit markets caused a sudden drop in demand. Of course, that isn’t true. Britain has been on a downward trajectory for several years. Taxes have been raised to levels incompatible with rapid growth. All the historical evidence suggests that once the state consumes more than 40% of GDP, growth stagnates. The burden of red tape and regulation has grown year by year and remains the only part of the economy that shows no signs of slowing down. In short, there were plenty of problems already – on top of which, the credit markets have collapsed. So even when we fix that, the underlying economy will still be a lot weaker than it has been for 30 years or more. The net result will be stagflation: a combination of moderate, persistent inflation and sluggish growth, probably never more than 1%. Interest rates will have to remain high for many years, business confidence will remain weak, there will be little incentive to save or invest and unemployment will rise steadily because growth is too weak to create new jobs.
• The odds: about 80%.
We keep being told that this recession is so threatening that governments and central banks have to throw everything they can at it. But it is worth keeping in mind that Britain now runs the risk of meltdown – and the cure might even turn out to be worse than the disease.