Hard Times - the need for structural change

Having already had a go at The Duchess of Cambridge Hilary Mantel recently struck a blow against another great British institution, Charles Dickens, her timing was impeccable as we in Britain still relies on Dickens for our economic guidance:

Annual income twenty pounds, annual expenditure nineteen nineteen six, result happiness. Annual income twenty pounds, annual expenditure twenty pounds ought and six, result misery

Mounting debt has been the cause of so much fun and subsequent misery is the West and particularly in the UK.  However, we have now had two months of uninterrupted good news on the economy, or rather we have had no really bad for two months.  The green shoots that I pointed at in December are now in plain view for all to see, but like a newly sown lawn there are still dangers ahead.  The chief threat is the overall level of debt and the threat of inflation and higher interest rates.  With negative real interest rates it’s possible to feel economically secure but if they were to rise to  5% how many governments, businesses and private individuals  would survive, this form of stress testing is deeply unfashionable as we all contemplate ‘free money’ for the nest 2-3 years.

So what are the numbers?  In the UK net debt is about 300% of GDP or about £7.5tn this is split quite equally in three areas - government debt, corporate debts (companies) and personal debt.  Added to this we have an enormous banking sector that is still in a very fragile state with poor liquidity and bloated balance sheets.  The important question is how much of this debt is distressed, or likely to default?  With notional interest rates of 0.5% and real interest rates at -2.5% many insolvent businesses and individuals can hang on in there but if real interest rates were to rise to 5% there would be real fall out.  It is the risk of this fall out that has encouraged George Osborne and the Bank of England to water down austerity and use monetary stimulus (QE) to keep the money supply up and interest rates down.  There is no doubt that the initial stages of the crisis were well handled by Alistair Darling and the emergency measures to bolster demand (cuts in VAT) and the massive injections of QE saved our banking sector and keep our weakened economy alive.  Since 2010 Osborne has pursued a very limited agenda of ‘austerity light’ balanced by more QE and the result is that we have survived but the big issues remain unresolved.  Overall debt is still way too high, structural changes to improve our competiveness have been focused on the one area where we don’t need growth, the already over priced housing market.  The good news is that over the last three years corporate and private debts have fallen from 232% of GDP to 208%.  We should expect this improvement in the private sector liquidity to continue at this gentle rate as most forecasters believe we have at least 2-3 years of low interest rates and low inflation.  The issue is that we will need 5-6 years of benign inflationary conditions to get back to a sensible ratio of debt to wealth (GDP).  On the debit side the Government has increased its own debt burden so much that this has more than compensated for the de-leveraging by families and private firms. General government debt has reached 90pc of GDP, up from 43.5pc when the crisis erupted in mid-2007.  And it seems that we are 3 or 4 years away from any significant reductions (where economic growth outstrips growth in government spending).

The up-shot of all of this is that we only have a few years to put in place the structural changes that the economy requires for us to be competitive before rising inflation and defaults kill off the recovery and pushes us back into depression.  The structural changes we need to consider would include:

1.     Deal with pension time bomb – increase  the retirement age and increase contributions
2.     Balance our economy with an industrial policy drives growth in the north of England and supports industries (other than finance) where we have shown that we can compete globally
3.     Simplifying tax to increase participation (reduce the black economy and tax avoidance)
4.     Improve the skills base of our young people and drive down unemployment for this group
5.     Improve our infra-structures – road, airports and rail networks
6.     Deregulate property industry to break the link between rents and values, which makes landlords happy to keep properties empty rather than occupied at lower rents.