“The UK’s fiscal reputation is on notice – given the size of the deficit, action is needed,” Peter Spencer, chief economic adviser to the Ernst and Young Item Club is quoted as saying. But, he goes on, “premature and over-aggressive fiscal tightening may damage an already fragile recovery.”
The director of the IMF’s fiscal affairs department came up with a similar argument a few weeks ago. “It is important over the medium term that fiscal adjustment takes place,” said Carlo Cottarelli, before hedging himself by adding, "this is not the moment to tighten fiscal policy.”
Alastair Darling, the UK Chancellor, is taking this advice to heart by postponing any real attempt at managing the deficit until after the election.
However, it’s worth remembering how stark the budget gap now is. Taking the UK as an example, Greg Hands, economics spokesman for the opposition Conservative party, spelled out at a conference last week that UK public spending is running at £675 billion on an annualised basis, while tax revenues are around £495 billion per annum.
That £180 billion gap, which is forecast to be in place for this fiscal year and next, represents annual net new government borrowing on an unprecedented scale. In fact, £180 billion is equal to the cumulative debt incurred by the UK state during its 300 years of sovereign issuance, said Hands. We’re now borrowing in a single year what we borrowed in the previous three centuries in total.
If an individual were behaving like this with a credit card or at the casino then the lender would no doubt be imposing a stop on further borrowing, while quietly preparing for a default.
In the government debt markets there is of course no single entity responsible for making such a call: the IMF might have done so in the past (as in the UK in 1976, when the fiscal deficit was at only half the current levels), but now it appears more part of the problem than the solution. Its recent ten-fold increase of SDRs to boost the borrowing power of member countries is essentially the same as what central banks have been doing at the country level by increasing the monetary base (and hoping that bank lending will increase again).
The responsibility for imposing fiscal discipline therefore rests primarily with bond investors and here politicians may have some tricks up their sleeves. Forced saving in government bonds was very much part of the post-WW2 landscape and we may be heading in that direction again. Whether such an outcome would be possible without the reimposition of currency controls is another matter.
However, the numbers don’t lie and they tell us that current government spending and borrowing trends are unsustainable. More taxes (and cuts in government outlays) are certain. Whether politicians can put off fiscal tightening for another few years without it being imposed on them seems very open to question.
With these issues in mind, I said in an interview on CNBC last week that sovereign default risk could be the major theme in the markets during the next couple of years. Maybe I’m wrong and we’ll muddle through as the Japanese have done for most of the last two decades. But sovereign credit spreads have crept towards the top of many investors’ watchlists over the last year. Could 2010 be the year when they hit the public consciousness as well?