Stephen King: What happens to us if everyone else rushes for the financial exit?

The UK has already used up its conventional policy ammunition. The cupboard is bare

Monday, 7 September 2009

The beads of sweat must have been building up on Gordon Brown's brow last week. What if the leaders of other nations suddenly decided to raise taxes, to cut public spending or to raise interest rates in a bid to bring last year's policy stimulus to a close?

What if they collectively felt that the industrialised world was over the worst and that it would no longer be appropriate to bail economies out through unusually lax fiscal policies or unusually generous monetary policies? The UK would then be on its own. It would also be in big trouble.

As it turned out, the G20 Finance Ministers' meeting concluded with a promise to maintain expansionary policies until a recovery was firmly secured. This, of course, is a bit of a cop-out. Economies don't all recover at the same time and policymakers are bound to disagree on the nature of a genuinely secure recovery.

For the UK, this creates a particularly awkward problem. Other economies, such as France and Germany, have already stopped contracting. The UK hasn't, at least not yet.

The UK desperately needs the help of other nations to pull itself out of the recessionary mire. To see why, think about the policies which have been adopted by the Treasury and the Bank of England since the crisis began.

There's been huge fiscal expansion. While almost all other OECD countries have also turned on the fiscal spigot (with the notable exception of Iceland, which had to go through a stomach-churning fiscal contraction), few started off in such a bad underlying position. In 2009, the UK is likely to have the biggest budget deficit of any of the OECD countries, a result not only of the Government's recent expansionary policies, but also of its earlier short-sighted profligacy (see chart). The UK has the lowest interest rates (0.5 per cent) since the Bank of England was first established in 1694. And it has been the only major country where the central bank has decided to buy huge amounts of government bonds: neither the Federal Reserve nor the European Central Bank (ECB) have resorted to quite such desperate measures. As Jean-Claude Trichet, the President of the ECB, noted in the press last week, "...we are unrestricted in our ability to take decisions, given the strong institutional independence of the ECB. This reflects the clear dividing-line in the euro area between the responsibilities of the central bank and those of the fiscal sphere. That the ECB has not purchased government bonds is in line with this institutional framework." Ouch.

My point is simple. The UK has already used up its conventional policy ammunition. There is nothing left. The cupboard is bare. The Bank has resorted to the purchase of gilts with the intention of pumping money into the system because the more attractive alternatives have already been exhausted. While there are some signs that very low interest rates may be having a beneficial effect – house prices have started to rise, the stock market is more robust and business confidence has improved – we're not completely out of the woods.

Domestically, there are two obvious constraints. First, although the banks are beginning to lend more freely, they are nevertheless not likely to return to the very loose lending standards which preceded the credit crunch, such as offering very large multiples of income for first-time buyer mortgages.

Second, British households, like those in the US and Spain, have borrowed huge amounts in recent years, and even with signs of a pick-up in house prices many of these households are choosing to repay past debts. At an individual level, that's an entirely sensible decision. Collectively, however, it means that low interest rates are not providing the stimulus of old.

Thus, a sustained UK recovery from now on is, perhaps, unusually dependent on developments elsewhere in the world. If other countries do decide to bring their expansionary policies to an end, demand for British goods will fade away, and British exports won't do quite so well. That will hold back growth.

Governor Mervyn King and others at the Bank of England have long argued the need for a rebalancing of the British economy, with more resources devoted to exports and investment and fewer to domestic consumption. That, however, is a lot easier to do if demand is being stoked up elsewhere in the world. If foreign policymakers decide to put a lid on demand through the imposition of so-called "exit strategies", the UK will struggle to rebalance in a relatively pain-free way. Indeed, in those circumstances, the only option would be to encourage sterling to drop: the UK would then be able to increase its share of global markets through an increase in the competitiveness of its exports. But, politically, that's playing with fire.

As for the G20 Finance Ministers' meeting, the fault-lines are easy enough to spot. In the accompanying statement, the ministers, in classic Yes Minister-speak, promised to "develop cooperative and coordinated exit strategies, recognising that the scale, timing and sequencing of actions will vary across countries and across the types of policy measures". An appropriate translation might be "each country will do whatever it wants to do".

Meanwhile, the G20 ministers have promised to "work to achieve high, stable and sustainable growth, which will require orderly rebalancing in global demand, removal of domestic barriers and promotion of the efficient functioning of global markets." Ahead of the crisis, lots of policymakers, wrongly, thought some of these conditions were already in place. Growth, after all, was reasonable while inflation was well-behaved. Yet with huge amounts of debt in both public and private sectors, countries like the US and the UK will not achieve high and sustainable rates of growth for many a year: they will instead be paying off the debt associated with past misdemeanours. The G20 statement gives the impression that a magic wand can be waved to make all economic problems disappear. If only that were true.

Still, the official G20 Statement offered hope elsewhere, notably the aim of increasing the representation of the major emerging powers in the IMF and in other international economic institutions. That's very important for all sorts of reasons.

Emerging nations such as China, India and Brazil are much bigger than used to be. They enjoy a much bigger share of global output than before. They are the now among the biggest players in global commodity markets. And they are America's biggest creditors. If another crisis of the kind we've lived through over the last couple of years is to be avoided, it is absolutely vital that China, India, Brazil, Russia and others have big seats at the big table: they might not always be the easiest of bedfellows but, whether we like it or not, and as we have seen recently, our economic progress is increasingly linked to theirs.

Indeed, as the US and the UK lick their economic wounds, by contrast the emerging nations are likely to flourish. Low American interest rates may offer only a modest domestic stimulus, but many emerging nations also link their monetary policies to those of the Federal Reserve, and they will see a bigger boost from low rates as they don't have the same sort of banking problems holding them back.

Over the next few years, as economic growth makes a comeback, the winners are likely to be China, India and the other increasingly dynamic emerging nations. The US and the UK will only be able to watch, financially wounded, on the touchline.

Stephen King is managing director of economics at HSBC