On The Brink

The UK is teetering on the cliff of economic Armageddon. There will be no escape unless the electorate gets real.

The old joke runs that if you ask two economists a question you will get at least three answers. That wasn’t the case at a Growth Commission conference on Mending Britain’s Broken Economy last week at the University of Buckingham. The unanimous view of the many eminent economists there was that the UK’s economy is stuffed (industry term). Worse, the current economic trajectory cannot succeed.

The chart below illustrates that trajectory.

In the last quarter century the State’s headcount has increased by 20%. That, of course, means that there is an increased demand on the public purse (your taxes) to cover the State’s payroll, plus another to cover the pensions. Sure enough, in 1999 government spending was 35% of GDP; today it is 46% (IFS data). That spending can only come from taxation or government borrowing, and successive governments have increased both. Of the £14 billion of government debt issued last month, £13 billion was spent on debt interest. (ONS Data).

The second aspect of the chart is the shift of public employees from local government (which delivers stuff) to central government (which doesn’t). In 1999 there was less than one central government employee for every local government one. Today there are more than two. This explains what the dogs on the potholed street can tell you: despite spending ever-increasing amounts on an expanding army of public servants, the service delivered is deteriorating.

The government is taking more money and employing more people to deliver less stuff. The tax take has increased to the point of being a brake on the economy. Rachel Reeves’ policies have triggered capital flight and a worker exodus. The UK’s lamentable growth (among lowest in the G20 and the G7). Were the UK a company, it would be calling in an administrator.

Those who hold the UK government bonds that constitute this debt have no interest in a default, which would cause them a total loss. So they will likely continue to buy debt as it is issued to both roll over the accumulated borrowing. (The average maturity is 13 to 14 years, so every year the UK’s Debt Management Office has to sell some £220 billion of gilts to finance repaying mature bonds, plus about another £130 billion to cover the annual deficit). As the UK’s economic outlook deteriorates, the interest rates demanded by the market will rise.

The economists present saw three routes out of the UK’s debt hole. Good luck, which they rated a 10% probability; runaway inflation (50%); or some financial crisis triggering default or an International Monetary Fund (IMF) intervention (40%). They noted that the IMF lacks the funds to bail the UK out.

Of course the solution to the problem is for the UK to start growing its economy. Even Rachel Reeves understands this; the only sensible thing in the Labour Party’s election manifesto was its commitment to growth. Delivering growth requires investment capital and bank finance, above all for the UK’s SMEs, which provide some 60% of employment and 50% of private sector turnover in the UK.

Unfortunately, as the speakers revealed, UK SMEs are being starved of capital in general and bank lending in particular. Most SMEs, indeed most UK companies, don’t have access to equity funding, so bank lending is crucial. And yet since the 2008 financial crisis, UK bank lending to SMEs has fallen from some 2.5% of GDP to about 0.5%. At the same time the banks’ holdings of UK gilts have risen massively and unhealthily. The bank’s capital adequacy is now very exposed to UK bond yields. If they rise, as they are, the value of the banks’ assets and cash-equivalent holdings fall. That in turn means that they can lend even less to SMEs.

This is entirely caused by the banking regulations, known as Basel 3. This agreement regulates banking, with the intention of ensuring that banks are adequately capitalised, manage their lending risks sensibly and therefore don’t crash. The original Basel agreement was introduced in 1988 and updated to Basel 2 in 2004. Key measures include the risk of default on the lending book and the amount of cash (or cash equivalents like UK government bonds) at hand. Basel 3 increases the capital and cash requirements as a proportion of the bank’s lending. In effect that compels a bank to lend less and to lend less riskily. As SMEs (companies with fewer than 250 employees and a turnover under £44 million) are generally regarded as inherently risky, the banks have lent to them less because the Basel 3 regulations make it impossible.

Over-regulation was one of the key reasons cited for the poor performance of the UK. One American banking expert, Professor Jill Ketina, suggested that the UK needed more banks, rather than a few monoliths too big to be allowed to fail, plus a handful of challenger banks. She pointed out that Texas had many small banks (termed “community banks”) that were fundamental to the Texan oil-boom economy. Small banks can fail without risking systemic collapse.

Regulations are broadly doomed to failure when they seek to regulate a market in detail. Regulations take time to develop while markets, particularly financial markets, can invent products more quickly. Thus, new banking regulations won’t, indeed can’t, remove emerging systemic risks. Worse, regulation protects market incumbents who can afford lobbyists and PR machines to maintain the status quo and stifle competition. Over-reliance on the perceived efficacy of banking regulations contributed to the 2008 crash.

(As an aside, the UK’s oldest bank, C Hoare & Co founded in 1672, is still run as a partnership. The partners have unlimited liability for losses, which they tend not to make! Almost 20 years ago the current CEO, Alexander Hoare, said, “…for many, many years governments have regulated to protect consumers, but what they’ve really protected is an oligopoly of not-very-efficient banks and given consumers very little choice.” C Hoare & Co survived the financial crash without requiring a sous from taxpayer. Hoare’s wonderful memoir, Impact Banker, is out now. Read it.)

Make no mistake, the UK’s dire economic situation stems from a consistent lack of growth. That in turn comes from denying the engine room of the economy access to capital, a consequence of ill-considered regulations, for which the responsibility ultimately lies with Parliament. As most modern careerist politicians have little experience of finance (or much else for that matter), they rely heavily upon their civil servants for briefings on the decisions they must make.

Unfortunately, those civil servants almost certainly lack experience of banking or the commercial world, as they too are careerists – there is very little churn of non-civil servants into top jobs. While the various quangos that run the finance industry are by definition quasi-autonomous, their masters remain in the Treasury. Despite the evidence, the civil service and the whole public sector believe in prescriptive regulation. (So of course does most of Westminster; politicians exist to pass laws, and laws become regulations).

The economic orthodoxy has become one of seeking a managed economy, with a large state machine, concomitantly high taxes, low growth and ever more regulation. The conference was pretty much unanimous that this approach has put the UK in a self-inflicted death spiral. The actions required to change the UK’s trajectory are (in theory) straightforward: a smaller state (requiring less tax) and a balanced budget (meaning no more borrowing). The last person to attempt this trajectory change in the UK is Liz Truss.

She gave a frank and forthright presentation on the dysfunctional split of the UK economy’s managers: the Bank of England, the Treasury and the Office of Budgetary Responsibility (OBR). They operate in splendid isolation from each other, simply looking after their remits. Thus, on the eve of the Truss mini-budget, the Bank blithely announced a £40 billion quantitative tightening (QT) programme without first notifying the Treasury. (QT is generally loss-making, so the Bank’s actions would have needed cash from the Treasury, who knew nothing of it.)

It also transpired that the Bank was aware of the Liability-Driven Investment (LDI) problem but had not deigned to share that information with the Treasury. The LDI schemes got themselves into a doom loop when the bond markets started to adjust to the new budget. That doom loop triggered forced sales of UK bonds, which the bank had to hoover up while the bond yield soared. While the Bank is independent of the Treasury and Westminster, it’s exceptionally strange that it didn’t consider the implications and timings of its actions.

There was some disagreement between the assembled economists as to whether the Bank’s independence was real, was a good thing or was fixable. After so much agreement watching veteran economists going at each other hammer and tongs was uplifting entertainment. There was no consensus on whether changing the management structure of the Bank or giving it more or less autonomy would fix the UK’s economic problems.

That those problems derive from an incompetent, unaffordable large state is self-evident to anyone who can count. Reducing the size of the state is, unfortunately, politically difficult – not least because the “progressives” (as some socialists now style themselves) have captured the vocabulary. Any attempt to cut the wasteful state is trumpeted as “austerity”, which in itself is treated as a synonym for inhumane.

Worse, progressivism is embedded in British universities, with some 60% to 80% of staff “left wing” or progressive. The general population is thought to be about 10% progressive activist. As the civil service and large companies recruit graduates, it seems inevitable that the progressive agenda, already deeply embedded in industry, media and government, will become the majority view in the key organs of the economy, but not the population. It may well have already happened - which would explain a lot.

Whether the economically literate parties (those of the right) can win power in such an environment is an open question. Whether they could then force through the necessary changes is equally unknown.

The certainty is that if they don’t, the UK’s future is bleak.

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This article was commissioned buy the The Conservative Woman, who published a shorted version. The full version above appears here with their gracious permission.

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