The outlook for Britain is grim.
The boom under Labour was bigger, and the bust was worse than anyone had realised. That’s left us standing in an even deeper hole than we’d thought. And now Europe’s making it harder for us to climb out.
That’s a rough summary of the first ten minutes of George Osborne’s Autumn Statement yesterday. The rest of the statement was largely composed of little gimmicks designed to distract us all from the sheer misery of the bigger picture.
If today’s papers are anything to go by, that particular ploy didn’t work.
And the bad news is, he’s probably being too optimistic.
Blame the Bank of England for weak UK growth
The Autumn Statement was depressing. One of the most depressing things about it was that, even although it was gloomy, it probably wasn’t gloomy enough. And that’s saying something.
In March this year, Osborne was convinced that Britain would be well on the way to starting to cut the national debt by the end of this parliament. But now it turns out that we’ll still be spending more than we make in tax revenue until well after the next election. As Chris Giles points out in the Financial Times, the Chancellor’s targets have slipped by three years in the space of just eight months.
So why have things deteriorated so badly? Assuming you believe our shiny new budget watchdog – the Office for Budget Responsibility (OBR) – it’s nothing to do with ‘the cuts’, whatever Ed Balls would like to pretend. Indeed, if you want to blame someone, blame the Bank of England.
The Bank’s policy of trashing the pound via quantitative easing (QE) is the main reason why growth has fallen so far behind forecasts. Robert Chote, chairman of the OBR, noted in his report: “Most of the weakness can be explained by an external inflation shock constraining real household consumption”. Households spent roughly as much as the OBR had expected. But because inflation was higher, that spending bought less.
The other reason that growth is so weak is because Britain has been permanently damaged by the financial crisis. In technical terms, our ‘output gap’ is smaller than the OBR had thought.
The easiest way to visualise this ‘output gap’ is to imagine you own a lot of car manufacturing plants. When the economy is running out of puff, you mothball some of the plants. When things pick up, you bring them back into production. The number of plants sitting in mothballs is your ‘output gap’ – the difference between current and potential production.
But then someone comes along and invents a car that runs on water. Demand for your cars is permanently damaged. Half of your factories need to be demolished. So regardless of what stage of the cycle we’re at, your peak capacity is always going to be smaller.
This is an incredibly subjective measure. But you don’t need to be a top statistician to realise that the 2008 crisis has rendered some parts of the financial and property industries completely redundant.
In short, this all means that Britain can expect lower growth in the future. Lower growth means lower taxes. And if you stretch that out over a few years, it means the gap between your income and your spending can end up being a lot larger than you had hoped.
Why gilt yields have stayed so low
With a miserable outlook like that, the chancellor was keen to accentuate the positives. He highlighted how Britain’s borrowing costs – as measured by the yield on government debt (gilts) – have remained spectacularly low.
He’s right. And to be fair to him, it’s at least partly because the government has talked a good game. It’s easy to forget now, but at the last election the big fear was a gilt strike and a run on the pound. There’s no question that the government’s tough talking has helped – the credit ratings agencies certainly stress that the government’s commitment to cutting borrowing is a key reason that Britain has maintained its AAA rating.
However, much as Osborne and David Cameron would like to pretend it’s all down to them, it’s not. The second reason is that the Bank of England is buying gilts. It makes it much less risky to enter a market if you know that you have a guaranteed, relatively price-insensitive buyer to sell to at a later date.
The third reason of course, is Europe. Here in Britain, things look ugly, but by comparison to Europe, we’re a safe harbour. Overseas buyers – the Japanese in particular it seems – have been fleeing Europe wholesale. They don’t just want to avoid insolvent states. They want out of the euro as a whole. That money has to go somewhere – so Britain is seeing part of that.
Trouble is, Britain is so heavily indebted that any big shock could knock us right off course. As rating agency Fitch put it: “The capacity of UK public finances to absorb adverse economic and financial shocks that would result in yet higher public debt while retaining its ‘AAA’ status has largely been exhausted.”
Stay defensive and avoid gilts
So what does all this mean for you? Firstly, it means you should stay defensive. QE might be hurting the UK’s growth, but the Bank is also convinced that it’s necessary to keep the financial system alive. So we can probably expect more of it. That will mean more pressure on consumers, and more reason to stick with companies that can withstand recession. Our roundtable experts pick out a few good options in the next issue of MoneyWeek magazine, out on Friday (if you would like to become a subscriber, you can claim your first three issues free here).
Also, we’d avoid gilts. They have been solid performers this year. And it’s hard to know when this particular ‘bubble’ will pop. But the fact is, the UK looks vulnerable. If attention turns from Europe for any length of time, investors might be reminded that our finances are in an atrocious state as well.
And lastly, don’t expect the government to do anything sensible about this. Osborne’s rag-bag of ideas was just tinkering around the edges. We’ve already criticised the first-time buyer subsidy: David Cameron is mad to spend £400m on the housing market. Launching other gimmicks just confuses things even more.
What we really need is simplification, and a flattening of the tax system. All we’re getting is more Gordon-Brown-style fiddling. That was probably the most depressing aspect of the whole statement.
Our recommended article for today
How Sweden dodged a bullet – and Britain could too
– Like Britain, Sweden once had a bloated public sector that it couldn’t afford and stunted economic growth. But no more, says Bengt Saelensminde. So, what lesson can we learn from the Swedes?: How Sweden dodged a bullet – and Britain could too
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