Why Darling is losing on three fronts
The three engines of the UK's economic growth - property, the public sector and the City - are all stalling. Which means Chancellor Alistair Darling's assurances are meaningless and misleading.
When politicians start delivering assurances that 'economic fundamentals are sound', it's time to be concerned. Back in 1997 when Asian economies were falling like ninepins, South Korean ministers and officials kept parroting the mantra 'sound fundamentals, sound fundamentals' right up to the point that the country needed a financial lifeboat from the IMF.
Now earlier this month Alistair Darling delivered his most important speech since becoming Chancellor. In an address to the Engineering Employers Federation, he said: 'We do not yet know the full effects of what has happened in the financial markets. But we do know that there are good reasons to believe that we will get through this difficult time provided we do what is right for the country. We have good reasons to be confident.' It's time to start worrying.
His confidence is based on the British economy's past record of riding out the Asian contagion, the Russian default, the dot.com bust and the 9/11 atrocity without the UK economy tilting into recession. He concludes that because the British economy has been resilient to financial shocks in the past, it will be well positioned for future challenges. Well, just as we are told repeatedly that in the world of investments that 'past performance is not a reliable indicator of future results', the same applies to the UK economy.
Are the UK's lenders really more responsible?
Mr Darling then goes on to try to convince us that there are important differences between the UK and US housing markets. In the speech he said: 'While many US mortgages were sold at hugely discounted rates, leaving people unable to meet repayments when rates increased, lenders in the UK have been more responsible in taking account of an individual's ability to pay. And demand for housing outstrips supply.' He does not substantiate these comments.
He clearly has a picture in his head of hard-selling American mortgage brokers signing up illiterate janitors in Alabama, and thinking this sort of thing doesn't happen here. But if you look at the numbers at the beginning of last year, mortgage loans outstanding amounted to 125% of disposable income in Britain, compared with 103% in the US. This does not support the view that lending practices in the UK are more prudent than they are across the pond. It is difficult to avoid the impression that the Chancellor is engaging in wishful thinking.
Last October he was at it again in the House of Commons when he offered the following reassurance: 'British institutions have less direct exposure to sub-prime assets, and our sub-prime market share, 5%, is much lower that of the US'. Where did the 5% figure come from? When pressed, the Treasury had to admit that although the phrase 'sub-prime' has a consistent and well understood definition in the US, there is no such clear definition in the UK. In short, the Chancellor's reassurance was meaningless and indeed misleading.
Mr Darling's third good reason for being confident was the importance he attached to the 'flexible economy' and the 'competitive business environment', which has seen the British economy weather the turbulent phases of the last 15 years. But during this period British economic growth has been extremely lop-sided, depending almost entirely on three sectors - finance, housing and public services. These sectors accounted for 120% of Britain's employment growth over this period, so the rest of the economy has actually been shrinking.
Our financial services specialisation has left us exposed
Britain's specialisation in finance and business services has yielded substantial benefits in terms of rising living standards. We have been able to sell services that have been rising in price and at the same time benefit from the fall in price of manufactured imports. But all good things have a habit of coming to an end. And Britain's specialisation in financial services leaves the country substantially exposed to the ongoing credit crunch.
To make matters worse there are the uncertainties surrounding the impact of Alistair Darling's unexpected tax changes on London's position as hitherto unchallenged centre of global finance, specifically the radical changes in tax treatment of foreigners living in the UK. Anecdotally, there is evidence of hedge funds, banks and international businesses moving some of their highly paid international staff out of London to Geneva, Monte Carlo and the Channel Islands. Clearly these tax havens cannot replace London as a global financial centre but at the margins the impact of wealthy foreigners moving out can be significant.
Official estimates say that 3,000 of the 29,000 non-domiciles affected will leave. Non-domiciles, who actually contribute £3bn in taxes, are being scared away by a hastily hatched plan not only by an annual levy of £30,000 a head, but also by plans to investigate their offshore trusts.
The house price boom has run its course
With the boom in financial services stalling, can Mr Darling count on the two other engines of growth? Well, the house price boom has run its course. According to the monthly Halifax index, house prices in London have fallen 7% from their peak last July. And further declines are likely as foreigners move to more consistent and less intrusive tax regimes. At the top end of the London property market, foreigners have accounted for more than 50% of the buyers in the past few years.
As far as the overall market is concerned the Halifax says it expects zero growth in house prices in the next year or two, which is about as close as anyone with such a vested interest could ever come to predicting a drop. So, two important engines of economic growth, financial services and housing, are in retreat. What about the third, the public sector?
Gordon Brown wasn't so prudent after all
Here the Government has already shot its bolt. How did the UK move from Gordon Brown's initial 'prudence' as chancellor to a state where, according to the Institute of Fiscal Studies, 19 out of 21 comparable countries have done more to improve their structural budget balances? It all seems to boil down to replacing common sense with a technical rule. It is common sense to allow the budget to move into deficit during a recession or an economic slowdown. This is natural. Tax receipts are hit by the slowing economic activity while welfare payments increase. But it is important to accumulate a surplus during upturn or boom years.
However, Gordon Brown and his advisors were not content with doing this on a year-by-year basis, instead insisting on relating their borrowing to the whole business cycle. But when the numbers did not add up, instead of being resolute and imposing some fiscal discipline, Gordon Brown simply moved the goalposts. As a result he allowed excessive borrowing in good times on the basis of highly conjectural computations going back to the 1990s. Although he was able to say he had stuck to his Golden Rules, no one believed him, and budgetary discipline went out of the window
And we also have the small matter of Northern Rock, which was nationalised this week. The taxpayer has been forced to buy a business that effectively is a busted flush. Alistair Darling may claim that the bank is being run at arm's length, but chairman elect Ron Sandler's business plan must ultimately be approved by the Treasury. Most of the employees are represented by the union Unite, which is the largest corporate donor to the Labour Party. So it is doubtful that decision making will be conducted purely on commercial merits.
Moreover, as the housing market stalls, the taxpayers' problems mount. Northern Rock was the most aggressive lender on the high street at the very time housing activity peaked last summer. If any lender is going to be hit by negative equity problems, it will the bank we all now own. A more pressing problem is the colossal £8bn book of unsecured personal debt. This represents outstanding amounts on credit cards, personal loans and overdrafts where Northern Rock has very little comeback if borrowers can't pay. Write-offs will balloon as economic conditions become more difficult.
In the 2007 Budget in spring last year the Government forecast public sector net borrowing to be £33.7bn in 2007/08. For the financial year to December, net borrowing reached £43.6bn, £11.4bn more than the year before. This excludes the Northern Rock debacle. The Government has been losing control of public finances for some time, and the situation will go from bad to worse as slower economic growth brings in lower taxes. Rules are no replacement for common sense, but if you have to have rules, stick to them.
So don't expect any economic stimulus from the public sector either. The increase in public sector employment also came to end last summer, and wages look like falling in inflation-adjusted terms for the first time in a decade.
All in all, the Chancellor is being complacent. There are serious headwinds facing the UK economy and the legacy of Brown's Chancellorship has left the UK less well equipped than it might have been. On 12 March Alistair Darling delivers his first Budget. Let's have less of the boasts about stability and the avoidance of boom and bust and more about attending to future challenges.
There is a precedent for getting out of this mess. In early 1993 as Chancellor Norman Lamont faced weak economic activity and a huge budget deficit, a legacy of our disastrous experiment with the ERM. His solution was to rein in the growth of public spending and announce a staggered rate of tax increase, which was designed to reduce the structural deficit without imposing heavy new taxes on a sagging economy. It worked. His successor, Kenneth Clark, took most of the credit - indeed, new Labour inherited this 'prudent' financial framework before blowing it.
By Brian Durrant for The Daily Reckoning