Friday, February 19, 2010

To cut or not to cut?

To cut or not to cut?

I have to say, having loved Lord Skidelsky’s biographies of Keynes and Oswald Mosley, I was rather disappointed by his interview on Today this morning.  As I am too with his co-signed letter to the FT.  Absolutely, it ought to be a priority to restore robust economic growth, and absolutely, drastic cuts in public expenditure pose a risk to any recovery.

But there really is an elephant in the room here.  Skidelsky et al criticise the ‘financial markets’ for their lack of foresight:

In urging a faster pace of deficit reduction to reassure the financial markets, the signatories of the Sunday Times letter implicitly accept as binding the views of the same financial markets whose mistakes precipitated the crisis in the first place!

What would really strangle an economic recovery would be a spike in interest rates.  The reason that this recession has felt less awful for those of us who have managed to stay in work is that interest rates are so low.  Mortgages are relatively affordable, and outstanding debts are less crippling.  If interest rates were to return even to long-term trend rates of 5% or so, let alone the 10-15% that previous recessions have brought, lots of us – businesses and individuals – would be absolutely destroyed.

What might cause such a spike?  Two things.  Inflation – which despite the recent rises is probably not a medium-term threat, given the huge surplus capacity in the economy – and the cost of borrowing on the markets.  It is the latter that should be worrying us.  If the markets start to believe that the Government will default in the medium term (by inflating away its debts – an actual default is vanishingly unlikely) then it will require a higher risk premium, making borrowing more expensive.  And when Govt borrowing becomes more expensive, interest rates go up. 

This, effectively, is what the group of 20 said in their letter to the Sunday Times.  The way to assuage the worries of the bond market is to set out a credible plan for deficit reduction in the medium term.  The way to show that this plan is believable is to make a start on it early.  But how credible is it that the markets really will lose confidence in HMT and increase the cost of borrowing?  Well…

The yield on Britain’s 10-year gilt just shot up to about 4.2 per cent, according to Reuters data…Using the 4.2 per cent Reuters yield, then, the spread between 10-year gilts and German bunds is now about 100bps. Oh dear.

As Gary Jenkins at Evolution Securities puts it:

10 year Greek government bonds currently yield 6.5%, the Portuguese yield is around 4.65% and 10 year Gilts trade at 4.20% While it is still more likely than not that the rating agencies will wait until after the general election to put any pressure on the AAA/Aaa ratings these numbers are so bad that we cannot rule out them taking a look at the rating pre election.

While I suspect that economists would agree that, other things being equal, it is better to cut public spending only when the economy is sufficiently robust to take it, it is becoming increasingly clear that the UK simply does not possess the requisite freedom of action to follow this plan.  If the Government – any Government – does not set out a reassuringly credible plan to eliminate the structural deficit within the life of the next Parliament, then you can bet your bottom dollar (maybe the Aussie dollar, now trading at about its highest level against sterling ever) that the IMF will do it for us.

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