There’s only one way out of the UK’s mess: default

The ‘austerity versus stimulus’ debate continues to grip the pundits on the political and business pages.

Broadly speaking, if you lean towards the right, you believe in austerity – but you still want tax cuts. If you lean to the left, you believe in stimulus – even although it means massive implicit bail-outs for the banks and the asset-rich wealthy.

It’s all a lot of rubbish.

When economies get into the kind of mess that ours are in, there’s only one way out – default.

The question is merely whether you do this the hard way or the easy way…

It’s not about austerity versus stimulus

The austerity versus stimulus debate is a red herring. Both paths lead to hell – the only difference between them is which groups of people take the most pain.

Assuming you’ve allowed your economy to be sucked into a catastrophic credit bubble in the first place, then the best route out is through default. That puts the pain squarely on those who most deserve it – careless lenders.

You only need to look at Greece to realise this is true.

Yes, labour costs are falling, which means that Greece is becoming a bit more competitive, although it’s still way behind Germany. And yes, a drop in imports combined with a very small rise in exports, has helped the state of its finances.

But what’s really behind the little progress Greece has made is not austerity – it’s defaulting on its debt.

As James Mackintosh points out in his FT column this morning, “Greece’s improved current account is mainly down to two factors: collapsing imports and cuts of several billion euros in interest payments after the government defaulted on its bonds.”

So the real lesson to take from Greece and its fellow eurozone pariah nations, is not about the effectiveness or otherwise of austerity. It’s that you’re going to default in the end – but only when your back is against the wall.

Greece was denied the option of printing money, which is the stealthy way to default. So the country had a choice. It could either cut costs the hard way, by cutting spending, raising taxes – and defaulting on its debt. Or it could quit the euro and return to the days of devaluation and inflation – and also defaulting on its debt.

Austerity is hard work. It’s not surprising that many of us thought that Greece would go for the second option, and dump the euro in disgust. It may yet do so. Or it could be ejected by other members of the eurozone, fed up with its slow progress.

But ditching the euro would be embarrassing. It would also be a terrible step into the unknown. Given the choice between grinding wage cuts and tax hikes, or the complete wipe-out of every savings account in the country that a return to the drachma would bring, which would you choose?

What choices will Britain make?

The big question for anyone living in the UK is: when Britain’s back is against the wall, what choices will the government make?

It wouldn’t take much to shake confidence in this country. Another slump into recession, maybe. Or clear evidence that this government’s spending cuts, promises and forecasts are no more believable than those of Gordon Brown. Or perhaps a bond market panic as the coalition tears itself apart over Europe, or Nick Clegg’s injured pride.

So what will the government do when that day comes? Would it bite the bullet and start reforming the tax system and trying to tackle the bad debts that have left a big chunk of the economy in the hands of zombies? Or would it call on the Bank of England to print more money and bail it out?

I think we all know the answer to that one. Osborne has already tapped the Bank for £35bn. Sir Mervyn King has put it on his tab behind the bar with a nod and a wink, but I’d be amazed if the Bank of England ever sees that £35bn again.

And what comes next, when markets realise that the UK is trying to plaster over a broken economy with printed money? A further 20% drop in the pound? Consumer price inflation taking off and becoming a headline issue (I’m guessing that 7% is the magic level that would trigger a proper public outcry)?

Will the government try to fill the hole in its finances by targeting pension pots? Osborne is already apparently considering cutting the amount you can put into your pension once again. Or will it take a look at corporate cash piles and decide that some of that money should be coming its way, as my colleague Merryn Somerset Webb has regularly warned?

The fact is, Britain will face some very tough choices before this crisis is finally over. You need to position your portfolio to take account of this. Have a look at this week’s MoneyWeek magazine cover story for more on why the UK faces hard times ahead. If you’re not already a subscriber, subscribe to MoneyWeek magazine.

• This article is taken from the free investment email Money Morning. Sign up to Money Morning here .

Follow John on Twitter || Google+ John Stepek

Our recommended articles for today

Two reasons to steer clear of Chinese stocks

China might look cheap, but it’s not cheap enough to make it an attractive long-term hold. And that’s not the only reason to steer clear of Chinese equities, says Merryn Somerset Webb.

Ocado was a terrible mistake

Shares in supermarket delivery firm Ocado rose on the news of a new share offering. But you still shouldn’t go anywhere near this company, says Bengt Saelensminde. Here, he explains why.

  • Mike B

    “That puts the pain squarely on those who most deserve it – careless lenders.”

    Worth pointing out that “savings” are actually a loan to the bank… and will also be lost in a default…

  • Bob

    Bearing in mind that neither Greece, Ireland or Spain has defaulted – what makes you think we will?

    Is Moneyweek now the Zerohedge of the UK?

  • flyfly

    Bob, what Greece did was a default in all but name but you are spot on about Spain and Ireland and I was thinking the exact same this as I read the article. I’ve read Moneyweek theorise that the high inflation route is a “default” in the sense that it breaks an implicit promise to taxpayers. Oddly, I think of high inflation as a form of austerity and the BoE thinks QE (and thus inflation) is stimulus.

  • Inflationnation

    1, mikeb

    The FSA covers the first £85k in most bank accounts (inc isa) .
    Anyone naive enough to hold £85k+ in any bank account deserves to lose their shirt.

    Gold is money. The £ is simply currency.

  • Chucklebus

    I’m not sure I agree with “That puts the pain squarely on those who most deserve it – careless lenders. “
    I would blame anybody stupid enough to borrow more money than they could ever hope to pay back as those who deserve it….ie the Government.
    However, a default wouldn’t hurt them as they continue to line their pockets with unnecessary departments and buraucracy to justify their existance with OUR MONEY.
    However, the banks are also to blame because they devised schemes to suck money out of the system (our pockets and those of whole countries).
    Capatalism is a giant game of monopoly that creates winners and losers. Once a big player takes money out of the game, it’s over and the losers default (so I agree there). Then we redistribute the money and start again. Why’s any of this come as a surprise?

  • Chucklebus

    Austerity measures are a waste of time as they stop the ‘money-go-round’…people lose more of their income (again to fund individuals in a bloated governement), have less to spend in the shops that provide jobs and wages (and tax revenue) for other people to spend. The key is to keep to money-go-round moving.

  • Jon

    @1 & @4 – savers provide the base captial & leverage does the rest, but who backstops the Financial Service Compensation Scheme when the prime contributors (the banks) and the secondary (the UK national debt as controlled by the Govt) are worse than penniless ?

    My suspicion is that pension funds are next to be appropriated, in particular the ‘contracted-out’ rebates and incentives doled out over the years to buy out future pension liabilities – haul these back into the national accounts & present them as a solution to current liabilities whilst the future can go and hang.

  • Max Stirner

    Sure, a default is coming, one way or another. At the moment they are choosing the hyperinflation way. And I guess they will stay on that way until they cannot control it anymore. But in anyway austerity will still have to come too. The current state cannot be financed without debt.

  • m. Rae

    iT AS BEEN EVIDENT TO MOST BROAdly educated people that the only purpose was to lock this country’s assets intgo their system, “In simp[le terms io get their hands in the Privy Purse” – %0 years ago I read a pamphlet which described how to ‘do away with the influence of the Church of England ! There are many ways to skin a rabbit ? Later a full page panoramnic of London and showing”the pinnacles of power” how a foreign entity could control Britain
    Now read Economist Prof.T Congdon’s 2012 Edition, on What the EU Costs Britain” esp. p20 to 24 – 10%GDP !!! Impoverish a nation and they are hostage!!

  • Dagengham Dave

    This is England! We will never default. English speaking countries do not default, only Latin speaking countries do that sort of nonsense.

  • Roberto Birquet

    s present govt really missed a trick. Surely, the major part of Britain’s debt sits in the private, not public sector. By focusing on the public sector, probably for ideological reasons, it forgot that 85% of Braitain’s debt in summer 2010 was private sector (compare Japan, same overall debt, but 50:50 pub/private). The idea that you must cut public sector spending because of too much debt, and expect the even-more indebted consumer to take up the slack was idiotic. Had this govt got the pain in early, it could blame “the last lot”. But it has continued bailing out the indebted and the asset rich, and we have zombie economy as a result. It’s probably too late for them now to change tack.

  • Merv the Swerve

    So according to Mr Stepek, not repaying debt is the solution to the U.K. financial crisis… i.e. follow the fine example of those who got us into this mess in the first place. What a curious form of logic, sounds as moral as bank execs taking multi-million pay offs and offers a familiar refrain to that of our no-blame culture.

    Mr Stepek uses the expression ‘careless lenders’… did he ever consider the principle of only borrowing what one can afford to repay ? This is clearly why he is writing a column and not running an institution… or perhaps my old fashioned logic means I merely belong in one…

  • cphilpo

    could this default practice be used privately to unload your debts ie like an iva because what is good for the men with jobs for the boys, has got to be good for people at the bottom due to no fault of their own.

  • alan

    You forgot the other plan, which is to simply create extra currency to buy all of your debt up and then simply cancel it. I see no flaw in this plan #sarcasm..but it is what is gradually happening anyway.

  • David N

    The UK is getting neitherAusterity and Stimulus. The UK Govt. still has a colossal programme of public spending. The ‘stimulus’ takes the form of buying debt from the Banks, who use it only to bolster their own balance sheets. The only factor maintaining normality in the UK is the low interest rate which JS was complaining about yesterday. Once we lose normality we are really in trouble. JS concedes that the UK has decided to default gradually by inflation. Agreed. The lesson to learn from Greece is not to join the Euro. Nothing more. Lets move on. The UK is now in a race against time to reduce its overheads to a level it can actually afford. Failure will result in uncontrolled default and the only benefit will be those betting on it.

    Roberto B – How can the Left be the party of privilege and the banks? By protecting the lifestyles of those employed in the public sector (including the ‘nationalised’ banks) at the expense of those in the private sector.

  • Aff

    Excellent article Mr Stepek. Hats off to you for telling it how it is. The mainstream media don’t even admit default is a solution, but then again the mainstream media cannot be relied on for anything like truth.

    To counter the first comment I believe the Icelandics made sure savers didn’t lose anything. Are not most savings accounts insured up to a fairly high amount?

  • pete

    Dont really get all of this, but does anyone. If I default on my loan I get taken to task, so what happens when a country does the same.

  • William

    Did not Hitler default on the Treaty of Versailles? I understand his tactics worked, but not for long…..

  • Lupulco

    To default is the Nuclear Option, Yes it would theoretically clear our debts; But
    1] Most of this debt is bonds owned by Insurance/Pension Companies to fund the payments of its Pension Liabilities.
    2] Future borrowing would only be on VV high rates, if at all.
    3] What if other Countries default on debts they owe us?
    Missed out on the option of
    1] freezing State spending at current levels
    2] freeze allowances at current levels [in real £ values]
    The above 2 measures would allow inflation to a] reduce spending and b] increase government income to help balance the books.
    3] I suppose a levy on Financial Institutions of their turnover within the UK and a levy of property values of 0.5% pa ear-marked for debt repayments would be to much to ask for?

  • Provider9

    e public and in the other the private. Can anybody tell me if they know anyone who is not a banker working in the private sector who’s employer contributes 14.9% salary to their pension?

    Who’s tax bills pay this? Private sector employees and corporation tax. Its a wonder the average private sector employee on £26500 isn’t rioting in the street. Oh wait sensor the BBC.