Why Britain has to slash its overdraft

Today, Fitch Ratings had its say on Britain’s national overdraft. It wasn’t pretty.

“The scale of the UK’s fiscal challenge is formidable and warrants a faster pace of medium-term deficit reduction than set out in the April 2010 budget”, says the credit ratings agency’s Brian Coulton. In other words – “you lot need to cut back fast and hard.”

So what? It’s hardly fresh news. David Cameron had already softened us up for big cuts. The action needed to tackle the deficit “will change everyone’s way of life”, he said.

And actually, despite what Cameron said, things aren’t actually any worse than we already thought, says Jeremy Warner in The Telegraph. Cameron’s warning about the UK government having to spend £70bn a year on interest servicing costs alone within five years weren’t new. And in fact, “interest costs as a percentage of GDP were actually higher in the 1980s”.

In other words, Britain has been in big financial messes before – and has lived to tell the tale. So is Fitch over-egging things?

Sadly not. The credit rating agency makes two key points. Since 2008 the UK’s budget deficit – how much we’re overspending each year – and the national debt – how much we owe in total – have deteriorated more rapidly than those of any other AAA-rated country. Also, the ‘primary deficit’ – which strips out interest payments – has now grown to almost twice that of the 1970s and early 1990s.

That’s bad enough. But here’s the nub: the world is changing fast and the markets who lend the cash to plug the gaps between tax and spending simply won’t wear such rapidly-rising deficits any longer.

Almost every other European country is now slashing spending hard to keep the global money-men happy. So Britain has to follow, whether it likes it or not. Because if we don’t, we’ll lose our cherished AAA rating, which means we’ll have to pay more to borrow. So our national interest bills will climb anyway. And that would leave us stuck in a vicious circle.

So what now?

First, our new government is likely to act to cut even harder than it was planning. Tax rises could prove to be even nastier than had been expected.

Second, as governments cut back, any economic recovery is likely to fizzle out, as John Stepek said in yesterday’s Money Morning.

Investment–wise, that’s bad news for commodities and China. But it’s much better, as we’ve stressed for a while, for defensive stocks that don’t need economic growth to make their money. We look at one such sector in this week’s issue of MoneyWeek magazine. If you’re not already a subscriber, subscribe to MoneyWeek magazine.