Britain’s broken finances

MoneyWeek magazine cover imageGeorge Osborne’s Budget speech was full of paltry tweaks that will fail to deliver the serious spending overhaul Britain needs, says James Ferguson.

What is the point of the Budget? The press obsesses about the small changes, the tinkering with alcohol and tobacco duties – even though it’s much like listening to a serial bankrupt explain how he’s going to cut back on the fags so that he can afford more cider.

But the reality is that the Budget is where the government of the day decides which special-interest groups to transfer tax revenues to, and explains how we either are (or soon will be) able to live within our means. After all, every single penny the state spends comes out of taxpayers’ pockets – it’s either done so already, or will do in the future.

So rather than worrying about the price of a pint, or even a tankful of petrol, we should be demanding a fair statement of account.

On that front, this time around, most commentators seemed to be impressed by Chancellor George Osborne’s final pre-election Budget last week. That’s mainly because he didn’t overtly bribe the electorate, and he funded any so-called “giveaways” with increased taxes – mainly on the banks and pension pots.

Based on a collection of wholly laughable austerity, productivity and growth assumptions, Britain is supposedly still on track for a primary surplus (in other words, excluding interest payments, the state will be taking in more in tax than it spends) by next year and an actual budget surplus by 2019.

Wishful thinking

Dream on. As Neil Woodford, the head of Woodford Investment Management, recently pointed out on his blog, the Office for Budget Responsibility’s forecast that government spending will not exceed income for the first time in nearly two decades (yes, you read that right) is based on wholly unrealistic five-year growth assumptions of about 5% nominal (including inflation) and 2.35% real (after-inflation) growth per year.

That’s very optimistic, given that over the last five years GDP growth has only been 1.8% – and if you look at it on “per person” terms, the economy is actually 2% smaller than it was in 2008.

This is why politicians love immigration – it’s the only reason that our headline GDP is now above pre-crisis levels. In total, more than half of the economic recovery is down to the fact that net immigration since 2008 has added about 1.4 million people to the adult population. That’s boosted the number of economically active people in the UK by 4.5%. It’s also meant an additional 1.15 million new jobs for the economy – 3.9% of the overall total.

However, even this headline growth is illusory, and here’s why. There have been 400,000 new full-time jobs created since 2008, but more than 800,000 new part-time ones. Part-time workers now make up 27% of the workforce, and their numbers have grown at a double-digit rate since 2008. Yet we subsidise these part-time jobs with a lavishly expensive in-work benefits system.

The cost of this benefits system each year amounts to the same as our current deficit – and it costs almost ten times what unemployment benefits cost. That’s even although there are only four times as many part-timers as there are unemployed people.

To qualify for in-work benefits, applicants for the most generous entitlement – tax credits – must work for at least 16 hours a week, or about three hours a day. As I pointed out in these pages a few weeks ago, given this hurdle, it’s hardly surprising that the median number of hours worked by the 8.3 million part-time employees is 16.1 hours.

You might think that tax credits are hardly incentive enough to refrain from full-time work. After all, men earn more than £13 an hour on average for full-time work, whereas working part-time they make just £8 and women £8.44.

But as long as you have children and childcare costs, tax credits and housing benefit alone can boost incomes to the equivalent of £60-£70 per hour of work. So part-time work isn’t just very unproductive – the benefit entitlements can also be divisively unfair towards truly “hard-working” families too.

So given all this, how does Osborne plan to balance the books? He aims to cut £12bn from welfare costs over the next two years. But he’s being coy about where these cuts will come from. He’s also planning to save £5bn from anti-tax-avoidance measures (otherwise known as “raising taxes”). So that’s £17bn in total.

Even if he succeeds – which many doubt – that’s a small chunk of an annual deficit that today stands at £90bn. (That’s the annual overspend, remember – that’s what gets added to our existing debt mountain each year.) This needs to be tackled – yet there’s no sign of it happening.

The real reason for our huge debts

There’s a widespread impression that our current government debt problem was down to the cost of bailing out the banks. The full recapitalisation programme did indeed cost £123bn at the time. But we are now showing a handsome profit on that bail-out. The reality is that it was the collapse in the real economy’s ability to generate tax revenue (which was caused by the global financial collapse and the state it left the banks in) that changed.

That might have been OK if government spending fell to match that drop in tax-raising capacity – however, despite all the talk of austerity, government spending has just continued to grow unabated. Government spending over and above tax revenues (funded by borrowing money in the so far very forgiving bond markets) over the last six years has now reached £844bn, or almost 50% of GDP.

Never has non-war spending grown by so much – and yet there’s no sign of any relief, imminent or otherwise. In 2000 there were less than 200,000 lone parents on income support. Today there are almost a million. Spending per head on welfare payments has risen by 60% over the same period – and that’s in real terms, so we’re taking account of inflation here.

Pensioners will bankrupt us

Spending hasn’t just rocketed on what people traditionally see as benefits. When the state pension was first launched in 1908, there were less than half a million recipients. Today there are over 12 million. The UK’s unfunded future pension liabilities are now estimated to be in excess of £6trn – that’s £100,000 for each and every one of us. There is just no way we can pay.

But what is the chancellor’s response? The triple lock – whereby pensioners get an annual increase of 2.5%, annual average UK salary growth, or consumer price index inflation – whichever is highest.

Guaranteeing pensioners an inflation-busting increase may secure the grey vote, but it will also bankrupt the country. Pensioners already receive too much, and from too young an age.

The largest cohort of pensioners resides in the country’s second income quintile – ie, on average they have more income than at least 60% of the population. Sure, after a lifetime of saving, pensioners should be in the second quintile for wealth – the size of their assets – but income?

For this unproductive group to be securing better-than-average incomes, as with many on welfare, is grossly inefficient.

Osborne’s solution? To remove incentives from productive private-sector savers by capping pension lifetime allowances (LTA) at £1m. That’s enough – at current rates – to buy you an inflation protected annuity of £30,000, somewhat less than some welfare beneficiaries.

A cynic would note that public-sector defined-benefit pensions, such as those enjoyed by MPs, are not subject to the same punitive tax rates until they’re almost twice as generous – excluding the 25% lump sum, you’re looking at a payment of around £50,000 a year before the LTA kicks in.

What with all these protected areas, where are the cuts going to come from? Non-discretionary spending only accounts for about half of government spending. But half of discretionary spending goes on services that are politically untouchable, such as the NHS and education. This puts the entire burden of austerity on a few government departmental budgets, including defence and policing.

When the NHS was launched after World War II, it cost 2%-3% of GDP. Today it sucks in 8% and rising. No politician seeking re-election, Conservative or otherwise, can tackle this. But the ageing population and the ongoing advance of medical science – which often keeps ill people alive for up to ten years longer – is getting increasingly expensive.

Only about 2% of the population is born disabled, but a further 16% of the population become so during their lifetimes. The main cause of disability is age, followed by low income, poor educational attainment and unemployment, according to the Papworth Trust, a charity.

To the more than ten million underemployed (ie, those who are welfare-supported) and unemployed, we must add an increasingly aged and disabled population – all of whom are being supported by an ever-shrinking productive full-time workforce.

The young can’t carry this weight

So since we’re going to have to depend on them more and more, what about the young? They tend not to qualify for in-work benefits like tax credits (because they don’t have children or council housing yet), so part-time work paying just £8 an hour isn’t such an attractive route for them.

As a result, youth unemployment, currently at 14.4%, is the worst it’s been for 20 years when compared to the overall unemployment rate of 5.7%. The average student leaves university in £44,000 of debt. Of course, they don’t need to repay this debt unless they become high earners, so really it’s just a higher-rate tax obligation. But even so, it hardly stimulates aspirations.

And even if young people do get good jobs, they face a ridiculously over-inflated housing market. Seven years of the lowest mortgage rates for 350 years has inevitably fed into cyclically high house prices.

One day, interest rates will normalise, interest-only mortgage payments might double or treble, and house prices will tumble to reflect higher borrowing costs. When that day comes, the young will once more be able to afford to climb onto the housing ladder.

But instead of offering genuine help on this front, what does the chancellor do? He’s urging the young to buy at the top with his help-to-buy individual savings account. This form of Isa – which tops up the first-time buyer’s deposit with taxpayers’ money – is little more than a subsidised boon for housebuilders and house sellers.

The risk to the housing market is the same one that faces the wider economy. The fact that banks have had to fix their balance sheets in the long aftermath of the financial crisis (and so stop lending, which makes setting up and expanding businesses even harder) is what hammered the economy’s ability to generate tax revenues.

The government has only been able to run a £100bn deficit for several years because of quantitative easing (QE). Unfortunately, QE enabled the government to expand its unproductive transfer systems and distort the economy further.

For now, the interest costs on our debt pile amount to £50bn, or about 3.3%. But each year the national debt grows larger, rate normalisation draws closer, and thus the potential for volatility – major ups and downs in the bond market – grows larger.

In short, what the UK really needs is £100bn of spending cuts, and a complete overhaul of in-work benefits. But instead, the Budget delivered us a “neutral” package of insignificant tweaks and a petty, aspiration-robbing pension raid.

• James Ferguson is a founding partner of the MacroStrategy Partnership LLP.

Avoid gilts, hold a little gold, and get exposure to the EU

John StepekPerhaps it’s no surprise that the latest Budget ducked most of the big issues facing Britain, writes John Stepek. As The Economist put it, “it would be unwise to expect the last Budget before a general election to be anything other than a political event… George Osborne, today’s chancellor, has excelled in this ignoble tradition.”

However, that doesn’t mean it was the right thing to do. “With a general election looming and money tight, Britain deserves a proper debate about how big the state should be and what it should do.”

That’s not what the Budget delivered. And as James’s research above clearly shows, it’s a discussion we urgently need to have – because both the level of spending and what we’re spending the money on needs revisiting.

The trouble is, of course, that – regardless of who wins the next election – no one has a particularly coherent plan (not one that they’re willing to admit to) either to cut the national debt or to make significant changes to the structure of Britain’s economy.

If a left-leaning party or coalition ends up in charge after 7 May, it’s hard to imagine any change in welfare spending or any serious attempt to reduce the national debt. And even if the Conservative party or a right-leaning coalition gets back in, it’s pretty clear that their forecasts cannot be relied on – as Fraser Nelson notes in The Spectator, Osborne’s debt-trimming hopes are a long way off from both his own and Alistair Darling’s original plans from back in 2010.

Right now none of that particularly matters from an investment point of view – the markets are happy to tolerate Britain’s hefty debt levels because we don’t look in any worse state than plenty of our peers. Why fret about the UK when Greece is on the verge of leaving the eurozone, for example? But this won’t always be the case. And in fact, the danger is that things could turn around quite rapidly as we get closer to the election.

Almost regardless of who gets in, we’ll have uncertainties over Britain’s constitutional status. For one thing, unless there’s a major surprise, the Scottish National Party (SNP) looks almost certain to win enough seats to leave the question of independence (whether through another referendum, or through devolutionary reforms that result in independence in all but name) firmly on the table.

That unnerved investors somewhat back in September – combine it with a Labour party that’s arguably perceived as being less business-friendly than any government we’ve had this millennium and you could have a recipe for capital flight.

On the other hand, a Conservative victory, particularly one that ends up being propped up in any way by Ukip, would cast doubts over Britain’s place in Europe. This might be a slightly longer-term concern – and there are arguments on both sides of the “in/out” debate – but there’s no doubt that at least some companies are fretting about the prospect of a “Brexit”.

For example, Sir Gerry Grimstone, the chairman of insurer Standard Life, argued this week that it “would be disastrous for London and the UK if the UK were to leave the single market”.

So what does this mean for your investments? We’re currently working on a major election-related project that we’ll be able to tell you more about closer to the big day.

But for now the main point to grasp is that the UK economy remains vulnerable and, whatever the outcome of the election, the next government is going to face an unenviable task of deciding what services to cut and who to tax more heavily. It won’t come as news to regular readers, but we wouldn’t be keen to invest in gilts (UK government bonds), even though the UK is now dipping into deflationary territory.

And as for shares, don’t keep all your money in the UK – have some exposure to attractive overseas markets such as Japan and the eurozone. And hold a little gold as insurance, in case of further financial emergencies.