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Reflections on the Comprehensive Spending Review (CSR)

Thursday October 21st 2010

The Chancellor of the Exchequer, George Osborne announced yesterday that the UK had a structural budget deficit of at £109Bn. The largest in Europe. Debt interest payments this year would amount to £43Bn.Therefore radical action to tackle the gap in the public finances was unavoidable. On this point the Chancellor is absolutely correct.
 
The opposition and Trade Unions can undertake as much posturing as they choose. However, without the measures taken in June. Just one month after the election. The process of steering public finances toward a sustainable path long term interest rates (the yield on gilts) would have been delayed . Gilt yields would certainly have been higher than now.
 
Why is it that opposition and unions fail to make a connection between debt levels, sovereign ratings, sovereign debt yields and the level of Base Rates? From the rate the Bank of England has to set, so the nation’s medium term economic fortunes will evolve.
 
Without the June judgments debt interest payments would also have been higher, so further increasing the deficit. This would have delayed the date when the ratio of debt to GDP stabilised.
 
This dismal scenario would have had wreaked carnage on private sector activity and also the longer term supply performance of the overall economy. In passing the first test of his nerve; one has to respect that the Chancellor has gone further in terms of welfare reform - Mr Osborne has maintained the downward pressure on gilt yields.
 
This will act as a non fiscally expansive stimulus to private sector activity. There will be no crowding out!
 
Still acolytes of Keynes still want their hero to see his name in the spotlight. This is, however, no time for a simplistic Y= C + I + G … model to be trotted out again.
 
Theory has to yield to empirical evidence. Evidence borne in the environment of economic dynamics, not dogmatic comparative statics. The data shows that periods in which the structural budget deficits have increased are generally associated with economic weakness and vice versa.
 
This is because in the real world increased government spending “crowds out” private sector activity. One only has to consider the UK case in the 1983-87 period, when the public finances moved into surplus whilst the economy enjoyed an extended period of above trend economic growth. The reverse case in seen in Sweden in the mid 1970’d when fiscal spending was hampering the economy despite the export success of ABBA!
 
This is no frivolous statement for one just has to question what happened to the Japanese economic miracle? Were it just a question of spending tax payers money Japan would have experienced an extended boom over the last 10-15 years. That was not the case. We all know about the dreadful and ongoing “lost decade”.
 
What is crucial for the UK and indeed any modern western market economy lies with where is the money supply. The Bank of England Governor, Dr. Mervyn King recognises this. On the road in the West Midlands he told his that there is “too little money in the economy”. Take that as an unsubtle hint that more QE in the UK is on the way. This is likely to be marked at the MPC in November.
 
Implications for Financial Markets
 
UK financial markets were little moved by the Chancellor’s statement yesterday. Be not surprised as the plan was well signaled. The macro message was barely changed from the June Budget. Yield to maturity on 10 year Gilts was unchanged at 3.00%. The 25 point rise in the FTSE 100 index to 5728 had more to do with the strong Wall Street opening than any of the detailed cuts in departmental budgets unveiled by the Chancellor.
 
Of course there is delight that there was no back-tracking in the CSR on the need for large cuts in planned expenditure or a shift in the emphasis from spending restraint to tax increases.
 
With the economic recovery likely to derive considerable support from sustained low long term interest rates and further asset purchases by the Bank of England I continue to expect equities to make solid gains over the rest of 2010 and throughout 2011.
 
 
Stephen Pope
Managing Partner ~ Spotlight Ideas
++ 44 (0) 7931 543 740

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