Beyond Austerity

On Wednesday morning last week the £1 sterling in my pocket could buy a full $1.47 worth of George Washington’s on the foreign exchange markets. On Wednesday afternoon the UK’s Chancellor of the Exchequer, George Osborne, stood up in the House of Commons to present his emergency budget, which outlined a virtually unprecedented set of cuts in public sector spending and tax rises which will affect “every man, woman and child” in the whole of the UK.

By the time Osborne had finished speaking the purchasing power of the pound in my pocket had (by foreign exchange market standards) rocketed northwards past $1.50, and yields on gilts (the interest rate of UK debt) had fallen considerably – and for those in the bond and currency markets the UK was suddenly a considerably happier place.

In cliched footballing speak (you’ll be hearing plenty of that as the excuses mount this week): At the end of the day, the lad Osborne gave 110% and you can’t ask any more than that. Fair play to the lad.

But what lies beyond this austerity? And are the bond and currency markets right to be sanguine?

This week’s blog could be kept very simple – and I could just say “no they aren’t” – that cutting spending and raising taxes is not a panacea for all that ails the UK (or many European countries). I should probably write a few more lines though to fill this out a bit.

The rate at which bond markets can make debt servicing unsustainable is rapid and having their backing is crucial when you have a deficit as large as the UK does. It is that issue which has been rightly addressed in this Budget. But over time big structural changes are required: The only meaningful way in which the UK Exchequer can pay off its debts is through increased tax revenues from an increasingly competitive and productive private sector – GDP growth needs to be trending upwards from the current 2.1% annualised projection. Achieving that, unfortunately, is considerably harder than pursuing austerity in public spending.

This aspect of solving the UK’s problems, albeit seemingly quite simple, is not widely commented on in the financial press, or political circles. The vast majority of discussion at the moment revolves around the timings of fiscal austerity.

In this debate, in one corner stand the “growth now” camp, who argue that expansion is a pre-requisite to service a country’s debts sustainably. Without it tax receipts implode, investment is turned away, and meeting future debt payments is harder. This camp is adamantly against Europe’s shift towards austerity, questions Tuesday’s tough UK budget, and urges countries like Germany to adopt expansionary policies. Some advocate additional fiscal stimulus even for high deficit countries, like the US.

On the other side of this debate stand the “austerity now” gang. They point to worsening sovereign debt ratings, in particular to the fact that (despite Europe’s rescue package) Greek and Spanish debt risk is back to worryingly high levels. Furthermore this group are concerned a coming sell-off in equity and corporate bond markets will deter new investments and exacerbate many countries’ debt problems. For this camp, the US request that others postpone fiscal adjustment is irresponsible. Instead, they want budget cuts to lower risk premiums and stave off disruptive debt restructurings.

In that debate, I’m firmly with the cut now approach on the basis that the rug can be pulled out from under you by bond markets if you don’t have a credible financial plan in place, and that cutting now is always easier than later. In the end, however, both camps are somewhat right and somewhat wrong.

Mohamed El-Erian – a big man in the bond world as Chief Investment Officer of PIMCO, seems to have been one of the few people that I’ve read to really clarify the issues at stake. Politicians across Europe should take note, not least because of the size of their sovereign debts held by PIMCO. In his Op-Ed in the FT this week “Beyond the false growth versus austerity debate”, he points out that austerity or fiscal expansion is only part of the process for remedying a large budget deficit – but of itself is insufficient.

“As a general rule industrial countries need to adopt both fiscal adjustment and higher medium-term growth as twin policy goals. The balance between the two will vary. Some, like Greece, need immediate fiscal retrenchment. Others, like Germany, the US and Japan have more room for manoeuvre. But no one should pursue just one of these objectives.”

For a country such as the UK, once we have accepted the need for fiscal austerity, the fundamental question is where does the ‘higher medium term growth’ come from? It’s when you pose this question that bond and currency markets should retain the right to be considerably concerned.

From a policy perspective it’s not clear what the strategy is; I can’t think of a single politician who has spoken coherently on the issue of where private sector growth really comes from. There have been various promises of past and current governments to address the need to bring back manufacturing competitiveness for the UK – once the powerhouse of economic growth. In reality this is hard to do – very high tech manufacturing does have a place in the UK’s high margin economy, but car production and the like are now genuinely low tech and are right to be outsourced to China, or elsewhere, where monthly incomes of production plant employees are closer to $200 a month rather than $3000.

So how can the UK be competitive in high tech manufacturing, bio-technology, green technology and the nano sciences – all of the high end, high margin industries that are used as buzz words by policy makers? If it is to be the case that the UK is creating truly world class companies who employ lots of people and pay lots of tax then it will not come about by accident.

The UK does not have vast natural resources (or virtually any for that matter) like Norway or Canada, nor does it have endless supplies of cheap labour, like India or China. What it does have is lots of relatively well educated people – that is the main resource; the UK’s source of a competitive advantage.

Developing that resource through a more strategically orientated approach to 3rd level education has to be a critical part of addressing the “structural deficit”. It’s no accident that the likes of Silicon Valley has produced companies like Apple and Oracle – world leaders in designing high tech software. These companies appear because of the links between venture capital and the best of what is happening in departments at Stanford, MIT and Harvard.

In Ireland, I’m optimistic when I understand that one the main reasons Intel has invested so much there, and created so many jobs, is because the nano-sciences department at my old university (Trinity College) is producing a stream of truly exceptional people in that field. The department is ranked number 2 in the world, on a budget that is approximately 1,000th of the size of the number 1 ranked University for that subject in the world. For a high cost, high margin, open economy like Ireland it is these successes that need to be copied and replicated.

The same goes for the UK, or else austerity may not be merely temporary.

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