Docstoc

britain at the crossroads

Document Sample
britain at the crossroads Powered By Docstoc
					britain at the crossroads
   the case for fundamental change
             Dr Tim Morgan Global Head of Research




                 strategy insights | issue four
britain at the crossroads | the case for fundamental change

    ‘It is possible to envisage a future
    in which the British population
    is subjected to ever-increasing
    taxation and charging to sustain
    an administrative superstructure
    which is increasingly coercive as
    well as unaffordably costly.’




2         strategy insights | issue four
britain at the crossroads
the case for fundamental change

“The UK needs to modernise, and to commence
a new ‘quest for national efficiency’”

contents

introduction an unreal debate

part one:          the road to here
1                  a golden inheritance?
2                  the great experiment

part two:          where is here?
3                  money troubles
4                  the way we live now

part three:        the road out
5                  limited options
6                  practical choices




Note: In Issue Three, we said that our ‘Dangerous Exponentials’ core thesis would form the
subject of Issue Four. However, because of the imminence of the UK general election, we have
brought this report forward. ‘Dangerous Exponentials’ will now be the subject of Issue Five.




                                                                                          strategy insights | issue four   3
britain at the crossroads | the case for fundamental change




          strategy insights | issue four
britain at the crossroads
the case for fundamental change – summary

•	   With a general election looming,           2. The debate is essentially short-           quangos that have proliferated
     investors are being inundated with            term in nature, so necessarily             over the last 20 years, and (b)
     research, much of it suggesting               misses some of the longer-term             reducing the complexity and cost
     appropriate investment strategies.            trends (such as the growth of              of departmental administration to
     Given our remit – which is to                 bureaucracy) which are critical            that of international best practice.
     stimulate debate on matters                   to an understanding of the
     of economic and financial                     current situation and of the         •	    In the final chapter, we explain
                                                   future imperatives.                        how this could be done. We
     significance, and to think outside
                                                                                              describe a route to achieving a
     the box – this report is different.
                                                3. Where the recent economic                  sustainable (3%) deficit over five
     We aim to probe some of the
                                                   and fiscal crisis is concerned,            years, while at the same both
     deeper and longer-term strands of
                                                   the bill hasn’t turned up yet, and         reducing (slightly) the overall
     the current UK situation.
                                                   politicians are understandably             burden of taxation, and actually
•	   To this end, this report is divided           loathe to reveal the full scale of         improving public service provision.
     into three parts. After an                    the challenges confronting the
     introductory discussion of some               United Kingdom.
     of the issues at stake, Part one
                                                4. It is only by grasping both
     takes a detailed look at how we got
                                                   the current situation and its
     here, reviewing both recent and
                                                   historical precedents that
     longer-term economic and political
                                                   we can frame practical
     developments. Part two assesses
                                                   new directions.
     the issues as they now stand, and
     the final section offers radical
     policy options going forward.
                                           •	   The latter point is the most
                                                important. It is perhaps a
•	   Readers might regard much of this          simplification, but not much of one,
     report as gloomy. It may certainly         to say that the best policy options
     seem so to those unaware of the            for the future may lie in the flip-
     full scale of the problems with            sides of the mistakes of the past
     which the UK is beset. Our analysis        and the weaknesses of the present.
     is certainly intended to be hard-
     hitting, for four main reasons:
                                           •	   Our strategy is predicated on the
                                                belief that, after a decade of break-
     1. Much of the political debate            neck increases in public spending,
        is being conducted in an air of         the UK system of administration
        unreality, and seems to assume          is ruinously over-expensive as well
        a freedom of manoeuvre (on              as absurdly complex. Huge savings
        issues such as the urgency of           could be achieved simply by (a)
        deficit reduction) which may not        consolidating or scrapping many
        in fact exist.                          of the plethora of ‘agencies’ and




                                                                                             strategy insights | issue four          1
britain at the crossroads | the case for fundamental change




principal recommendations

•	     Recognise that Britain’s public                 the real-terms level of 2007-08                •	   Tackle the deficit, reduce taxation.
       services are over-expensive                     (£615bn at 2010 values).                            Our calculations suggest that a
       because they are over-managed.             •	   A quest for national efficiency.                    real-terms cut of £80bn in public
       This over-management has arisen                 Essential modernising steps                         spending would, if achieved by
       from (a) the fragmentation of                   include:                                            2015, reduce the deficit to 3% of
       services (such as the NHS) in the               - reconsolidating fragmented                        GDP while enabling the overall tax
       vain pursuit of quasi-competition,                public services                                   burden to fall slightly, from 36% to
       and (b) the proliferation of quangos                                                                35% of GDP.
                                                       - reducing administrative costs to
       and semi-autonomous ‘agencies’.
                                                         best-practice international levels           •	   Helping at the margin. If scope
•	     Live within realistic revenues. The             - dispensing with large numbers                     did indeed exist for some modest
       next Parliament should adopt a                    of quangos and semi-                              reductions in taxation, our
       ‘self-denying ordinance’ which says               autonomous ‘agencies’                             preference would be to raise the
       that government must decide upon                - capping the tax deductibility of                  basic tax allowance from the
       a realistic level of revenue and only             interest expense                                  current £6,475 to the level of the
       then decide how this spending                                                                       minimum wage (about £10,200).
                                                       - abandoning the wasteful
       should be allocated.                                                                                Likewise, we would address the
                                                         PFI process
                                                                                                           interface between benefits
•	     Reduce public spending by                       - abolishing the failed tripartite                  and work.
       £80bn. Far from devastating                       regulatory system, with the
       public services, this would only                  banking oversight function
       cut outlays (currently £700bn) to                 restored to the Bank of England.


    Fig. 1: Outline financing projections
    £bn                               2008-09    2009-10      2010-11       2011-12       2012-13          2013-14       2014-5      vs 09-10

    GDP                                 £1,435    £1,409        £1,465       £1,520         £1,593          £1,672       £1,756

    Revenue             nominal          £534       £508          £525         £541           £564            £588         £614

                        in 2010 £        £547       £508          £514         £522           £530            £538         £546       +£38.4

                        as % GDP         37.2%     36.1%         35.8%        35.6%           35.4%          35.2%        35.0%

     Spending           nominal          £630       £674          £672         £667           £668            £668         £667

                        in 2010 £        £645       £674          £657         £643           £628            £611         £594        -£80.2

                        as % GDP         43.9%     47.8%         45.9%        43.9%           41.9%          40.0%        38.0%

     Deficit            nominal            £96      £166          £147         £126           £104             £80          £53

                        in 2010 £          £98      £166          £144         £121            £98             £73          £48      -£118.6

                        as % GDP          6.7%     11.8%         10.0%         8.3%            6.5%           4.8%         3.0%




2              strategy insights | issue four
about this report

Economic slumps do not happen by                           ‘boom and bust’. This was simply                   finances but of the front-line workers
accident. Fiscal crises are not ordained                   hubris. Much worse, public spending                and of the users of social services
by a malignant economic deity. Though                      was allowed to rise dramatically,                  as well. For example, the Ministry of
the immediate catalyst for the UK’s                        largely on the assumption that growth              Defence spends 20% of its budget
debt crunch was the global downturn                        was both real and sustainable. As a                on administration while its foreign
triggered by US sub-prime, this merely                     result, the government is running an               counterparts manage to get by on
crystallised the implications of a policy                  unprecedented deficit (of 12% of GDP)              just 11%1. The situation in an NHS
direction that, sooner or later, was                       that far exceeds either the IMF crisis             fragmented both by this government
always destined to hit the buffers                         of the 1970s (7%) or the post-ERM                  and by its predecessor is even worse.
anyway.                                                    squeeze (7.7%) of 1993-94.                         Examples of administrative profligacy
                                                                                                              abound.
Events follow from policies, and the                       When anyone calls for cuts in public
policies which have been followed in                       spending, there are howls of protest,              This report proposes an alternative
the UK for more than a decade have                         and grim warnings that slashing                    strategy. We advocate reducing
been fundamentally flawed. The                             spending would inflict unacceptable                the deficit to 3% of GDP by 2015
country’s current straitened economic                      damage on the public services that are             through radical overall of the public
and fiscal circumstances are the logical                   required by a civilised society. This is           sector, culling quangos and slashing
outcome of these mistakes.                                 bunkum. In 2009-10, the government                 overheads. An important implication
                                                           spent £674bn. If this were reduced                 of this strategy would be that quality
This report, which takes a radical                         by £50bn, it would remain higher                   public services could be maintained
view of the British malaise, explains                      than the inflation-adjusted total for              at a level of taxation (35%) that
this process. The basics of the                            2007-08, when the public services                  would give Britain’s economy a real
UK’s self-chosen route to crisis are                       were hardly under-funded. Even a                   competitive edge. Any such strategy
straightforward enough. ‘Light                             £100bn reduction would only take real              would, of course, provoke screams
touch’ (for which read ‘negligent’)                        spending back to the 2004-05 level.                of protest from vested interests.
regulation of the financial system                                                                            Government should turn a deaf ear to
led to a totally unsustainable, and                        In any case, the claim that big cuts               such screams, and make a quest for
almost entirely illusory, economic                         would devastate front-line services is             national renewal as its overriding aim.
‘boom’. Far from recognising this,                         bogus. The reality is that the UK public           It is a matter of choices.
and responding accordingly, the                            sector is grotesquely over-managed, to
government proclaimed an end to                            the detriment not just of the national




     Fig. 2: An inexorable rise – public spending, 2001-10
     £bn                     01-02           02-03          03-04            04-05    05-06           06-07         07-08        08-09           09-10

     Actual spend             £389           £421            £456            £492     £524            £550           £583         £630           £674

     In 2010 £                £480           £508            £533            £559     £580            £597           £615         £645           £674




1
    Source: report by McKinsey, cited The Financial Times, 23rd March 2010                                      strategy insights | issue four           3
britain at the crossroads | the case for fundamental change




    Fig. 3: Financial summary, 2009-15*
    £bn                              2008-09      2009-10     2010-11   2011-12   2012-13   2013-14   2014-15

    GDP                               £1,435        £1,406     £1,464    £1,533    £1,621    £1,720    £1,824

    Revenue                             £534          £508      £541      £582      £621      £660      £699

    Expenditure                         £630          £674      £704      £713      £730      £748      £772

    Surplus/(deficit)                    £96          £167      £163      £131      £109       £88       £73

    Debt at year-end:

    Reported debt                       £629          £761      £931     £1,065    £1,183    £1,281    £1,366

    Treaty debt                         £796        £1,004     £1,179    £1,318    £1,438    £1,534    £1,618

    As % GDP:

    Revenue                            37.2%         36.1%      37.0%     38.0%     38.3%     38.4%     38.3%

    Expenditure                        43.9%         47.9%      48.1%     46.5%     45.0%     43.5%     42.3%

    Deficit                             6.7%         11.8%      11.1%      8.5%      6.7%      5.1%      4.0%

    Reported debt                      43.8%         54.1%      63.6%     69.5%     73.0%     74.5%     74.9%

    Treaty debt                        55.5%         71.4%      80.5%     86.0%     88.7%     89.2%     88.7%

    Memo:

    Real growth                        -1.5%         -3.8%       2.0%      3.0%      3.3%      3.3%      3.3%

    GDP deflator                        2.5%          1.8%       2.3%      1.5%      2.5%      2.8%      2.8%



    *Source: Budget 2010




4             strategy insights | issue four
      Fig. 4: Financial projections 2009-15*
      £bn                                 2008-09            2009-10           2010-11            2011-12   2012-13       2013-14         2014-15

      GDP                                   £1,435            £1,409             £1,465            £1,520    £1,593         £1,672         £1,756

      Revenue                                 £534              £508               £525             £541      £564            £588             £614

      Expenditure                             £630              £674               £672             £667      £668            £668             £667

      Surplus/(deficit)                        £96              £166               £147             £126      £104             £80              £53

      Debt at year-end:

      Reported debt                           £629              £761               £970            £1,109    £1,227         £1,320         £1,385

      Treaty debt                             £796            £1,004             £1,218            £1,362    £1,482         £1,573         £1,637

      As % GDP:

      Revenue                               37.2%              36.1%              35.8%             35.6%     35.4%          35.2%             35.0%

      Expenditure                           43.9%              47.8%              45.9%             43.9%     41.9%          40.0%             38.0%

      Deficit                                 6.7%             11.8%              10.0%              8.3%      6.5%           4.8%              3.0%

      Reported debt                            44%               54%                66%              73%       77%            79%               79%

      Treaty debt                              55%               71%                83%              90%       93%            94%               93%

      Memo:

      Real growth                           -1.25%            -3.50%              1.50%             2.00%     2.00%          2.00%             2.00%

      GDP deflator                           2.50%             1.75%              2.25%             1.50%     2.50%          2.75%             2.75%



*
    Source: Tullett Prebon projections, based on 2% real GDP growth, a tax target of 35% of GDP
*
    Source: Tullett Prebon projections, based on 2% real GDP growth, a tax target of 35% of GDP
    by 2014-15, and a deficit target of 3%
    by 2014-15, and a deficit target of 3%




                                                                                                              strategy insights | issue four           5
britain at the crossroads | the case for fundamental change




summaries:
part one – the road to here

1. a golden legacy?

•	   Though much of the blame for the             •	   There has been a long-standing
     state of the economy and of the                   failure to target the welfare system
     national finances falls squarely at               on those in genuine need, or to
     the feet of the current government,               overcome the poverty trap.
     significant weaknesses pre-dated
     1997.                                        •	   Trends towards excessive
                                                       deregulation of financial services
•	   The British tax system has long                   began in the 1980s, and triggered
     favoured debt capital over equity.                the regrettable de-mutualisation of
     While defenders of this bias claim                the building societies.
     that it attracts investment, the
     reality is that it simply attracts           •	   Since the early 1990s, the need for
     debt. The employers’ National                     energy security has been neglected,
     Insurance (NI) system penalises                   and short-termism (most notably
     job-creation, and NI itself has                   in the ‘dash to gas’ in power
     become nothing more than an                       generation) has damaged the
     income tax masquerading under                     longer-term outlook for energy.
     another name.
                                                  •	   Britain has, since the 1990s, taken
•	   The original aim of privatisation                 an unduly relaxed stance towards
     was to return to the private sector               overseas ownership of key strategic
     industries which had no logical                   industries. Britain is almost alone
     place in government ownership.                    among major developed economies
     After the departure of Mrs Thatcher,              in that it has allowed
     however, privatisation was pushed                 its utilities, airports and other
     into wholly inappropriate areas                   key strategic assets to become
     of public service provision. This                 foreign-owned.
     resulted in a costly and inefficient
     fragmentation of the public
     services, and claims that this would
     offer both efficiency and consumer
     choice were essentially bogus.

•	   The British bureaucracy has been
     growing, with few pauses and even
     fewer reversals, since 1945. This
     growth has long been out
     of control.




6         strategy insights | issue four
2. the great experiment

•	   Since 1997, Labour has attempted             overstretch transitioned into
     to remodel society along essentially         the national debt, while the
     ideological lines. Unfortunately,            reversal of earlier, largely illusory
     these objectives have been                   growth pushed the relationship
     undermined by failed economic,               between government revenue and
     fiscal, monetary and regulatory              spending into the red to an extent
     policies which continued and                 unparalleled in the peace-time
     worsened, rather than reversing,             history of the UK.
     inherited weaknesses.
                                            •	    This has in turn damaged the
•	   Together, the introduction of the            performance of an economy
     tripartite system, and the exclusion         whose competitiveness has been
     of asset price inflation from                undermined by excessive taxation
     monetary targeting, paved the                and by burdensome regulation and
     way for a ‘notional value’ bubble of         interference. Moral absolutism
     which the 2008 financial crisis was          has been the cause of many of the
     the inevitable result.                       mistakes of the last 13 years.

•	   Far from realising that the 2000-
     07 ‘boom’ was essentially both
     illusory and borrowed, government
     bought into the theory that ‘boom
     and bust’ had been abolished. This,
     it was believed, could pay for a
     remodelling of society based upon
     increases in public spending which
     took government outlays from 36%
     to 48% of GDP in the space of a
     decade.

•	   At this point, two inevitable
     processes combined to stretch
     the government balance sheet to
     somewhere near breaking point.
     Via an inevitable TAT (toxic asset
     transference) process, banking




                                                 strategy insights | issue four           7
britain at the crossroads | the case for fundamental change




summaries:
part two – where is here?

3. money troubles

•	   The United Kingdom has become                     assumptions, while the exclusion of
     mired in debt. Reported national                  pensions and PFI increments leads
     debt – which the government                       to the under-reporting of the real
     says will rise from £760bn today                  deficit.
     to £1.37 trillion by 2015 – severely
     understates indebtedness because
                                                  •	   Britain faces significant ‘vortex risk’,
                                                       by which we mean the danger that
     it omits both public sector pension
                                                       the economy could be damaged,
     obligations (of perhaps £1 trillion)
                                                       via much higher interest rates,
     and PFI (private finance initiative)
                                                       if the markets conclude that UK
     commitments.
                                                       government indebtedness is out
•	   Projections for the future                        of control.
     trajectories of debt and the deficit
     are flattered by unrealistic growth
                                                  •	   ‘Vortex risk’ makes resolute action
                                                       imperative.




8         strategy insights | issue four
4. the way we live now

•	   The argument that cutting public     •	   The debate over how long Britain       •	    The wastefulness of government
     spending could put at risk the            can defer spending cuts is                   spending has combined with
     ‘recovery’ (which has been anaemic        essentially a false one.                     increasingly burdensome
     at best) misses the key point,                                                         regulation to undermine economic
     which is that the British system     •	   The bill for the downturn is about           competitiveness.
     of government has become both             to turn up, and the markets may
     unaffordable and inefficient.             not be willing to help pay it unless   •	    Quasi-market ‘reforms’, and a
                                               a determination to reform is                 proliferation of agencies and
•	   Thus far, ‘vortex risk’ has been          demonstrated.                                quangos, have created a sprawling,
     averted thanks to ‘three props’ –                                                      costly and inefficient bureaucracy.
     quantitative easing, the imminence   •	   The UK economy has been stifled
     of the general election, and the          by a system of government which is
     weakness of sterling – each of            at once both excessively costly and
     which is time-limited.                    unnecessarily interventionist.




                                                                                           strategy insights | issue four     9
britain at the crossroads | the case for fundamental change




summaries:
part three – the road out

5. limited options

•	   The policy alternatives available
     to the next government are stark.
     Attempting to muddle through with
     a ‘business as usual’ approach will
     not work, because Britain’s economic
     and fiscal problems are structural,
     not transitory.

•	   Any attempt to repair fiscal
     balances simply through higher
     taxation would impoverish British
     households and inflict further
     damage upon the economy.

•	   The obvious solution would be
     to reverse the growth in public
     spending by seeking, over a five-
     year period, real cuts of £80bn. This
     would amount to nothing more
     drastic than reducing real-terms
     spending to the levels of 2004-05,
     when public services were hardly
     cash-starved.

•	   Critics would contend that cuts
     of this magnitude would damage
     public services, but we completely
     disagree with such scare-mongering.

•	   Britain’s sprawling and inefficient
     bureaucracy is so vast and wasteful
     that it would not be difficult to find
     £80bn of savings without in any way
     damaging front-line services.




10        strategy insights | issue four
6. practical alternatives

•	   How, then, can public spending         •	   This should include:
     be slashed without damaging
     essential services?                         - Driving down administrative costs

•	   No less a person than Steve                 - Scrapping many quangos and
     Bundred, Chief Executive of the               quasi-autonomous ‘agencies’
     Audit Commission, has stated                - Reconsolidating fragmented
     that spending cuts are ‘inevitable,           public services
     and perfectly manageable’, and
     that fears that front-line service          - Simplifying the tax system (and
     impairment will result from                   combining National Insurance
     spending reductions is a ‘myth’.              with income tax)
     Mr Bundred has urged the public
     not to ‘believe the shroud wavers           - Abandoning the ID card and NHS
     who tell you grannies will die and            computer programmes
     children starve if spending is cut.
                                                 - Scrapping the wasteful PFI system
     They won’t.’
                                                 - Concentrating any possible scope
•	   Since our outline reform plan is
                                                   for realignment of taxation into
     aimed at slashing administrative
                                                   raising personal tax thresholds
     overheads, we see no need to
                                                   at least to the level of the
     reduce the salaries of public sector
                                                   minimum wage
     workers earning less than £30,000
     annually (though higher pension             - Limiting corporate tax relief on
     contributions seem inevitable).               interest expense

•	   Rather, we would aim to drive               - Scrapping the failed tripartite
     administrative overheads down to              system and handing responsibility
     best-practice international levels,           for banking supervision to the
     and to cut entire agencies and                Bank of England
     quangos out of the public sector
     gravy-train.                                - Imposing mortgage lending
                                                   limits in order to minimise the risk
•	   Essentially, Britain needs                    of future asset bubbles.
     to commence a ‘quest for
     national efficiency’.




                                             strategy insights | issue four        11
britain at the crossroads | the case for fundamental change




introduction
an unreal debate

Within the next month, British electors           exists a lot of freedom of choice over                    at a figure which is not drastically
will go to the polls in an election               the timing of a reduction in the deficit.                 dissimilar to the deficits recorded in
which is widely (and rightly) regarded            As the public both in Ireland and in                      2009 by Greece (10.8%), Spain (11.1%)
as the most important since 1979.                 Greece have discovered, such freedom                      or the United States (11.9%).
Not surprisingly, investors are already           of choice is illusory.
being inundated with reports aimed at                                                         The UK number (and, no doubt, at
influencing investment strategies.                Second, none of the canvassed options       least some of the others) understates
                                                  for deficit reduction really tackles the    the depth of the problem, because
Our purpose, however, is a different              structural problems                                          it excludes very
one, the aim of our strategy research             which have rendered ‘Where the recession                     significant increments
being to stimulate debate on issues               the British system         and the fiscal crisis are         to off-balance-sheet
of importance. The pivotal UK general             of government ever
                                                                             concerned, the bill hasn’t obligations such as
election of 2010, and the economic                more expensive                                               public sector pensions
issues which will hinge upon it, clearly          and burdensome             turned up yet. But it will’ and PFI3 commitments.
belong within our remit. In order to              and, as a result, the                                        By the same token,
fulfil our brief, which is to present new         economy increasingly uncompetitive.         reported national debt – which,
perspectives and to think outside the             Moreover, and as we shall explain           according to the budget, will rise
box, we shall not confine ourselves               later in this report, this debate is being  from £760bn to £1.37 trillion, or 75%
to – though of course we must                     conducted in the context of data which      of GDP, by 2014-15 – very materially
address – the near-term, battleground             may be at best misleading.                  understates true government
arguments over taxation, spending, the                                                        obligations, which we estimate at £2.1
deficit, and other current policy areas.          In order to identify the real issues, this  trillion, and believe could rise to £3.15
Rather, we endeavour to undertake a               analysis will take a lengthy look at the    trillion (180% of GDP) over the same
longer-term and more fundamental                  underlying causes of Britain’s current      time-frame. During 2009-10, the
analysis of underlying issues.                    problems. We shall then examine             deficit was essentially monetised
                                                  the current situation, and pass on to       through £200bn of quantitative easing
There is, in any case, an air of unreality        consider possible solutions. Many of        (QE). For obvious reasons, this is not a
about the current economic debate.                these solutions will be radical but, as     long-term solution.
Essentially, the Conservatives are                we shall explain, the circumstances
arguing for an early (though by no                call for fundamental reform, not for        Neither is the burden of forward
means swingeing) attack on the deficit,           tinkering and muddling through.             obligations by any means confined
while the government counters that                                                            to government. According to recent
early spending cuts could endanger the            During 2009-10, the government              reports, the liabilities of the private
economic recovery.                                borrowed £167bn. This is equivalent         sector pension system exceed £1
                                                  to 11.8% of GDP on the reported             trillion4. Some £1.2 trillion is owed
This debate is unreal, in two senses.             format and, when calibrated on              by individuals on mortgages secured
First, the assumption is that there               an international basis2, works out          against a housing stock which, based




                                                  2
                                                    See appendix 1 for the basis of international comparisons used in this report. Essentially, we
                                                    use CIA World Factbook dollar-denominated data for calendar year 2009.
                                                  3
                                                    Private Finance Initiative
12        strategy insights | issue four          4
                                                    See Financial Times, 22nd February 2010
both on historic multiples and on          homebuyers to energy companies,              Of course, this situation cannot last.
likely future trends in net-of-tax         oil producing states, and reckless and       In due course – and, we think, sooner
incomes, continues to look overvalued.     foolhardy bankers.                           rather than later – taxes will rise, and
Commercial property probably                                                            government spending will fall. Unless
represents another serious financial       Over-rewarded bankers are an easy            resolute action is taken on the deficit,
black hole. And, through a process         target, but the public is being asked        there is every danger that raising
that we describe later in this report      to believe that the leaders of the           sufficient new funds to finance the
as ‘TAT’ (toxic asset transference), the   UK banks suffered simultaneous               deficit may prove difficult, resulting
government is, in principle, the forced    brain-storms, which seems to us              in a sharp increase in interest rates.
underwriter of any future setbacks in      highly implausible. The problem was          Indeed, and again unless resolute
the banking system.                        clearly systemic and regulatory, not         action is taken, we cannot rule out
                                           idiosyncratic. The crisis is indubitably     the possibility of a ‘perfect storm’
It should be said from the outset          global, but a lot of the UK’s problems       for the UK economy – higher interest
that the UK is by no means alone           are self-inflicted. A country which          rates, rising unemployment, falling
where these problems are concerned.        believed that it was ‘best placed’ to        property prices, an even weaker
American off-balance-sheet obligations     weather a global downturn and, even          currency, rising inflation (caused in part
are probably well in excess of $50         more ludicrously, that it had abolished      by higher import costs), and escalating
trillion, and the administration itself    ‘boom and bust’, will soon wake up           public debt.
admits that committed spending             to reality.
(in areas such as healthcare and social                                                 A report which looks ahead to a
security) will rise, not diminish, over    Indeed, part of the air of unreality         post-election economic landscape
the coming decade, even without            which surrounds the current debate           obviously cannot avoid politics.
healthcare reform. There are similar       springs from the fact that, where            Political decisions are a critical part
problems both in Europe and in             the recession and the fiscal crisis are      of the economic landscape because,
Japan. The global dynamic – in             concerned, the bill hasn’t turned up         as we have explained in a previous
which the west borrows from Asian          yet. But it will. Public sector debt has     report, economic outcomes are not
savers to fund unsustainable levels        escalated, but the deficit has been          the workings of blind chance but,
of consumption – is fundamentally          funded thus far by QE to the point           rather, are matters of choice5. In this
unbalanced.                                where the UK has not been confronted         assessment we shall be highly critical
                                           by the challenge of raising genuinely        of the Labour administration which
This said, Britain’s situation is by       new debt. Indeed, and because of             has governed the UK since 1997, but
no means wholly (or even mainly)           low interest rates, most consumers           investors should be in no doubt that
a consequence of global trends. To         – so long as they have avoided               many of Britain’s woes long pre-date
understand the nature of the UK            unemployment – have felt better off          the advent of Blair and Brown.
economic crisis, and to consider what      than they did before the crisis. Thus far,
happens next, and what shape a             government spending has not been
solution might take, we need to look       cut, and there have been few material
beyond a blame-shifting exercise           increases in taxation. This, then, is the
which has attempted to pin the             unreal atmosphere in which fiscal and
culpability on everyone from American      economic choices are being discussed.




5
    See Issue Two, Brave New World?                                                       strategy insights | issue four       13
britain at the crossroads | the case for fundamental change




                                ‘most members of the
                            public have, as yet, no real
                              conception of quite how
                             weak the economy of the
                                      UK has become’




14        strategy insights | issue four
not broke, not broken – but in urgent need of repair

One big conundrum presents itself at                      The observation that, while Britain          taxpayer at least £1m annually? Why,
the outset and is, we think, central to                   is not ‘broken’, the public are clearly      indeed, has the inquiry into Bloody
the debate about the future of Britain.                   extremely dissatisfied, poses                Sunday cost the taxpayer £200m?
A recent opinion poll6 showed that a                      two questions. First, how is this
clear majority of the British public are                  contradiction to be explained? Second,       In other words, why has the British
very dissatisfied with the state of the                   does it matter? The answer to the            system of government become so
country. By a significant margin (64% of                  latter question is, emphatically, yes – it   expensive, so cumbersome, and so
those asked), those polled responded                      matters very much indeed. A depressed        divorced from reality?
that Britain was going in the wrong                       population is not compatible with
                                                                                                       Second, politicians (of all parties) need
direction, and, according to the                          a progressive, wealth-generating
                                                                                                       simply to listen to the general public,
majority (56%), was a country that they                   economy.
                                                                                                       in order to appreciate the breadth of
no longer recognised. A remarkably
                                                          The answer to the former question            the divide that has arisen between
large minority (42%) said that they
                                                          must follow an economic overview             governing and governed. Bleak opinion
would emigrate if it were practical for
                                                          which falls into three principal             poll findings essentially highlight a
them to so.
                                                          categories:                                  deep sense of unease in a population
Opposition politicians see such                                                                        which increasingly believes that it is
findings as support for their ‘broken                     1. Weaknesses which pre-date 1997,           serving, rather than being served by,
Britain’ thesis – indeed, 70% of those                       and the evolution of the economy          the apparatus of the state. Unless and
polled agreed with them about this                           under Labour.                             until this can be resolved, the British
- yet the evidence for this is actually                                                                public will increasingly believe that
                                                          2. The current state of the economy          they are governed by what they regard
scant. Crime (including violent crime)
                                                             and the public finances.                  as a self-serving, gravy-train elite which
has diminished, not increased, while
teenage pregnancy and binge drinking                                                                   has become disconnected from the
                                                          3. Future challenges and policy
have not been escalating, as is widely                                                                 hinterland of broader society.
                                                             options.
assumed (though both remain
                                                                                                       These are issues to which we shall
uncomfortably high)7. In short, and                       In the meantime, however, we can
                                                                                                       return. First, though, let’s look at how
while the ‘broken Britain’ tag does not                   anticipate two of the conclusions
                                                                                                       weaknesses, both recent and long-
accord with the facts, it remains true                    which inform our thinking. First, and
                                                                                                       standing, led the UK economy to
that a significant majority of the British                simply as an indicative example,
                                                                                                       perform poorly, and the public finances
public are deeply unhappy about the                       public anger over revelations about
                                                                                                       to deteriorate alarmingly, during an
state of the country. The condition of                    MPs’ expenses has completely missed
                                                                                                       economic crisis that Ed Balls famously
the economy is a factor here, of course,                  the point, which is this – why has it
                                                                                                       described as ‘the most serious
though we are convinced that most                         cost perhaps £7m to recover £1.1m
                                                                                                       global recession for...over one hundred
members of the public have, as yet, no                    in overpaid expenses, and why is the
                                                                                                       years’.8
real conception of quite how weak the                     simple task of monitoring the invoices
economy of the UK has become.                             of just 646 people going to cost the




6
    Populus poll for The Times, conducted 5th-7th February 2010.
7
    See The Economist, 6th February 2010, for a discussion of this issue.
8
    Quoted in Boom and Bust: The Politics and Legacy of Gordon Brown, Simon Lee (2007, 2009)             strategy insights | issue four       15
britain at the crossroads | the case for fundamental change




part one:
the road to here
1. a golden legacy?

This report is highly critical of
Labour’s management of the
economy, but it must first be said
that several important strands of
the current economic and fiscal
malaise significantly pre-date 1997.
The structural problems inherited by
Labour included:

•	   Asymmetric fiscal treatment of
     debt and equity capital, and the
     employers’ National Insurance tax
     on jobs.

•	   A privatisation programme which
     had morphed from the ‘laudably-
     industrial’ into the ‘imitation-
     and-quango’.

•	   A long-standing tendency towards
     an ever larger and more costly
     bureaucracy, a trend worsened
     by the fragmentation of public
     service providers.

•	   A failure to target the welfare
     system on those in genuine need,
     or to overcome the poverty trap.

•	   Neglect of the longer-term outlook
     for energy security.

•	   A trend towards excessive
     deregulation of the financial
     services sector.




16        strategy insights | issue four
a kingdom of quirks

Britain has always been a somewhat                          NI because it enables them to raise
quirky country – within living memory,                      additional funds while claiming,
it was possible to buy a bread roll or                      speciously, that income tax has not
a copy of Playboy on a Sunday, but                          been increased.
not a currant bun or a Bible9 – and
the honours system is either a quaint                       Pre-dating the present administration,
survival or a risible anachronism,                          the tax system has long favoured debt
according to taste. But some quirks are                     over equity capital, because interest
far more harmful. These include two                         payments on companies’ debt capital
very long-standing fiscal idiocies – the                    are tax-deductible while dividends
employers’ National Insurance (NI)                          paid to shareholders are not. This led
system, and the very different ways in                      directly to excessive leverage and the
which the tax system treats interest                        rise of private equity (which is actually
and dividend payments.                                      a euphemism for ‘little or no equity
                                                            at all’).
The objection to employers’ NI is that
it is a tax on jobs. Particularly when                      Essentially, the current system
set against the allowances that apply                       creates an uneven playing field
to capital investment, NI skews the                         between debt and equity capital.
system against employment. It has                           The tax-deductibility of interest is
also contributed to the overseas                            often defended on the grounds that
outsourcing of labour-intensive work.                       it attracts business, whereas the
More broadly, employers’ NI is part of                      truth is that it simply attracts debt.
a huge fiscal and regulatory burden                         Conservative politicians have hinted
which places unquantifiable (but                            that the fiscal relationship between
undoubtedly huge) obstacles in the                          debt and equity might be reviewed
way of business start-ups, and is thus                      and, since excessive borrowing (public,
extremely detrimental to economic                           corporate and private) has taken the
renewal. (The nature of the offer which                     UK to the brink of a ‘debt vortex’, such
Britain makes to new businesses is                          a review is surely long overdue. Later in
considered later in this report). The                       this report, we look at how this might
linkage between social protection                           be accomplished.
and NI has long since been weakened
but, far from consolidating NI into
the income tax system, governments
of both hues have tended to increase




9
    On Sundays, shops were allowed to sell magazines
    (hence Playboy) but not books. Bread rolls were
    permissible, but currant buns – being deemed ‘luxury’
    items – were not.                                         strategy insights | issue four       17
britain at the crossroads | the case for fundamental change




                                                  privatisation – from wisdom to folly

‘Governments of the                               Another policy strand long pre-             ordinary car (British Leyland) or sell you
                                                  dating 1997 is privatisation. After         a luxury vehicle (Jaguar). The Thatcher
future face a compelling                          the departure of Margaret Thatcher,         administration reasoned, surely very
                                                  a fundamental (and extraordinarily          logically, that none of these activities
need to reverse the steady
                                                  detrimental) shift took place in the        remotely belonged in government
rise of the bureaucracy, a                        aims and structure of privatisation.        hands – why on earth was government
                                                  Privatisation had been a flagship           involved in manufacturing cars or
rise which really began in                        policy of the Conservatives in the          running an airline? Privatisation of
                                                  1980s, but the aim at that time was         these industries made perfect sense,
1945, and has continued
                                                  that government should withdraw             as well as yielding huge windfalls for
ever since, with few pauses                       from wholly-inappropriate industrial        the taxpayer.
                                                  activities.
and even fewer reversals’                                                                     Thereafter, however, and under both
                                                  In 1979, the state was involved in a        parties, privatisation increasingly
                                                  bewildering array of activities which       moved from the appropriately-
                                                  had no logical place in government. At      industrial into areas which involved
                                                  that time, the government controlled        the provision of public services. One
                                                  monopolies in telecommunications,           effect of this was that the consumer
                                                  ship-building, coal, gas and electricity.   paid again for services previously
                                                  The state could take you on holiday         provided out of taxation. Where
                                                  (British Airways), supply you with an       outright privatisation was impossible,




18        strategy insights | issue four
government moved to create quasi-         create artificial ‘markets’ in essentially   blunting the genuine benefits which
independent ‘agencies’, and to make       monopolistic, state-controlled fields.       could otherwise have resulted from
extensive use of out-sourcing. The        This process, which began in the early       the massive increase in health funding
effect of this process was not to         1990s, has resulted in a huge increase       which has been achieved since 1997.
extend, but rather to reverse, Mrs        in administrative costs, often with          In an age of advanced information
Thatcher’s famous ‘bonfire of the         little or no benefit to the consumer         technology, does the NHS really
quangos’. It also helped pave the         and sometimes with effects which are         need to employ more than 200,000
way towards                                                           detrimental      administrators? To put it mildly, we
an excessive                                                          to the quality   doubt it. This situation, which is
dependency on
                       ‘If the apparent Conservative                  and the cost-    replicated across the gamut of state
arbitrary targets in intention to restore the primacy                 effectiveness    activities, has worsened under Labour,
the public sector.     of the Bank is surely wise,                    of public        but the process has clear origins in
                       Labour’s reluctance to accept that services.                    the pursuit of quasi-‘markets’ by the
While privatisation                                                                    Conservative administration of the
was being              the tripartite system has failed               To take          early 1990s.
diverted from the      looks a lot like hubris.’                      just one
industrial-and-                                                       example, the
appropriate model                                                     percentage of
of the 1980s to the imitation-and-        National Health Service (NHS) funding
quango hybrid of more recent times,       absorbed by management appears
government simultaneously set out to      to have tripled over the last 19 years,




                                                                                         strategy insights | issue four    19
britain at the crossroads | the case for fundamental change




                                                              the seeds of
                                                              light touch
                                                              ‘Light touch’ (which has all too often
                                                              amounted to ‘negligent’) supervision
                                                              of the financial system has necessarily
                                                              become a hot topic since the collapse
                                                              of Northern Rock in 2007 and the
                                                              government’s rescue of the banking
                                                              system in 2008. Labour has received a
                                                              lot of criticism for its supervision of the
                                                              banking system – and gets a lot more
                                                              such criticism later in this report – but
                                                              the trend towards lax oversight and
                                                              excessive deregulation really began
                                                              under the preceding Conservative
                                                              administration.

                                                              In the 1980s, laws governing building
                                                              societies were relaxed to enable
                                                              these previously-narrow (but fiscally
                                                              conservative and socially beneficial)
                                                              organisations to act like banks. Under
                                                              legislation passed in 1986, societies
                                                              became able to demutualise. While
                                                              some society managements were
                                                              happy to embrace demutualisation,
                                                              others were pressured into it by
                                                              members seeking short-term gains.
                                                              The crisis which engulfed Bradford &
                                                              Bingley and Northern Rock happened
                                                              on Labour’s watch, but the erosion
                                                              of this valuable tier of the financial
                                                              system began under the preceding
                                                              Conservative administration.

                                                              Another problem inherited by Labour
                                                              was the progressive abandonment of
                                                              any really coherent energy strategy. As
                                                              memories of the frightening energy




20        strategy insights | issue four
                                                                                                      the cost
                                                                                                      of government
crises of the 1970s faded, an ever more                     The Conservative government of the        A recurring theme of this analysis is
laissez-faire stance was adopted, which                     1990s became extremely – excessively,     that the British system of government
culminated in the abolition of the                          we believe – relaxed about overseas       has become ever more expensive
Department of Energy itself in 1992.                        ownership of British businesses. The      and bureaucratic. If this was ever
                                                            recent acquisition of Cadburys by         affordable (which we doubt), those
Simultaneously, the Conservative                            Kraft has attracted much attention        times have surely gone. The state’s
government scrapped most of Britain’s                       but, if looked at in practical rather     fiscally-enfeebled condition – and
coal mines, and permitted two                               than in emotional terms, ownership        future challenges in areas such as
dangerous trends in the management                          of a chocolate manufacturer is            demographic change and the security
of the UK’s reserves of natural gas. First                  hardly a matter of national strategic     of energy supply – surely mean that
- and despite a pretty modest reserves                      interest. The same cannot be said of      this sprawling bureaucracy is no longer
base of 22 tcf10 of gas – exports were                      infrastructure assets such as airports,   remotely affordable. Governments
allowed. Between 1995 and 2003, the                         power generation and utilities, the       of the future face a compelling
UK exported about 1.7 tcf. Second,                          majority of which are no longer under     need to reverse the steady rise of
and in our opinion more damagingly,                         UK ownership.                             the bureaucracy, a rise which really
a ‘dash to gas’ in electricity generation                                                             began in 1945, and has continued
was initiated, prompted in part by                          In his well-known early 2009 slating      ever since, with few pauses and even
a structurally-botched electricity                          of the outlook for sterling, renowned     fewer reversals. Though this problem
privatisation which encouraged RECs                         investor Jim Rogers pointed out that      has worsened since 1997, it was
(regional electricity companies) to                         Britain had very little left to sell.     not invented by the current Labour
integrate upstream into less-regulated                      Other governments have notably            administration. Since the ending of
power generation activities. Not only                       avoided this relaxed approach to the      the Second World War, successive
did this deplete more gas (about 8 tcf                      ownership of strategic assets, which      administrations have presided over a
over the same period) than exports, but                     is why neither Spanish airports nor       rise in the scale, scope and cost of the
it has continued since, and has aligned                     the French electricity industry could     administrative apparatus.
Britain’s power generating sector firmly                    ever have become British-owned.
towards gas despite the comparative                         If Mr Brown’s recent list of possible     It must be emphasised, however, that
paucity of the country’s remaining                          asset sales – essentially, the Dartford   the dramatic increase in bureaucracy
reserves. Partly as a result of exports                     crossing, the high-speed rail link and    over the last 20 years has not primarily
and of power generation, Britain’s gas                      the student loans book – underlined       been a matter of the over-rapid
reserves now equate to just 4.9 years                       quite how bare the national asset         expansion of the conventional civil
of current production, or 3.6 years of                      cupboard has become, it is a process      service. Though the scale of expansion
current consumption11, and imports                          that began under the Conservative         in employment, especially in the
are rising rapidly. Compounding energy                      government that preceded the current      middle and junior ranks of the civil
sector errors (and policy neglect) have                     administration.                           service, has been excessive – and,
occurred since 1997.                                                                                  undoubtedly, inadequate use has been




10
     trillion cubic feet
11
     Based on data for 2008. Source: BP Statistical Review of World Energy, June 2009                   strategy insights | issue four      21
britain at the crossroads | the case for fundamental change




made of the labour-saving potential               Britain played a pioneering role in                          ‘Why did government fail
of information technology – the                   the creation of an all-encompassing
expansion in the bureaucracy has been             welfare system, Niall Ferguson has                           to spot the causal chain
concentrated primarily, not into the              explained13 that Japan was the real
civil service, but into the plethora of           pioneer of the modern welfare state.
                                                                                                               here – a causal chain which
agencies and quangos that have come               But successive British (and overseas)                        included deregulation, lax
into existence since 1990.                        governments have yet to find an
                                                  answer to a conundrum described                              lending criteria, excessive
Indeed, career civil servants would be            by Professor Ferguson. Essentially,
entitled to resent the growth of the              welfare was designed as a safety net
                                                                                                               leverage, unsustainable
administration outside the confines               which, while eminently workable in                           increases in property prices,
of the conventional civil service.                ‘a culture of social conformism’ such
This has seen outside advisers and                as that of Japan, can rapidly become                         imprudent consumer
consultants promoted over the heads               unaffordable (and detrimental to
of professional civil servants, and has           growth) in a more individualistic
                                                                                                               behaviour, a serious skewing
also seen the payment, to individuals             culture which encourages people to                           of the economy and the
in agencies and quangos, of salaries              ‘game the system’14.
vastly higher than those permitted by                                                                          creation of a largely illusory
the civil service pay scale. As we shall          The future of welfare may be the
remark later in this report, no less than         subject of a future report in the                            acceleration in growth?’
72 taxpayer employees are paid more               Tullett Prebon Strategy Insights
than the highest paid civil servant               series but, for present purposes, it is
while, of the 296 people who earn                 sufficient to note that flaws in the
more than the Prime Minister, only 11             system now seem certain to
are conventional civil servants (while            be exposed by an ageing population,
Transport for London alone accounts               by strained government finances and
for 21)12.                                        by an uncertain economic future.

A second long-running (and related)
theme concerns welfare. Although




                                                  12
                                                       See The Public Sector Rich List, 2009
                                                  13
                                                       Niall Ferguson, The Ascent of Money, 2009, pp 207-212
22        strategy insights | issue four          14
                                                       Ferguson, op cit, p 211
2. the great experiment

Thus far, we have observed that the                       •	   Government made two cardinal            •	    Reflecting these factors, on- and
Labour government elected in 1997                              errors in 1997 – the supervisory role         off-balance-sheet debt has taken
inherited many significant weaknesses                          of the Bank of England was fatally            on an upwards trajectory which
in addition to a reasonably strong                             weakened by the introduction of               seriously threatens both national
economy. Some of these weaknesses                              the tripartite system, and monetary           creditworthiness and the ability
were very long-standing, such as the                           policy was tied to a definition of            of government to finance deficits
NI tax on jobs, a fiscal system which                          inflation which wholly ignored the            going forward.
favoured debt rather than equity                               very concept of asset inflation.
capital, a welfare state with inherent                                                                 Where Labour’s management of
contradictions and, above, all, a costly                  •	   There was no satisfactory               the economy is concerned, let’s first
and over-bearing bureaucracy which                             monetary, regulatory or fiscal          consider some mitigating factors.
had been growing, relentlessly and                             response to the house price bubble      First, and where Labour’s stewardship
almost continuously, since 1945.                               which inevitably ensued.                is concerned, we cannot say that a
                                                                                                       government of another party would
Other problems were of more recent                        •	   The largely illusory boom which         have fared better, since we cannot
origin, including the diversion of                             this bubble created was mistaken        know this. Second, Labour has a
privatisation from the logically-                              for real and sustainable growth,        number of achievements to its credit,
industrial into the quasi-market-                              in the ludicrous belief that            even if the word ‘but’ has too often
bureaucratic. Nothing had been done                            ‘boom and bust’ had somehow             had to be appended to them. For
about a looming energy squeeze                                 been abolished.                         example, the introduction of a national
which, while it lay far in the future in                                                               minimum wage was commendable,
1997, nevertheless required urgent                        •	   Labour has presided over an
                                                                                                       but why has the income tax threshold
attention given the ultra-long-term                            unsustainable escalation in public
                                                                                                       not been raised in accordance with the
nature of the energy industries.                               spending and the worsening of a
                                                                                                       implicit recognition that the wage floor
                                                               pre-existing trend towards over-
                                                                                                       really does represent the minimum
Our assessment of the conduct of the                           complex and excessively-expensive
                                                                                                       amount on which a working person
economy and the public finances since                          government.
                                                                                                       can live satisfactorily?15
1997 is substantially negative, for the
following reasons:




15
     At the adult rate (of £5.80 per hour), and assuming a 37-hour working week, the annual
     equivalent of the minimum wage is £11,159, yet the income tax threshold is
     £6,475, meaning that 42% of the minimum wage is taxable.                                               strategy insights | issue four       23
                                      britain at the crossroads | the case for fundamental change




                                      Likewise, George Robertson’s                             government, business and individuals
                                      admirable 1998 Strategic Defence                         – was running up unsustainable levels
                                      Review (SDR), while an excellent                         of debt.
                                      policy framework, was based upon
                                      an essentially expeditionary and            Policy errors began straight away
                                      power-projection assumption                 in 1997, when the incoming
                                      which was wholly undercut by the            administration made two cardinal
                                      commitment to long-term ground              mistakes. The first of these was the
                                      involvement in Afghanistan and Iraq.        notorious tax ‘raid’ on private pensions.
                                      The aggregate £18bn cost of these           As well as breaking a long-standing
                                      wars has necessarily skewed defence         cross-party consensus, this policy was
                                      spending away from the very sensible        mean-spirited, and sent precisely the
                                      assumptions of the SDR.                     wrong signal where incentives for
                                                                                  saving were concerned. In its first year
                                      If Labour’s inheritance was rather          alone, this raid extracted some £5bn
                                      less ‘golden’ than it may have seemed       from pension funds. Depending upon
                                      at the time – and                                               the rates of return
                                      even allowing for             ‘A false assumption               which funds might
                                      achievements in other                                           have achieved since
                                      areas – we believe that of permanent growth                     then, the aggregate
                                      Labour’s conduct of           seems to have segued              cost to investors
                                      the economy and of                                              of the raid to date
                                      the public finances has into a reckless expansion is probably well in
                                      been strikingly weak.                                           excess of £150bn,
                                      As it transpired, the         in public spending                and could be as
                                      denouement of this                                              much as £225bn16.
                                      mismanagement came                                              Over the same
                                      about in 2008, the catalyst being an        period, state pensions can only be
                                      international (and domestic) financial      said to have kept up with the cost
                                      crisis. Even if this catalyst had not       of living if the government’s own
                                      occurred, however, we question quite        preferred measure of inflation (the very
                                      how long Labour’s Great Experiment          questionable CPI) is accepted as the
                                      could have continued before hitting         basis of calculation17. It is true that the
                                      the financial buffers. On the faulty        Conservatives first broke the traditional
                                      assumption that a largely illusory          link to earnings in 1980, albeit under
                                      boom was both real and permanent,           horrendous fiscal conditions. But
                                      public spending already appeared to         Labour has done precious little to put
                                      be out of control, and every sector –       this right.




                                      16
                                         See Terry Arthur and Corin Taylor, The UK Pensions Crisis, 2008
                                      17
                                        Between 1996-97 and 2009-10, the single-person full weekly pension has increased by a
                                      nominal 56%, to £95.25 from £61.15. This compares with a nominal increase in GDP of 80%
                                      over the same period. On a CPI-adjusted basis, the rise in the weekly sum is equivalent to a
24   strategy insights | issue four   real increase 15%, but the state pension has decreased by 15% relative to GDP.
faulty reform – the tripartite system

The second (and far more serious) error                      scenes conversations with banks,                    to a supposedly-independent Bank
concerned the regulatory structure.                          while no-one other than an authorised               of England, were referenced wholly
In 1997, new chancellor Gordon                               bank was allowed to lend - had been                 to retail prices, and specifically to the
Brown gave the Bank of England                               replaced with something very close to               new CPI measure which, we believe,
quasi-independent status, but at the                         a free-for-all.                                     leaves a great deal to be desired19. This
same time, we believe, made two                                                                                  left a huge risk area – asset inflation
very serious mistakes. First, he divided                     One of the biggest ironies of the                   – unmonitored and unchecked. With
regulatory responsibility – previously                       Labour era has been that, while ‘light              hindsight – though many observers
the preserve of the Bank – between                           touch’ regulation contributed to the                said so at the time – interest
the Bank, the FSA18 and the Treasury in                      creation of the unsustainable debt                  rates should have been increased
the new ‘tripartite structure’. Second,                      bubble, regulation in other, essentially            significantly no later than 2002, by
the Bank was given a very narrow                             petty areas has become ever more                    which point it should have been
monetary policy remit based entirely                         onerous. At a time when supervision                 obvious that a housing bubble was
on retail price inflation. This meant                        of financial risk was impaired by the               being fostered to replace the previous
that the Bank was not empowered to                           ill-starred tripartite system, other                dotcom bubble. This new bubble
monitor asset inflation, and amounted                        industries have suffered successive                 needed to be choked off. Tragically, it
to a near-disastrous blunder in                              strangulation from a worsening                      was not.
monetary policy.                                             complexity of regulation. Meanwhile,
                                                             businesses (and individuals) have                   These two factors – ‘light touch’
The tripartite system effectively                            been burdened by a tax code which                   regulation, and a monetary policy
removed the long-established (and,                           has more than doubled in length                     which ignored asset inflation - should
historically, very effective) role of the                    and complexity since 1997. The                      be considered together, since it is
Bank as the informal guardian of                             government itself has put the annual                unlikely that interest rate policy would,
overall lending probity. As a result, no                     cost of regulation to business at                   of itself, have been sufficient to have
single authority could act to rein-in                        £13bn, but we believe that this sum is              prevented the dangerous escalation in
excessive lending, most pertinently                          calculated on a very narrow basis, and              indebtedness which has occurred over
where mortgages were concerned. At                           that the real cost is far higher.                   the last decade. We suspect that the
the same time, institutions other than                                                                           Bank understood this perfectly well –
banks began lending in forms which                           Together with the weakening of                      and, indeed, had a better grasp of the
ran the gamut from junk-mail loan                            regulatory oversight through the                    situation than Alan Greenspan’s Fed –
offers to shop cards and car finance.                        tripartite system, one of the biggest               but was unable to take effective action
‘Anything goes’, in fact. Any concept of                     mistakes made by the government                     because of its reduced regulatory
controlling credit seemed to have been                       was a complete failure to appreciate                powers, and the straitjacket imposed
progressively abandoned. The previous                        the concept of asset inflation. As a                by a CPI-defined monetary policy remit.
system - whereby the Bank regulated                          result, inflation-targeting and interest
lending through cosy, behind-the-                            rate management, though devolved




18
     Financial Services Authority
19
     For 2007 – when nominal CPI was just 1.8%, but fuel and food costs were soaring - supermarket group
     ASDA calculated inflation, as it affected consumers, at 5.2%. See ASDA press release, 27th March 2008.
     ASDA calculated that, within a cost-of-living rise of 5.2%, petrol costs had risen by 20.3%, transport by
     6.2%, and food by 5.6%. Average after-tax incomes had increased by only 2.3%.                                 strategy insights | issue four       25
britain at the crossroads | the case for fundamental change




As a result, mortgage lending criteria            Thus seen, huge swathes of the            of course, injected yet more borrowed
became dangerously relaxed, with                  economy became hostage to an              liquidity into the housing bubble. By
borrowers able to obtain funds on                 intrinsically-unsustainable house         2007, 26% of mortgage issuance was
unsafe LTV10 ratios, at excessive                 price bubble. It is not possible to       going into buy-to-let and 39% into
multiples of earnings, and often on               isolate the broader housing effect        equity release, such that just 35% was
self-certified statements of income               from the remainder of the economy,        actually being used to finance house
which were not verified by lenders.               but it is more than probable that the     purchases22. Again, this was ludicrous,
Under the previous system, the Bank,              ex-property economy – that is, the        and should have sounded warning-
in its role as supervisory authority,             economy excluding                                                  bells. Again, it
would have acted informally to check              all housing-             ‘Mr Brown mistook bubble                  seems to have
the irresponsible lending practices               related activities                                                 been either
which saw outstanding mortgage debt               - contracted very        growth for the real thing, and unnoticed or
rise from £500bn in 2000 to £1,220bn              materially while the                                               ignored.
                                                                           assumed that government
by 2009, a nominal rise of 140% and a             asset bubble was
real-terms increase of almost 50%21. If           taking shape.            could safely spend up to                  Bank leaders
the apparent Conservative intention                                                                                  played a part
to restore the primacy of the Bank                Impacted by low          it (and beyond it), on the                in all this, of
is surely wise, Labour’s reluctance to            interest rates – and                                               course, but their
                                                  by the savage tax        grounds that ‘boom and bust’ actions need
accept that the tripartite system has
failed looks a lot like hubris.                   on pension funds         had been abolished’                       to be seen in
                                                  introduced in 1997                                                 the context of
                                                  – savings ratios                                                   an economic
                                                  deteriorated, which did not seem to       and fiscal structure which amounted
the distorting                                    matter because of the availability of
                                                  wholesale funding on international
                                                                                            to an unwatched free-for-all. Those
                                                                                            few banks which stood aside from
bubble                                            markets. Many individuals saw buy-        this jamboree were often criticised
                                                  to-let as an alternative to investing     for being too cautious, while
The housing bubble injected growth
                                                  in tax-raided pensions, yet buy-to-let    demutualisation had largely stripped
into housing-related activities running
                                                  was wholly predicated on capital gains    the system of the building societies,
the gamut from estate-agents to
                                                  (through perpetual rises in house         hitherto a stabilising tier in the
domestic appliance suppliers via
                                                  prices), because after-cost yields on     housing finance structure. Almost all
house-builders, builders’ merchants,
                                                  UK domestic property never exceeded       of the demutualised societies (such as
white goods retailers, electrical and
                                                  3.5%, well below the cost of capital at   Northern Rock and Halifax) have since
plumbing contractors, furniture
                                                  any time during the boom. Buy-to-let,     come to grief.
companies and the legal profession.




                                                  20
                                                       Loan To Value
                                                  21
                                                       Adjusted for the GDP deflator, outstanding mortgages of £500bn in 2000 would correspond to
                                                       £590bn in 2009 money, far below the actual outstanding total of £1,220bn.
26        strategy insights | issue four          22
                                                       Source: FSA – Address by Adair Turner: The Mortgage Market: Issues for Debate, 12th May 2009
                                                       the perils of notional value

•      Slack lending behaviour had                     Notional value was discussed in Issue        model which itself exploited the
       consequences far beyond a                       Three of this series21, but this concept     bizarre way in which the tax system
       simple and unsustainable                        is of such importance that we need to        favours debt over equity capital. As
       bubble in property prices. These                reiterate it here. Essentially, notional     Robert Peston has explained, Labour
       consequences included:                          value means that increases in property       seems to have made ‘a bit of a cock-
                                                       prices need to be distinguished from         up or a case of mistaken identity’ by
•      An illusory economic boom that                  realisable rises in wealth. While an         confusing private equity with venture
       was mistaken for the real thing.                individual feels richer if the notional      capital, and encouraging the former
                                                       price of his or her house rises, this        with generous tax breaks24. When the
•      An escalation in public spending                increased wealth is essentially              tax status of private equity began to
       driven, in part, by false confidence            theoretical, and capable of reversal. It     attract adverse public comment, the
       in the sustainability of the apparent           is obviously impossible for the whole        government compounded this mistake
       boom.                                           of the national housing stock (or            by raising CGT25 from 10% to 18%
                                                       even a material proportion of it) to be      without discriminating between the
•      Imprudent consumer behaviour
                                                       monetised.                                   types of gain involved.
       driven by inflated property equity.
                                                       Mistaking notional for real value can        Once notional value – most notably
At the heart of the problem, where
                                                       be lethally dangerous if it distorts         in the housing market - took hold
consumers were concerned, was the
                                                       behaviour. The danger with notional          in an under-regulated environment,
critically-important concept of notional
                                                       value occurs when its owners borrow          the unavoidable result was that both
value, a misunderstanding which,
                                                       up to it (or, in absurd cases, beyond it),   debt and risk escalated. After that, the
while it can accompany any asset
                                                       via mortgage and consumer debt in            transitioning of unsustainable private
bubble, is particularly dangerous
                                                       the instance of individuals, or increased    debt, via banks, to the government - a
when it results from a bubble in
                                                       leverage in the case of corporates, and      process that we describe as TAT (toxic
property prices.
                                                       this is what happened in the UK.             asset transference) – became an
                                                                                                    inevitability. This process is described
                                                       Drawing upon confidence falsely              later in this report.
                                                       derived from the ‘notional value’ of
                                                       rising property equity, individuals          Why did government fail to spot the
                                                       – and, to a considerable extent,             causal chain here – a causal chain
                                                       businesses as well – bought into             which included deregulation, lax
                                                       the belief that leveraging was good.         lending criteria, excessive leverage,
                                                       While mortgage debt escalated, so            unsustainable increases in property
                                                       did consumer and corporate debt, the         prices, imprudent consumer behaviour,
                                                       latter reflected in the private equity       a serious skewing of the economy




23
     See Forever Blowing Bubbles, March 2010, pp8-10
24
     Robert Peston, Who Runs Britain? , 2008
25
     Capital gains tax                                                                                strategy insights | issue four      27
britain at the crossroads | the case for fundamental change




and the creation of a largely illusory            ‘boom and bust’, thereby implying that                 ‘The European Commission
acceleration in growth? Critics would             growth had become permanent, and
no doubt ascribe it either to wishful             that the law of economic cyclicality                   is quite right to warn
thinking about the abolition of ‘boom             had, presumably, been abolished.
and bust’, or to a simple failure of
                                                                                                         that the pace at which
                                                  Worse still, government appears to
comprehension. The theory that Mr                                                                        the government plans to
Brown has never really understood                 have believed its own rhetoric, since a
economics seems to be supported by                false assumption of permanent growth                   tackle the deficit shows
his gobbledegook 1994 reference to                seems to have segued into a reckless
‘the importance of macro-economics,               expansion in public spending. It is                    insufficient urgency’.
post neo-classical endogenous growth              difficult to avoid the conclusion that
theory and the symbiotic relationships            government simply did not understand
between growth and investment, and                the concept of bubbles and asset
people and infrastructure’26. Right.              inflation or, conversely, understood it
                                                  all too well but was happy to ride the
Far from recognising the unsustainable            wave in the Micawberish hope that
nature of the housing boom and                    ‘something will turn up’. Something did
the dangers implicit in the notional              indeed ‘turn up’ – a full-blown banking
value trap – and therefore trying to              and fiscal crisis combined with massive
do something about it - government                consumer and corporate indebtedness.
itself fell into notional value thinking.
Instead of realising that the UK was
riding an unsustainable debt bubble,
government proclaimed an end to




                                                  26 See Michael White, ‘The gift of tired tongues’, The Guardian, 30 September 1994,
28        strategy insights | issue four             and Norman Macrae, ‘You’ve never had it so incoherent’, Sunday Times, 2 October 1994.
this and TAT

When the crisis struck in 2008,                      The TAT process is shown schematically          •     Believing that, because of the
the preceding expansion in non-                      in fig. 5. The TAT model divides the                  abolition of ‘boom and bust’, the
government debt (and most notably                    stages of the financial crisis into three             bubble was permanent, sustainable
of mortgages) inevitably dragged                     phases – problem creation, toxic asset                and benign.
government into costly intervention                  transference and long-run implications.
(which, to their credit, both                                                                        In the second stage of TAT, the burden
chancellor Alistair Darling and Bank                 In the first phase, policy weakness             of the resulting debt, by becoming
governor Mervyn King handled with                    results in a failure to recognise and           excessive for originators (such as
considerable skill). This was inevitable,            to curb an asset bubble in a timely             home owners), becomes a problem
because over-extension of private                    fashion. In the UK, this policy weakness        for the banks. When the banks in turn
borrowing, if it imperils the viability of           took three main forms:                          are unable to withstand the resulting
the banking system, necessarily draws                                                                damage to their balance sheets, the
in governments through a process
                                                     •   Failure to appreciate and manage
                                                                                                     state is forced into shouldering the
                                                         the concept of asset inflation.
which we describe as ‘TAT’ (toxic asset                                                              burden as the only alternative to an
transference). The TAT concept is an                 •   Weakening, through the tripartite           implosion of the financial system.
important tool in understanding how                      system, a largely informal
the financial crisis developed, and                      supervisory structure which
where it might go from here.                             could hitherto have choked off a
                                                         borrowing bubble.


  Fig. 5: Toxic asset transference




                        Problem creation
                               Policy weakness                   Excessive borrowing                     Asset bubble



                                                                           Toxic asset transference
                                 Fiscal stress                       Bank Stress                     Originator stress



                        Long-run implications
                                     Reduced competitiveness                           Economic underperformance




                                                                                                          strategy insights | issue four   29
britain at the crossroads | the case for fundamental change




Fiscal stress inaugurates the third
phase of TAT. Escalating government
debt threatens to drive interest rates
upwards, and at the same time forces
government into fiscal tightening, in
the form both of increased taxation
and of reduced expenditure. This
in turn results in economic under-
performance. The UK story is a classic
example of this process, and has left
the economy firmly in the talons of
toxic asset transference.

TAT is, of course, by no means
unique to the UK. Seen as a global
phenomenon, TAT explains why the
consequences of excessive lending
have transitioned from the banking
system into sovereign debt, where a
string of countries now look vulnerable.
Though by no means alone where the
sovereign debt problem is concerned,
Britain is one of a number of countries
where TAT-related problems have piled
additional burdens onto a government
balance sheet which had already
been stretched by excessive levels of
public spending.




30        strategy insights | issue four
                                                     spend, spend, spend

                                                     When Labour returned to power in
                                                     1997 after an absence of 18 years, a
                                                     key element of the party’s election
                                                     manifesto had been a commitment
                                                     to stick to the spending plans of
                                                     the outgoing administration. This
                                                     commitment - designed to rebut
                                                     accusations that Labour would return
                                                     to the profligacy of the 1970s – tied the
                                                     government’s hands during the first
                                                     Blair-Brown term.

                                                     After the 2001 election, with Labour
                                                     now free from this commitment,
                                                     government expenditure began to
                                                     escalate in a wholly unsustainable
                                                     way. Between 1999-2000 and 2008-09,
                                                     annual public spending increased from
                                                     £343bn to £628bn. To understand the
                                                     step-change which this represents, we
                                                     need to appreciate that, had spending
                                                     simply risen in line with inflation27, the
                                                     outturn for 2008-09 would have been
                                                     £429bn. Conversely, if expenditure
                                                     growth had matched the increase in
                                                     nominal GDP, the total would have
                                                     risen to £521bn. So the £628bn out-
                                                     turn for 2007-08 represented a real-
                                                     terms increase of £200bn (46%) and an
                                                     above-GDP rise of £107bn (21%).




27
     The GDP deflator is used in this calculation.     strategy insights | issue four       31
britain at the crossroads | the case for fundamental change




  Fig. 6: Spend, spend, spend – public spending, 2000-09



     700
                Actual
                GDP-constant                                                                                                                         £628bn
     600        Inflation-adjusted
                                                                                                                                                     £521bn
     500
                                                                                                                                                     £429bn
     400

     300
            £343bn
     200

     100

       0
             99-00          00-01    01-02       02-03           03-04          04-05         05-06          06-07         07-08         08-09




The above-inflation increase – of                 to James Buchan, ‘Brown thought that                        as it affected the average consumer,
£200bn – should be seen in the context            the profits of the City would finance                       was far higher (5.2%) than the
of a fiscal deficit of £167bn during              a new welfare state that would be                           reported CPI number (1.8%) or the GDP
2009-10. In other words, the surge in             a monument to him more lasting                              deflator (3%). The reliability of official
public spending correlates pretty closely         than bronze. He was mistaken’28. Our                        statistics is a controversial topic in
with the deficit.                                 own view, which is not at odds with                         America, where analysts such as John
                                                  this interpretation, is that Mr Brown                       Williams (of Shadow Government
Between 1999-2000 and 2008-09,                    mistook bubble growth for the real                          Statistics) have done a great deal
the proportion of GDP spent by the                thing, and assumed that government                          to call this reliability into question.
government increased from 36% to                  could safely spend up to it (and beyond                     Where inflation is concerned, both
44%, and reached 48% in 2009-10.                  it), on the grounds that ‘boom and                          substitution and hedonics seem to play
Unfortunately, government income did              bust’ had been abolished.                                   a significant role in distorting reported
not behave in the same way, rising only                                                                       out-turns, while the GDP number itself
fractionally - from 38% of GDP in 1999-           One factor which we believe should                          may be distorted by the controversial
2000 to a peak of 38.6% in both 2007-             be borne in mind here is that reported                      use of imputations29.
08 and 2008-09 - before declining to              inflation numbers may well be
36% in 2009-10.                                   misleading. If this is true, it has at
                                                  least two implications for government
Exactly why this was allowed to                   spending. As remarked earlier, ASDA
happen is open to debate. According               data for 2007 indicated that inflation,




                                                  28
                                                       ‘Is Britain Bust?’, Prospect, August 2009, pp28-33
                                                  29
                                                       Hedonics – lowering the recorded price of an item because its quality has improved, even if the actual price
                                                       has increased or remained unchanged. Substitution – replacing an item in the measurement basket on the
                                                       grounds that, as its price has increased, consumers would purchase something else instead. Imputation –
32         strategy insights | issue four              attaching cash values to goods and services where no money has actually changed hands.
In the absence of such comprehensive         ‘UK government spending is
external analysis, the UK position is
less clear, but it is at least possible      more wasteful than that of
that inflation, particularly as
measured by CPI, is understated. If          Tunisia, the Gambia, Malawi,
such understatement were to be               Ethiopia or Albania, and
reflected in the GDP deflator as well,
this would imply the overstatement           government regulation is
of GDP growth. So, where the
superheated growth in public spending        more burdensome in Britain
is concerned, it is possible that            than in Bulgaria, Nigeria,
government planning was predicated
on an exaggerated reading of the real        Pakistan or China’
strength of the economy during the
‘boom’ years before 2008. Moreover,
much of the growth of those years
was essentially borrowed, funded by
wholesale borrowings from overseas
and distorted by the impact on
consumer behaviour which resulted
from the property price bubble.

If, as we very strongly suspect, inflation
has been routinely understated, this
would have had a second implication
for government spending. It would
mean that ‘real’ inflation, as it
impacted activities such as health,
education and defence, was a great
deal higher than was generally
assumed.




                                              strategy insights | issue four   33
britain at the crossroads | the case for fundamental change




remodelling society

In any case, government seems to have             Though a sense of purpose is desirable                    involve increased state spending), or
been philosophically inclined towards             in government, politicians always                         by a media which often pushes these
increased public spending. From the               need to be aware that, at any level                       groups’ agendas without an adequate
outset of the Blair-Brown project, the            other than that of platitude, morality                    recognition of the limitation of fiscal
assumption seems to have been that                is essentially subjective. At a very                      resources.
the ills of society can be cured if state         general level, everyone is surely in
activity (and, by implication, fiscal             favour of ‘fairness’, but this means very                 Reflecting both the breadth of Labour’s
redistribution) is increased. In the              different things to different people.                     ambitions and an increasing and
Thatcher and Major eras, much stress              For example, a wealthy person might                       regrettable tendency towards moral
was placed on holding taxes down,                 believe that a ‘fair’ tax would take                      absolutism, a large part of the increase
and reducing them wherever possible.              the same percentage of everyone’s                         in spending has resulted from a
But much higher spending seems to                 income, while a poor person might                         hands-on, interventionist philosophy
have been an implication of Tony Blair’s          argue that the better off should pay                      which puts emphasis on ‘fairness’ (as
1994 leadership election manifesto,               a higher proportion. Philosophically,                     Labour defines it) when an emphasis
Change and National Renewal, in which             there is no wholly objective ‘right’ or                   on efficiency, wealth-generation and
Mr Blair wrote of ‘social renewal’30.             ‘wrong’ answer to such a conundrum,                       individual choice might have been
                                                  which therefore needs to be resolved                      much more desirable. It is noteworthy
Certainly, a great deal of the increase in        pragmatically.                                            that a whole chapter of the 2009
government spending seems to have                                                                           budget was entitled ‘Helping people
been predicated on social activism,               And, in any case, politics is essentially a               fairly’. Helping them effectively might,
and upon an agenda of remodelling                 matter of choices. Most people would                      we think, have been a much better
society. Within the expansion in                  applaud Labour’s aim of eliminating                       idea. More generally, Labour seems to
public spending, there have been                  child poverty, but what if we have                        have had a preference for the most
huge increases in benefits paid, on               to choose between this and, say,                          complicated solution on offer. Since
an essentially capricious basis, to               eliminating pensioner poverty? (And,                      1997, the length of the tax code has
people of working age, while the cost             for that matter, what was the moral                       more than doubled, an ultra-complex
of government, too, has escalated.                justification for Labour’s pension                        tax credit system has been preferred
By contrast, the sums paid to state               raid?) Both reducing child poverty                        to simplifying reforms, and a torrent of
pensioners, for example, have barely              and helping the elderly are laudable                      legislation has been passed on every
kept pace with relevant inflation,                aims, but both make competing                             conceivable subject.
while defence spending seems to have              claims on limited resources, meaning
been inadequate in the context of two             that choices have to be made. In this                     Ultimately, the purpose of a tax system
simultaneous wars and of pre-existing             regard, Labour has not been helped by                     is to raise money. But Labour, from its
defence commitments.                              lobby groups which push particular                        standpoint of moral absolutism and
                                                  special interests (almost all of which                    a preference for the complicated, has




34        strategy insights | issue four          30
                                                       Quoted by Simon Lee in Boom and Bust: The Politics and Legacy of Gordon Brown (2007, 2009)
                                             taking count

often seemed to regard the primary           Overall, where the Labour                  oil crises, major financial failures
purpose of taxation as a means               administration is concerned, it seems      or political instability in important
of social engineering. The recent            impossible not to conclude that a lot of   economic players. The assumption
introduction of a 50% top tax rate is        very serious mistakes have been made,      of perpetual economic growth defies
largely gesture-politics, since any sum      though sometimes with the best of          all past history, pre-supposes that
realised from this is likely to be modest,   intentions, and often in furtherance of    nothing can ever go wrong, and leads
and may be more than offset anyway           adverse trends already in place before     to highly dangerous assumptions
by collateral damage in the form of          1997.                                                        about affordable
reduced incentives. Governments need                             ‘It   is possible to envisage            levels of spending and
to realise that, in a global economy,        ‘Light touch’                                                borrowing.
tax rates need to be competitive with        regulation clearly a future in which the
those operative in other countries,          represented a                                               Within the increase in
                                             continuation           British population is                public spending, the
since individuals and businesses are
quite capable of moving to a more            of pre-1997            subjected to ever-increasing simple fact seems to
attractive fiscal (and regulatory)           policy, though                                              be that, at least since
environment.                                 the tripartite         taxation and charging to             2001, government has
                                             system – and the                                            been living beyond its
The effectiveness of a fiscal system         exclusion of asset sustain an administrative                sustainable means,
can be judged by three criteria - yield,     inflation from         superstructure which is              not just in terms of
distortion effects and cost of collection    monetary policy                                             the cost of public
- and Labour’s complex fiddling with         - look like grave      increasingly coercive as well services but also,
the system fails all three tests.            and idiosyncratic                                           and less forgivably, in
                                             mistakes. As the       as unaffordably costly’              the cost of delivering
                                             housing market                                              those services, which
                                             overheated and as debt escalated, the     has escalated over the last decade.
                                             largely illusory nature of the ensuing    Tax assumptions, too, seem to have
                                             ‘boom’ was not appreciated, and           been over-optimistic, at least in the
                                             government spending was allowed           sense that, even before the present
                                             to escalate on the assumption that        administration came to power,
                                             a period of temporary and illusory        government was reaching a level
                                             growth was a genuine and sustainable      of public fiscal resistance, resulting
                                             pointer to the future.                    in a recourse to so-called ‘stealth
                                                                                       taxes’. This has continued relentlessly,
                                             In particular, the claim that ‘boom       combined with an insidious (and
                                             and bust’ had been abolished was          largely unremarked) process of
                                             manifestly absurd. Even at times when     charging for services hitherto paid for
                                             the global economy appears to be          out of taxation. The latter, in particular,
                                             performing well, shocks are always        is extremely damaging to businesses.
                                             possible. These could take any one
                                             of numerous forms, including wars,




                                                                                             strategy insights | issue four    35
britain at the crossroads | the case for fundamental change




part two:
where is here?

3. money troubles

So much, then, for the unedifying                 We have no such compunction, so              3.25% annually from 2012 – are far too
history of how Britain got into its               this section of our report might             optimistic.
current economic and fiscal mess.                 hurt. For a start, the reported figures
Two questions remain. First, exactly              for government indebtedness                  Each of these points will be addressed
how bad is the situation? Second, and             seriously understate the situation. In       later in this report. There are other
much more importantly, how can the                comparison with reported national            problems, too, but this should act as
UK progress towards sustainability? As            debt (of £760bn, excluding the one-off       a clear summary of the scale of the
we explained earlier in this report, the          effects of interventions, and projected      issues needing to be tackled. The good
appropriate sequence here is to let the           to rise to £1,370bn by 2014-15),             news – and there is some – is that
answers to the first question prompt              we estimate the real public sector           the solutions may be a great deal less
answers to the second. It is not too              obligation at £2.1 trillion, a number        difficult than is often supposed.
much of an over-simplification to say             which could rise to £3.2 trillion, or
                                                                                               Are these problems simply part of an
that the best policies for the future will        more, over the same timescale (see
                                                                                               international malaise, and will they
lie in the reverse of the mistakes and            figs. 9 and 10).
                                                                                               therefore self-rectify if and when the
weaknesses that have brought Britain
                                                  Second, Britain’s 2009-10 fiscal deficit –   global economy returns to pre-2008
here.
                                                  of £167bn, or 11.8% of GDP – exceeded        levels of growth and prosperity? Since
First, though, where is ‘here’? For               the prudent, Maastricht-required 3%          the financial crisis began in 2008,
understandable reasons, the election              limit by £135bn, equivalent to £5,300        ministers have gone to great lengths
battleground is being fought in a fog of          per UK household. This is the sum            to insist that Britain’s problems are,
unreality, because no politician really           which needs to be rebalanced through         almost entirely, part of a worldwide
wants to tell the electorate quite how            tax increases and/or cuts in public          downturn. No mention is ever made
serious Britain’s problems are, or, more          spending. Third, we believe that the         of ‘crisis’ or ‘recession’ without the
to the point, how painful the necessary           official projections for the economy         obligatory prefix ‘global’ being tacked
post-election responses will need to be.          – essentially, a real growth rate of         on to it. Even if the government had
                                                                                               not previously claimed that the UK




36        strategy insights | issue four
was ‘best placed’ to weather any           – escalating western indebtedness,           These issues are:
downturn, this ‘globalisation’ of the      and rapidly increasing energy costs -
issue is, essentially, an exercise in      were running pretty much in tandem           1. The true extent of government
blame-shifting, as have been attempts      prior to 2008. Borrowed liquidity and            indebtedness, including off-
to fix the entire responsibility onto      excessive consumption – ‘excessive’,             balance-sheet liabilities such as
bankers. The reality is that domestic      that is, in relation to domestic output          public sector pensions and PFI
trends – most notably, slack regulation,   – do not form a solid basis for a                obligations.
the reckless boom in property markets      sustainable economy.
                                                                                        2. The real scale of the deficit when
and the out-of-control surge in public
                                           Second, the Anglo-American model,                increments to these off-balance-
spending – would, sooner or later, have
                                           which has been a dominant economic               sheet items are taken into account.
resulted in a crisis even without the
catalyst of a global economic slump.       ideology for three decades, has now
                                                                                        3. The very real risks posed by excessive
                                           suffered a serious (perhaps a crippling)
                                                                                            government borrowing.
This said, of course, there is a global    setback. This issue was discussed at
dimension to the crisis. The key           length in Issue Two, and will no doubt       In examining each of these issues, it
elements of the global problem are         recur in future reports as we comment        is essential to bear in mind that the
structural, and form an essential          further on the implications of the           solutions to these problems can only
context to the UK issues.                  emergence of the ‘new normal’.               be found if policymakers and the public
                                                                                        (a) face the current situation as it really
First, the global dynamic is seriously     Since this section of our report – which
                                                                                        is, and (b) understand the root causes
flawed. A system in which the west         aims to examine the true scale of
                                                                                        of these problems.
borrows Asian savings and spends           the problems which the UK faces – is
the proceeds on imported consumer          necessarily depressing, let’s take a line-
goods from Asia – and on imported          item look at the biggest challenges.
energy, principally from the Middle        Only then can some solutions be
East – is fundamentally unsustainable.     explored.
In this context, two adverse trends




                                                                                          strategy insights | issue four        37
britain at the crossroads | the case for fundamental change




the real scale of national indebtedness

According to the 2010 budget, and                    current figure is not an accurate                 had a capital cost to the contractors
excluding the one-off effects of the                 reflection of the true scale of public            of £55bn. Annual payments by the
financial sector intervention, public                sector indebtedness, while the forward            government currently stand at some
sector net debt stands at £760bn,                    projections seem to us to be fancifully           £7.8bn, and are projected – on the
equivalent to 54% of GDP. Based on                   optimistic anyway.                                basis of current projects only – to
official forecasts, this number will rise                                                              peak at around £9bn in 2017 before
to £1.37 trillion (75% of GDP) by 2014-              First of all, the reported debt figures           declining gradually over a repayment
15. Neither figure, we are reassured,                exclude obligations under the PFI                 schedule which runs to 2047
is particularly high by international                (Private Finance Initiative) programme.
standards, which is true – but only                  Based on published data, projects
as far as it goes. Unfortunately, the                completed thus far under PFI have




  Fig. 7: PFI economics – existing projects

  Year to end         Pre-
  March (£bn)       2010* 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 2021 2022 2023 2024 2025

  Capital cost         £55

  Payments             £45    £7.8   £8.1     £8.3    £8.6   £8.7   £8.9   £8.9   £9.1   £8.5   £8.7    £8.6   £8.3   £8.2   £8.2   £8.4   £8.3

  NPV of future
                     £110     £7.8   £7.7     £7.4    £7.3   £6.9   £6.6   £6.2   £5.9   £5.2   £4.9    £4.6   £4.1   £3.9   £3.6   £3.5   £3.2
  payments

  Total repayment    £155

  Discount rate       4.0%


*1997-2009




38        strategy insights | issue four
     Fig. 8: PFI economics – example hospital

     Year to end            Pre-
     March (£bn)          2010* 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 2021 2022 2023 2024 2025

     Capital cost          £158

     Payments              £319 £46.0 £47.2 £48.3 £49.5 £50.8 £52.0 £53.4 £54.7 £56.1 £57.5 £58.9 £60.4 £61.9 £63.4 £65.0 £66.6

     NPV of future
                           £699 £46.0 £44.6 £43.0 £41.8 £40.2 £38.6 £37.1 £35.6 £34.2 £32.8 £31.5 £30.3 £29.1 £27.9 £26.8 £25.7
     payments

     Total repayment £1,019

     Discount rate         4.0%


*2002-09

Applying an annual real discount rate                     First, it fits within our ‘generational   had a capital value of £158m (fig.
of 4%, the NPV (net present value)                        theft’ analysis, which is that the        8). Against this, the government has
of the forward payment stream is                          current generation – not just in the      already paid the contractors £319m
some £110bn. Of course, it might be                       UK but throughout the developed           over seven years. Future money-of-the-
argued that 4% is a rather generous                       world – is piling hefty (and perhaps      day payments are stated at £1.6bn.
real discount rate and, in any case,                      unsustainable) financial burdens          Applying a 4% real discount factor to
this calculation is based on existing                     onto future generations31. PFI is a       the future payment stream reduces
projects, so does not factor in the                       particularly good (by which, of course,   this sum to £700m. So the ultimate
NPV of any new developments. On                           we mean a particularly bad) example       cost to the taxpayer of past and future
this basis, we include £115bn in our                      of generational value-transfer – the      payments for this £158m hospital is
assessment of current true obligations,                   current generation gets to use the new    over £1bn. It is very difficult to see how
and assume that this figure rises to                      hospitals, while future generations get   this can possibly represent good value
a (money-of-the-day) total of about                       to pay for them.                          for the taxpayer.
£165bn by 2015.
                                                          Second, the financing part of PFI         During the financial crisis, the PF
We make no secret of the fact that                        can look bizarre. We have examined,       part of PFI essentially dried up
we dislike PFI, on several grounds.                       simply as an example, a hospital which    anyway so, under a seemingly-surreal




31
     See Strategy Note 001 – The Dick Turpin Generation                                               strategy insights | issue four       39
                                      britain at the crossroads | the case for fundamental change




                                      arrangement, government agreed to                 Next – and vastly larger in absolute
                                      lend money to contractors who would,              terms – is the issue of public sector
                                      in return, effectively lend it back to the        pensions. These are operated on a
                                      government (at a profit) through PFI.             PAYGO (pay as you go) basis, meaning
                                      There must surely be better ways of               that they are not funded – rather, those
                                      financing public sector capital projects.         drawing pensions today are paid from
                                                                                        the contributions of today’s workers.
                                      Third, we suspect that the capital                Because of the way in which unfunded
                                      repayment stream does not capture                 public sector pensions obligations are
                                      the full value to contractors (who, for           accounted, the future liability does not
                                      example, can control the maintenance              appear on the government balance
                                      of facilities such as hospitals,                  sheet, but exclusion of this committed
                                      thereby denying the government                    liability hugely distorts perceptions of
                                      the competitive benefits of either                the national debt.
                                      competitively out-sourcing these
                                      services or taking them in-house –
                                      anecdotes abound about nurses being
                                      forbidden even to change light-bulbs in
                                      PFI hospitals).




40   strategy insights | issue four
  Fig. 9: Estimated public sector indebtedness, based on budget debt forecasts
                                                2010                                                         2015*

                               £bn            % of GDP       £ per household**               £bn          % of GDP       £ per household**

  Reported debt               £761                 54%                £29,843            £1,366               75%                £53,569

  Increment                   £243                 17%                 £9,529              £252               14%                 £9,882

  Treaty debt               £1,004                 71%                £39,373            £1,618               89%                £63,451

  PS pensions                 £995                 71%                £39,020            £1,195               66%                £46,863

  PFI                         £110                  8%                 £4,310              £160                 9%                £6,289

  Total obligations         £2,109               150%                 £82,702            £2,973              163%               £116,603

  Memo items:

  GDP                       £1,406                                                       £1,824

  External debt***          £5,902



*Reported and Treaty debt based on budget forecasts **Based on 25.5 million households ***Source: CIA World Factbook data for end-2009


How big is the pension liability? In            mind a critical distinction between                2009-10, £760bn – is computed on the
2006, the government calculated the             on- and off-balance sheet public                   government’s own methodology. But
sum at £650bn. In December 2008,                sector obligations. A government                   government also reports ‘Treaty debt’,
the CBI estimated the liability at              which controls the printing presses                which is debt calculated on the criteria
£915bn, a figure which the CBI itself           is unlikely to go bankrupt in its own              specified by the Maastricht Treaty.
said was ‘conservative’. We believe             currency. Rather, sovereign debts tend             The official number for the end of the
that the liability is rising by not less        to be deflated away through the ‘soft              2009-10 fiscal year is 71% of GDP, or
than £40 billion annually, so now               default’ mechanism of devaluation and              £1.0 trillion.
probably stands at about £1,000bn               inflation. But the critical distinction is
(official figures do provide annual             that this process does not work where              Together, then, Treaty debt, plus the
increments, but then write them out).           off-balance-sheet obligations are                  two principal off-balance-sheet items,
Later in this report, we look at the            concerned, because the monetary cost               total some £2.1 trillion, or 150% of
role that tightening of public sector           of these obligations tends to rise if the          GDP, as set out in fig. 9. According to
pension provisions will need to play if         value of the currency deteriorates.                budget projections, Treaty debt will
Britain is to get its real public sector                                                           increase to £1.6 trillion by 2015. Adding
indebtedness under control.                     In addition to off-balance-sheet                   off-balance-sheet items – and our
                                                liabilities, one further component                 expected increments to these items
Before we move on to tot up our                 is required if we are to assess the                – to this forecast suggests that total
assessment of the ‘real’ level of               full extent of the national debt. The              obligations will reach £3 trillion (163%
national debt, we need to bear in               reported debt number – for the end of              of GDP) by that date.




                                                                                                     strategy insights | issue four        41
britain at the crossroads | the case for fundamental change




  Fig. 10: Estimated public sector indebtedness, based on 2% real growth
                                                 2010                                                                     2015

                                £bn           % of GDP          £ per household**                    £bn             % of GDP            £ per household**

  Reported debt                £761                    54%                 £29,843                £1,542                   88%                      £60,454

  Increment                    £243                    17%                  £9,529                  £252                   14%                       £9,882

  Treaty debt                £1,004                    71%                 £39,373                £1,794                  102%                      £70,336

  PS pensions                  £995                    71%                 £39,020                £1,195                   68%                      £46,863

  PFI                          £110                    8%                   £4,310                  £160                     9%                      £6,271

  Total obligations          £2,109               150%                     £82,702               £3,148                   180%                    £123,470

  Memo items:

  GDP                        £1,406                                                               £1,752

  External debt***           £5,902


* Reported and Treaty debt based on lower growth forecasts, assuming real GDP growth of 2.00% from 2011-12 **Based on 25.5 million
households ***Source: CIA World Factbook data for end-2009

Nor is this all. Budget debt projections,         all private sector commitments (such                       – a very high proportion of overseas
used in fig. 9, assume a real annual              as outstanding mortgages of £1.2                           assets is owned by corporates (such
economic growth rate of 3.25% from                trillion, big pension liabilities, and very                as oil companies) whose debts are
2012. Since we believe that this                  large corporate and consumer debts).                       comparatively small – so netting off is
growth assumption is extremely over-              Britain as a whole – government,                           not realistically applicable.
optimistic (for reasons which will be             businesses and individuals – is very
explored later), we have run alternative          deeply mired in debt.                                      At $9.1 trillion, British external
calculations, again discussed later, on                                                                      debt equates to a rather disturbing
the basis that growth actually averages           In one sense, the domestic component                       $149,000 (say £96,000) per person, or
2% whereas public spending remains                of these debts is less important than                      £230,000 per household. The $149,000
at the officially-projected monetary              the sums owed to overseas lenders.                         per capita figure is far higher than
level. On this basis, the total obligation        The CIA World Factbook puts the United                     the equivalent numbers for France
rises to £3.15 trillion, or 180% of GDP           Kingdom’s end-2009 external debt at                        ($78,000), Germany ($63,000) or the
(fig. 10).                                        $9.1 trillion, equivalent to about £5.85                   US ($44,000), and is much larger than
                                                  trillion32. Though this debt is materially                 the equivalents for Spain, Greece,
Before leaving the subject of debt and            offset by overseas assets, the net                         Portugal or Italy (see fig. 11). (The
turning to the more important issue of            sum remains very large (perhaps $7.5                       figure for Ireland is frighteningly higher
deficits, we need to bear in mind that            trillion). Moreover, asset ownership                       even than that for the UK)33.
the obligations discussed so far exclude          and debt obligations are asymmetric




                                                  32
                                                    Based	on	a	sterling	exchange	rate	for	2009	of	$1.54	=	£1.	
                                                  33
                                                    The	CIA World Factbook	puts	end-2009	Irish	external	debt	at	$2.4	trillion,	or	$568,000	for	each of	Ireland’s	
42        strategy insights | issue four          	 4.1	million	citizens.
what is the real deficit?

In any case, the absolute level of                        accounted for 47% of all net gilts                   both quantitatively and in terms of
debt with which the taxpayers of the                      issuance34, and foreign gilts ownership              the threat which excessive deficits
future have been burdened is not the                      (of £191bn) equated to 32% of the                    represent. We believe that the
immediate point. The real issue is the                    outstanding total by the end of 2008,                European Commission is quite right
ability to raise fresh funding from                       up from 16% as recently as 2000. (This               to warn that the pace at which the
international markets going forward.                      situation, incidentally, puts into context           government plans to tackle the deficit
A deficit-to-GDP percentage anywhere                      the sheer absurdity of the sometimes-                shows insufficient urgency35. The
near double-digits is more than                           expressed belief that the government                 counter-argument – which is that
enough to give these markets grave                        ‘should not have policy dictated to it               precipitate fiscal tightening could
cause for concern.                                        by international markets’. The reality               damage the economic recovery – will
                                                          is that Britain is hugely dependent                  be addressed shortly.
And international markets are critical                    not only on overseas trade but on
here. Although the process of debt                        international capital markets as well).              Quantitatively, the foregoing
recycling through QE has reduced                                                                               examination of national debt – in
the foreign-owned share of total                          Though most people seem to be                        which we explained that the debt is
government debt over the last year,                       aware of the problem represented by                  understated because it excludes huge
overseas investors continue to own                        the public sector deficit, we believe                off-balance-sheet items – is equally
28% of all outstanding gilts. Between                     that the underlying scale of the                     applicable to the more pressing issue
2003 and 2008, foreign purchasers                         problem is improperly understood,                    of the deficit.


     Fig. 11: External debt, selected countries, end-2009*

                                                              External debt                              Population                    Debt per capita
                                                                      ($bn)                               (millions)                               ($)

     UK                                                               $9,088                                   61.1                          $148,708

     France                                                           $5,021                                   64.1                           $78,382

     Germany                                                          $5,208                                   82.3                           $63,258

     Spain                                                            $2,410                                   40.5                           $59,469

     Greece                                                             $553                                   10.7                           $51,486

     Portugal                                                           $507                                   10.7                           $47,348

     US                                                             $13,450                                   307.2                           $43,781

     Italy                                                            $2,328                                   58.1                           $40,051

     Canada                                                             $834                                   33.5                           $24,899

     Japan                                                            $2,132                                  127.1                           $16,777


* Source: CIA World Factbook



34
     Between the end of 2002 and the end of 2008, net overseas ownership of gilts increased by £145bn,
      within total net issuance of £307bn.
35
     In a report issued on 24th March 2010, the European Commission called upon the UK to reduce the
     deficit to the 3% Maastricht ceiling by 2013-14.                                                             strategy insights | issue four         43
britain at the crossroads | the case for fundamental change




    Fig 12: Foreign net purchasing of gilts, 2003-09
    £bn                                     2003           2004           2005           2006        2007           2008          2009

    Net issuance                            £20.7          £39.8          £50.3         £27.1        £41.6        £127.6         £149.2

    of which foreign:                        £9.0          £17.8          £26.7         £25.0        £22.7         £43.3          £16.9

    Foreign %                                43%              45%          53%            92%         55%           34%            11%


According to budget figures, the                    fiscal year. On this basis, the deficit is   in this line, together with smaller
deficit is projected to fall from £167bn            set to fall from £208bn (14.8% of GDP)       annual additions to outstanding PFI
(11.8% of GDP) in 2010-11 to £73bn                  in 2009-10 to £84bn (4.6%) by 2014-15.       obligations. After adjustment both
(4.0%) by 2014-15. In fact, this is a                                                            for the Treaty definition and for these
rather misleading set of figures, for the           Increments to PFI and public sector          off-balance-sheet items, we estimate
following reasons:                                  pension obligations are difficult            that the underlying deficit was £255bn
                                                    to estimate, but are undoubtedly             (18.2% of GDP) in 2009-10, and is likely
•    These numbers are based on the                 significant. The CBI, in the report          to fall to £135bn (7.4%) by 2014-15.
     Treasury’s own definition of public            mentioned earlier, calculated that
     sector debt, whereas adjustment                the pension obligation increased by          However, one further adjustment is
     to the Treaty basis is necessary for           £265bn – from £650bn to £915bn - in          required. Where forward projections
     effective comparisons.                         the 29 months between March 2006             are concerned, the above calculation
                                                    and August 2008, an annualised rate of       is based on Treasury forecasts which
•    The official numbers exclude                   increase of £110bn.                          assume annual real GDP growth of
     annual increments to outstanding                                                            3.25% from 2012 onwards. Since
     PFI and public sector pension                  Because the CBI calculation assumes          we find this growth rate pretty
     obligations.                                   a significant item which might be            implausible, we have calculated
                                                    regarded as a one-off – a £90bn ‘move        likely forward deficits on the basis of
•    Official projections assume annual             to realistic mortality’ - this might         a more restrained (2%) real growth
     real GDP growth of 3.25% annually              materially overstate the ongoing rate        trajectory. On this basis, the underlying
     from 2012 onwards, a forecast                  of increase, though the remaining            deficit – that is, aggregate additions to
     which (for reasons outlined later)             increment (of £175bn) still equates to       government indebtedness including
     we regard as over-optimistic.                  £72bn annually. On the assumption            Treaty adjustments and off-balance-
                                                    – perhaps an optimistic one - that           sheet items – is projected at £170bn in
Of these, the Treaty adjustment is the
                                                    progress has been made towards               2014-15, equivalent to 9.7% of (lower)
simplest, and can be calculated by
                                                    containing the rise in the public sector     GDP for that year.
comparing official Treaty debt numbers
                                                    pension obligation since 2008, we
for the beginning and end of each
                                                    include annual increments of £40bn




44         strategy insights | issue four
  Fig. 13: Reported and underlying deficits
  £bn                                                2009-10             2010-11             2011-12             2012-13          2013-14         2014-15

  Official deficit*                                      £167                £163                £131                £109             £88               £73

  Adjustment: Treaty basis                               +£41                +£12                 +£8                +£11             +£8              +£11

  Deficit: Treaty basis*                                 £207                £175                £139                £120             £96               £84

  Adjustment: low growth                                                     +£52                +£26                +£30            +£33              +£34

  2% growth basis                                        £207                £227                £165                £150            £129              £118

  Increment to PFI**                                      +£8                 +£8                 +£9                 +£9            +£10              +£11

  Increment to pensions***                               +£40                +£40                +£40                +£40            +£40              +£40

  Underlying deficit: low growth case                    £255                £275                £213                £199            £179              £169

  As % GDP:

  Official basis*                                       11.8%               11.1%                8.5%                6.7%            5.1%              4.0%

  Treaty basis*                                         14.8%               12.0%                9.1%                7.4%            5.6%              4.6%

  Low growth basis                                      14.8%               15.6%               10.9%                9.4%            7.8%              6.8%

  Including OBS****                                     18.2%               18.8%              14.1%               12.5%            10.8%              9.7%

  Memo: GDP

  Reported basis                                       £1,406              £1,464              £1,533              £1,621          £1,720          £1,824

  2% growth basis                                      £1,406              £1,462              £1,517              £1,589          £1,669          £1,752




*Source: Budget 2010 **Private Finance Initiative: estimated increment to obligations *** Public Sector Pensions: estimated
increment to obligations **** Off-balance-sheet items – PFI and Public Sector Pension increments




                                                                                                                      strategy insights | issue four          45
                                      britain at the crossroads | the case for fundamental change




                                      Even if we leave out both Treaty                  levels are. In 1976 – when the UK
                                      adjustments and the off-balance-                  needed an IMF bail-out to preserve
                                      sheet items, our 2% growth case puts              the public finances – the ratio reached
                                      the 2014-15 deficit at some £107bn                a hitherto-unprecedented 7%. In
                                      (6.1% of GDP) rather than the £73bn               1993-94, after the UK had crashed
                                      (4.0%) predicted by the Treasury. In              out of the European ERM36, the ratio
                                      that year, we estimate government                 reached an all-time (until now) peak
                                      revenue at £665bn (£30bn below the                of 7.7%. Historically, there seems to
                                      Treasury forecast) and assume that                be a very strong correlation between
                                      public spending is in line with the               the Maastricht-required 3% deficit
                                      projected £772bn. These calculations              ceiling and the health of the economy,
                                      are summarised in fig. 12. Moreover,              a correlation which suggests that the
                                      this calculation suggests only sluggish           current (and projected) levels of UK
                                      annual change between the out-turn                deficits may be unsustainable. Both
                                      for 2009-10 (£167bn) and our estimate             in 1976 and in 1993-94, the value of
                                      for 2014-15 (£107bn). The European                sterling crashed, and drastic cuts in
                                      Commission is surely right to call for            public spending became unavoidable.
                                      much more resolute action.                        Yet on neither occasion did the deficit/
                                                                                        GDP relationship reach anywhere
                                      Investors need to be aware of quite               near the double-digit rates now being
                                      how unprecedented such borrowing                  experienced.




46   strategy insights | issue four   36
                                           Exchange Rate Mechanism
vortex risk

The danger with running deficits at                      of its value that has haemorrhaged                    term ‘money supply’ typically conveys
these unprecedented levels is that the                   since 2007. This in turn could lead to                the idea of a simple quantity of money,
UK runs significant ‘vortex risk’. What                  an inability to borrow in sterling at all.            the effective money supply is actually
we mean by this is that the process                      In this situation, the sterling burden                a quantity-and-velocity equation.
may become a downward spiral if                          of servicing borrowings taken out in                  By velocity, economists mean the
a lack of perceived determination                        foreign currencies would escalate.                    frequency with which money changes
to reduce the deficit spooks the                                                                               hands. In the context of the financial
international markets, at which point a                  This kind of scenario seems to                        crisis, velocity naturally declined
very nasty, multi-dimensional feedback                   have been in the mind of Steve                        sharply as businesses and individuals
loop could kick in.                                      Bundred, chief executive of the Audit                 scaled back their spending and
                                                         Commission, when he warned, in                        endeavoured to hoard cash. Therefore,
What happens first under this scenario                   February last year, that the UK ran the               increasing the quantity of the money
is that the UK finds it increasingly                     risk of ‘[an] Armageddon scenario most                supply was an appropriate offset to a
difficult to secure foreign borrowings,                  feared by the Treasury - that there                   decline in its velocity.
meaning that interest rates rise. This                   will be insufficient lenders to match
in turn would have no less than three                    the planned level of borrowing’. This,                As the authorities admitted when the
adverse implications. First, and most                    he warned, ‘begins to look a distinct                 policy commenced in March 2009, the
obviously, higher rates would damage                     possibility’37                                        use of QE is on this scale took the UK
an economic recovery which already                                                                             into uncharted territory. There were
looks extremely fragile. Second, higher                  It was in this context – that of                      two obvious risks with this policy.
rates would drive property prices                        a looming problem of funding                          The first was that QE would stoke up
downwards, inflicting further severe                     government spending through new                       inflation. Though this is a real risk, it
damage to consumer spending. Third,                      borrowings on international markets –                 can be averted if – but only if – the
the cost of servicing government debt                    that the decision was taken to engage                 QE process (a) is not over-used, and
would rise, worsening the deficit.                       in ‘quantitative easing’ (QE).                        (b) is reversed at a later stage. The
                                                                                                               second risk was that QE could spook
The end-game of such a vortex process                    It should be said from the outset that
                                                                                                               international markets by conveying
is full-scale currency crisis, in which                  the use of QE, though a dangerous
                                                                                                               the impression that the government
sterling loses even more than the 25%                    decision, was the right one. Though the
                                                                                                               was printing new money because




37 ‘Our public debt is hitting Armageddon levels’, The Times, 27th February 2009. The article can be read at
    www.timesonline.co.uk/tol/comment/columnists/guest_contributors/article5811186.ece                           strategy insights | issue four       47
britain at the crossroads | the case for fundamental change




it was running out of the genuine        back door, despite official protestations                                  could be extremely dangerous. QE
commodity. This impression may           to the contrary38.                                                         has bought the government a vital
have been reinforced by the fact that                                                                               breathing-space (as well as artificially
virtually all (99%)                      The introduction of QE was handled                                         depressing the rates at which
of QE purchasing                                              superbly in terms                                     government can borrow). But QE is a
                      ‘The excessive cost of                  of public relations.
has been directed                                                                                                   one-off, emergency contingency - if
to gilts rather than government provides a                    Rather than                                           international markets ever came to
corporate bonds.                                              ‘printing money’ – a                                  believe that QE was anything other
                      valuable pointer towards                term which conveys                                    than a temporary, stop-gap measure,
Printing money                                                images of Weimar                                      the UK could very soon find itself
with which to         necessary reforms, and                  wheelbarrows                                          slipping into the kind of ‘vortex’ (the
fund government       leads us to believe that                or Zimbabwean                                         ‘Armageddon scenario’) described
borrowings –                                                  billion-dollar loaves                                 above.
the so-called         it is perfectly possible for            – a shiny new name
monetisation                                                  was coined for a                                      From here on, government, irrespective
of debt – is          government to cut spending process which, it                                                  of party, must move decisively towards
specifically          very markedly without                   is insisted, is quite                                 balancing expenditure and revenue.
forbidden under                                               different from                                        This may appear difficult, especially if,
Article 101 of the    damaging the provision of               ‘printing money’                                      as we strongly suspect to be the case,
Maastricht Treaty.                                            anyway. This is                                       the British economy is appreciably
The UK got around front-line services’.                       simply not true.                                      weaker than is generally supposed.
this restriction                                              Second, markets
by purchasing existing gilts from        have been informed that QE is wise                                         Actually, we believe – and will explain
(principally domestic) institutional     and prudent because Britain faces a                                        in Part Three of this study - that
investors whose risk profile essentially threat, not of inflation, but of deflation.                                cutting public spending may be a lot
required them to reinvest the            Again, and in anything other than the                                      less painful than most commentators
proceeds in new government paper.        short-term, this is simply not true either.                                believe.
In other words, the use of QE to buy
government debt paper seems to us        Where QE is concerned, our view is that
to have confirmed the impression that    the gamble has paid off, but that any
debt was being monetised through the     further significant use of the process



38
  ‘the Bank is not being forced to create money in order to cover the gap between the government’s tax income and its spending
  commitments. If it were carried out to finance the budget deficit, it would be a violation of Article 101 of the Maastricht Treaty
  (which the United Kingdom must abide by, even though it is not a member of the euro zone). Rather, the Bank is undertaking
  quantitative easing in order to meet the inflation target and will sell the government debt back to the private sector once the
  economy recovers, thus unwinding the original increase in the money supply.
‘ Central banks routinely buy and sell government debt in the secondary market as part of their normal operations in the money
  markets and such operations are not deemed to amount to monetary financing under the Maastricht Treaty. The only thing that
  distinguishes quantitative easing from normal operations is their scale and the length of time for which the assets are likely to be
  held’. Source: Bank of England web site




48         strategy insights | issue four
strategy insights | issue four   49
britain at the crossroads | the case for fundamental change



‘The UK is in great need of a system
of governance which is more efficient,
less expensive, less intimidating, less
ideological, and more responsive to the
broader public’


                                                              4. the way we live now

                                                              To the limited extent to which there
                                                              has been any public debate at all
                                                              about the urgency of deficit reduction,
                                                              the dividing line, essentially, has
                                                              been between two views. The first,
                                                              associated with the Conservatives,
                                                              is that there is a need to commence
                                                              deficit reduction without too much
                                                              delay. The counter-argument, advanced
                                                              by the government, is that early action
                                                              to reduce the deficit would imperil
                                                              the economic recovery. An ironic (and
                                                              seemingly counter-intuitive) by-
                                                              product of this positioning is that any
                                                              bad news about the economy appears
                                                              to strengthen the government’s case
                                                              for ‘safeguarding the recovery’.

                                                              In fact, and as we have been at pains
                                                              to argue throughout, this is a false
                                                              debate, for two main reasons. First, the
                                                              government’s argument assumes that
                                                              Britain has plenty of time in which to
                                                              tackle deficit reduction. This is not true.
                                                              Time is in fact very limited. Second,
                                                              the implicit assumption – and one
                                                              underpinned by the optimistic budget
                                                              growth projection – is that economic
                                                              expansion will go a long way in itself
                                                              towards bringing down the deficit. This
                                                              isn’t true either. Britain cannot expect
                                                              to ‘grow out of’ the deficit.

                                                              There has been a natural progression
                                                              – through the TAT process described
                                                              earlier – in which toxic risk has
                                                              migrated from individuals, via the




50        strategy insights | issue four
banking system, to government                    Each of these ‘props’ is now fast            recent GDP figures (for the fourth
balance sheets. Most conspicuously               approaching its sell-by-date. For            quarter of 2009) showed growth of
in the case of Greece, this has put              reasons outlined earlier, QE is a strictly   just 0.3%. Though the revised number
sovereign debt into the firing line. Thus        limited expedient which cannot be            was better than the initially-released
far, Britain has largely escaped from            used on an ongoing basis without             figure (+0.1%), growth of 0.3% is, by
serious market pressure. In one sense,           shaking investor confidence and              any standards, anaemic, particularly
Britain’s comparative immunity is                triggering inflation. The election           when the weakness of sterling ought
surprising, given the severe weakness            defence is obviously about to become         to be benefiting net trade. Far from
of public finances which are, in the             time-expired. And sterling weakness          benefiting from currency depreciation,
words of Pimco’s Bill Gross, ‘resting on         does not appear to be boosting               the trade figures for January showed
a bed of nitroglycerine’39.                      economic performance.                        that the deficit had widened to £3.8bn.
                                                                                              Moreover, the net figure emerges from
This immunity is purely temporary, and           Our ‘three props’ interpretation leads       a combination of weak imports (which
results, we believe, from three factors –        us to believe that resolute action           have negative implications for levels of
we term them ‘the three props’ – each            immediately after the election is            economic activity) and sluggish exports
of which is essentially short-term in            imperative, such that the debate             (which suggest that exporters are not
nature. These ‘props’ are:                       over timing is essentially a false one.      benefiting from the depreciation of
                                                 We believe, first, that it would be too      sterling).
1. Quantitative easing, which                    hazardous for the UK to use QE to
   obviated any need for the                     monetise its deficit for a second year       The clear impression, then, is that the
   UK government to seek new                     – if this happened, QE would begin           UK economy is mired in recession, even
   borrowings from the international             to look like a permanent instrument,         if a single quarter of only marginal
   markets despite a CGNCR40 fund-               and markets would punish the UK              growth is sufficient to mark the
   raising requirement of £201bn                 accordingly.                                 technical end of recession (which is
   during 2009-10.                                                                            defined as two or more quarters of
                                                 Second, markets are not going to wait        consecutive GDP shrinkage). As we
2. The imminence of the general                  indefinitely for a UK economic recovery      explained earlier, we suspect that
   election, which has given the UK              which, thus far, appears pretty feeble.      reported GDP growth figures may be
   a fragile ‘year of grace’ through             Third, a post-election government (of        questionable anyway.
   market recognition that resolute              whichever party) will no longer be
   action is unlikely to happen before           able to play the ‘pre-election hiatus’
   the election takes place.                     card. Markets will expect swift action
                                                 immediately after the election.
3. The weakness of sterling, which is
   regarded as an automatic stabiliser           Thus far, and despite solid recoveries
   which should boost exports                    in other developed nations such as
   and deter imports, thus helping               the US, France and Germany, the
   economic recovery.                            British economy is lagging. The most




39
     Quoted in The Guardian, 26th January 2010
40
     Central Government Net Cash Requirement                                                    strategy insights | issue four     51
britain at the crossroads | the case for fundamental change




the economy – what is the problem?

The overall impression, then, is that             do not have a huge impact on overall      which are by no means unique to
UK’s economy is not performing either             rankings. But as individual measures      the UK. However, we believe that
as well as competitors’ or as well as             they are telling. They mean that UK       over-complex and excessively costly
might have been expected as the world             government spending is more wasteful      government has been a by-product
economy gradually emerges from                    than that of, for example, Tunisia, the   of an attempt to remodel society,
recession. Why?                                   Gambia, Malawi, Ethiopia or Albania,      certainly since 1997 and arguably since
                                                  and government regulation is more         1990. This shows up most obviously
The bottom line, we believe, is that              burdensome in Britain than in Bulgaria,   in bureaucracy where, as explained
UK competitiveness is being stifled               Nigeria, Pakistan or China.               earlier, the bulk of the expansion has
by a system of government which is                                                          occurred not in the conventional civil
at once both excessively costly and               These factors – government                service but in a plethora of ‘agencies’
unnecessarily interventionist. Industry           wastefulness and bureaucratic             and quangos. This is a critical issue, not
is burdened by a level of regulation,             meddling – adversely impact the ‘offer’   just because of its adverse implications
much of it essentially petty, which runs          which Britain makes to businesses,        for business, but also because of the
the gamut from unduly prescriptive                which can be summarised as follows:       role that the expansion in the cost of
health and safety rules to a pursuit of                                                     government has played in creating an
equality which, while commendable in              ‘We encourage you to invest in Britain.
                                                                                            unsustainable fiscal deficit.
principle, imposes too great a burden             If you do so, you will be required to
on enterprise.                                    comply to the letter with vast codes of   Given that the Prime Minister is the
                                                  practice governing all aspects of your    elected chief executive of the British
This interpretation seems to be borne             activities. You will be expected to act   government, one might expect him
out by the Global Competitiveness                 as an unpaid tax collector, collecting    to rank at least somewhere near the
Report 2009-10, produced by the                   sales, income and local taxes. Your       top of the public sector pay league.
World Economic Forum (WEF). The                   business will be subject to a tax code    In fact, this is not the case. Based on
UK has fallen by four places in the               which, having more than doubled in        remuneration of £194,000 – and even
last two reports, and now ranks 13th              length since 1997, now exceeds 10,000     excluding the government-owned
in the rankings. While 13th sounds                pages. Even our own tax authorities       banks from the list – Mr Brown ranked
a reasonable position, this in part               do not fully understand the tax code      297th in the 2008-09 league table of
reflects some natural advantages (such            but, where in doubt, we reserve the       those employed by the taxpayer. Of the
as market size, and developed world               right to interpret it to our advantage.   296 people above him, only 11 were
levels of education and health).                  In addition to national regulatory and    civil servants (of whom the highest
                                                  fiscal agencies, you should also expect   paid earned £248,000).
Some of the detailed findings and                 interference from local authorities, to
trends are much more worrying.                    whom you will pay substantial taxes in    Of the other 285 people paid more
Britain ranks 75th on ‘wastefulness               return for minimal services. Welcome to   than Mr Brown, no less than 82 were
of government spending’, and 86th                 the United Kingdom’                       employed (at an aggregate cost of
on ‘burden of government regulation’.                                                       £17.5m) by the health care trusts into
These are only two categories within              Obviously, this is put rather starkly.    which the NHS has been fragmented
the 110 covered by the research, so               Obviously too, it highlights problems




52        strategy insights | issue four
by quasi-market reforms. Some £4m
was paid to seven employees of
National Rail, £6.1m to 21 members
of Transport for London, £3.2m to six
Channel Four executives and £13.9m to
fifty BBC managers. The £3.3m paid to
four Royal Mail executives surely needs
no further comment41.

In total, the 296 people who were paid
more than Mr Brown in 2008-09 cost
the taxpayer £81m. While this is not
a major sum in the context of total
public spending of £630bn during that
year, it does highlight the sheer extent
of the UK bureaucracy. The total cost of
government administration – including
all quangos, agencies and local
authorities – is difficult to isolate, but
our outline estimates suggest a figure
of at least £150bn annually. We suspect
that the overall cost of administering
the NHS alone exceeds £25bn, with
MoD administration costing about
£8bn and HMRC perhaps £16bn.

As we explain later in this report, the
excessive cost of government provides
a valuable pointer towards necessary
reforms, and leads us to believe that it
is perfectly possible for government to
cut spending very markedly without
damaging the provision of front-line
services. To be sure, this will not be
easy. But, in a situation in which the
deficit exceeds safe limits by more than
£5,000 per household, there are no
pain-free and easy solutions.




41
     Source: The Public Sector Rich List, 2009   strategy insights | issue four   53
britain at the crossroads | the case for fundamental change




part three:
the road out

5. limited options

Thus far in this report, our aim has              1. Business as usual.                      inflation will actually be as low as the
been to examine the origins and nature                                                       official forecasts assume).
of the fiscal problems facing the United          2. Narrowing the deficit through tax
Kingdom. Essentially, government has                 increases alone.                        A business-as-usual scenario - in which
allowed itself to be misled by a largely                                                     growth is relied upon to bridge the
                                                  3. Applying a balanced approach in         deficit – is effectively the government’s
illusory boom in economic growth, and
                                                     which taxes are increased and           default position, and is summarised
has driven spending up to – or rather,
                                                     spending is reduced.                    in fig. 14. As yet, there have been
far beyond - levels that, surely naively,
appeared affordable under those                                                              neither major tax increases nor drastic
                                                  4. Tackling the deficit entirely through
circumstances. As a result, and as soon                                                      spending cuts. The government has
                                                     spending reductions.
as the illusory boom gave way to an all-                                                     spoken of ‘restraint’ in public spending,
too-real bust, the gap between revenue            We think that we have made clear           but restraint and cuts are quite
and expenditure widened, reaching                 our view – which appears to be the         different things. Essentially, growth is
levels which are both unprecedented               view of informed observers, such as        relied upon to do most of the work in
and unsustainable.                                the European Commission, as well -         bringing down the deficit to 4% of GDP
                                                  that relying on growth to rectify the      by 2015.
The funding gap has, thus far,                    deficit is not going to work, neither
been met by the one-off (and risky)                                                          This objective is less ambitious than
                                                  will any such attempt command the
expedient of QE. Britain thus faces the                                                      the European Commission – with
                                                  confidence of markets once the ‘three
very real risk of a ‘debt vortex’ unless                                                     which our own analysis agrees -
                                                  props’ – QE, the pre-election hiatus
resolute action is taken to reduce the                                                       believes to be necessary. Moreover,
                                                  and the devaluation of sterling – have
deficit to a more viable level, by which                                                     it is heavily dependent upon growth
                                                  fallen away.
we mean the 3% limit mandated by                                                             assumptions which look to us
the Maastricht Treaty. It is to be hoped          Specifically, we believe that relying on   pretty heroic. We have tested the
that our examination of the causes of             real GDP growth of 3.25% annually is       government’s spending plans against
the problem has suggested some of                 neither realistic nor, where markets       a core 2% growth assumption and a
the solutions. First, though, we need to          are concerned, convincing. Therefore,      downside 1% case. In the former, the
assess some of the basic options where            we have assumed real growth of             deficit is over £100bn in 2015, is an
the balance between revenue and                   2% annually in each of our case-           uncomfortable 6.1% of GDP. Using a 1%
spending is concerned. These options              studies. (We have also accepted the        growth assumption, the outcome is,
can be summarised as:                             government’s inflation projections,        naturally, even worse.
                                                  though we are far from persuaded that




54        strategy insights | issue four
Fig 14: Budget projections
£bn                    2008-09      2009-10   2010-11   2011-12   2012-13   2013-14       2014-15       vs 09-10

Revenue                      £534     £508      £541      £582      £621       £660          £699

(as % GDP)               37.2%       36.1%     37.0%     38.0%     38.3%      38.4%         38.3%

Expenditure                  £630     £674      £704      £713      £730       £748          £772

(as % GDP)               43.9%       47.9%     48.1%     46.5%     45.0%      43.5%         42.3%

Deficit                       £96     £167      £163      £131      £109        £88           £73

(as % GDP)                   6.7%    11.8%     11.1%      8.5%      6.7%       5.1%          4.0%

Treaty debt                  £796    £1,004    £1,179    £1,318    £1,438    £1,534        £1,618

(as % GDP)                   55%       71%       81%       86%       89%        89%           89%

Memo:

GDP                      £1,435      £1,406    £1,464    £1,533    £1,621    £1,720        £1,824

Growth                   -1.50%      -3.75%    2.00%     3.00%     3.25%      3.25%         3.25%

GDP deflator             2.50%       1.75%     2.25%     1.50%     2.50%      2.75%         2.75%

In 2010 £:

Revenue                      £547     £508      £529      £561      £584       £604          £622        +22.6%

Expenditure                  £645     £674      £689      £687      £686       £684          £687            +2.0%

Deficit                       £99     £167      £159      £126      £102        £81           £65




                                                                            strategy insights | issue four           55
britain at the crossroads | the case for fundamental change




Next, let’s consider dealing with the             a reduction of almost 15% in average        that are affordable within the levels
deficit entirely through raising taxes            household after-tax income. After the       of government revenue that are likely
(a strategy that would no doubt be                deduction of non-discretionary costs        given a realistic growth trajectory.
popular with many in the public                   such as utilities, food, housing and        Incorporating already-announced tax
sector). Using this approach, narrowing           fuel, this would decimate the average       rises, achieving a reduction of the
the deficit to our self-imposed but, we           consumer’s discretionary spending           deficit to 3% of GDP over five years via
think, reasonable objective – a deficit           capability. This would wreak havoc on       this route might see the real-terms tax
of 3% by 2015 – involves increasing the           discretionary industries (such as leisure   take rise by about 20%, combined with
tax take by 26%, in real terms, over five         and non-food retailing). Since the          a real-terms spending reduction of
years. To put this in broad-brush terms,          word ‘lethal’ would not be too strong       4%. If huge swathes of spending (such
this increase, were it spread equally             a term to apply to the implications         as health and education) were ring-
across all categories of taxation, would          of this for business, investment and        fenced – which we think would be a
imply VAT of 22%, basic-rate income               trade, a national decision to fix the       mistake – then real-terms spending in
tax of 25%, and higher-rate tax of 50%,           deficit entirely through tax hikes          unprotected areas could fall by 8-10%.
accompanied, of course, by big hikes in           could amount to a collective economic       In many ways, this scenario would be
excise duties on items such as alcohol            suicide pact.                               commendable only in the sense that it
and fuel.                                                                                     would spread pain across the board.
                                                  A balanced approach might work,
In real (2010) terms, it would burden             and seems likely to be applied unless
the average household with extra taxes            the next UK government is serious
of over £5,200 per year, equivalent to            about reducing spending to levels




56        strategy insights | issue four
Fig 15: Case study based on tax at 35% of GDP, deficit at 3%
£bn                     2008-09      2009-10      2010-11      2011-12   2012-13   2013-14       2014-15       vs 09-10

Revenue                    £534         £508         £525        £541      £564       £588          £614

(as % GDP)                37.2%        36.1%        35.8%       35.6%     35.4%      35.2%         35.0%

Expenditure                £630         £674         £672        £667      £668       £668          £667

(as % GDP)                43.9%        47.8%        45.9%       43.9%     41.9%      40.0%         38.0%

Deficit                     £96         £166         £147        £126      £104        £80           £53

(as % GDP)                 6.7%        11.8%        10.0%        8.3%      6.5%       4.8%          3.0%

Treaty debt                £796       £1,004       £1,218       £1,362    £1,482    £1,573        £1,637

(as % GDP)                 55%           71%          83%         90%       93%        94%           93%

Memo:

GDP                      £1,435       £1,409       £1,465       £1,520    £1,593    £1,672        £1,756

Growth                   -1.25%       -3.50%        1.50%       2.00%     2.00%      2.00%         2.00%

GDP deflator              2.50%        1.75%        2.25%       1.50%     2.50%      2.75%         2.75%

In 2010 £:

Revenue                    £547         £508         £514        £522      £530       £538          £546            +7.6%

Expenditure                £645         £674         £657        £643      £628       £611          £594        -11.9%

Deficit                     £98         £166         £144        £121       £98        £73           £48




                                                                                   strategy insights | issue four           57
                                      britain at the crossroads | the case for fundamental change




                                      This kind of pain-spreading approach              administrative costs can deliver
                                      would then pose two possibilities. One            huge savings, what would be the
                                      is that government would become                   implications for fiscal balances? Our
                                      unpopular with virtually everybody,               ‘drastic reform’ case-study, set out
                                      from tax-payers and businesses at                 in fig. 15, assumes that government
                                      the one end of the spectrum to public             makes two very bold decisions.
                                      sector workers at the other. The
                                      alternative (and much more politically            The first is that government should
                                      likely) possibility is that government            live within its means. This means
                                      would go soft on the deficit target. This         reversing the current situation, in
                                      would deliver the worst of all worlds             which government decides what it
                                      – sluggish economic growth, and a                 would like to spend and only then sets
                                      continuation of all of the potential              out to find this sum through taxation
                                      hazards (such as higher interest rates            and borrowing.
                                      and inflation) that accompany ‘vortex
                                                                                        The second bold decision is that the
                                      risk’.
                                                                                        UK needs to create a more competitive
                                      Is there, then, a viable alternative?             economy by reducing the tax take,
                                      We believe that there is. The massive             albeit only slightly, to 35% of GDP from
                                      increase in public expenditures over              the current 36%. Therefore, the object
                                      the last decade has been hugely                   of the exercise is to tailor spending to
                                      wasteful, most notably in terms of the            the twin objectives of (a) fitting within
                                      costs of administration. For example,             a 35% tax take, and (b) reducing the
                                      administration absorbs 20% of the                 deficit to 3% of GDP over five years.
                                      budget of the Ministry of Defence,                Naturally enough, this means cutting
                                      whereas international peers get by on             public spending from 48% of GDP in
                                      just 11%. Much the same applies to                2009-10 to 38% by 2014-15. How this
                                      the NHS and, indeed, to most aspects              seemingly-difficult challenge might be
                                      of administration. On top of that are             accomplished is considered in the next
                                      the huge expenditures incurred by the             chapter.
                                      forest of quangos that has proliferated
                                                                                        In nominal, money-of-the-day terms,
                                      over the last two decades.
                                                                                        this objective indicates that spending
                                      If we start with the assumption –                 in 2014 would, at about £670bn, be
                                      before going on to look at how it                 about the same as the sum spent in
                                      might be accomplished – that slashing             2009-10. In real, inflation-adjusted




58   strategy insights | issue four
terms, of course, spending would                       benefit from lower taxes and less           simply, this means that an economic
decline by 12% in this scenario, to                    intrusive government. The scope             system which, by its nature, must
£594bn at 2010 values, compared with                   for discretionary spending by the           grow, may be on course to collide
the 2009-10 out-turn of £674bn.                        consumer would increase, leaving him        with a global resource set which,
                                                       or her better off. The deficit would        by definition, cannot grow. This, to
At this point, some will doubtless                     decline to 3% by 2015, and would be         us, unmistakably spells inflation on
suggest that a spending cut of this                    likely to fall further thereafter. And      anything other than a short-term
magnitude would be impossibly                          spending reductions on this scale           view. Additionally, the UK faces local
difficult, and would inflict serious                   would give Britain a margin of error for    inflationary pressures through an
damage on the public services. But                     coping with any unexpected economic         ominously weak currency, through the
reducing spending to about £590bn                      setbacks in the future.                     temptation to push inherently-risky
at 2010 values would still leave                                                                   QE one stage too far, and through a
real expenditures well ahead of the                    And there is every reason for factoring     looming energy squeeze.
2004-05 level (£560bn), let alone the                  a significant degree of caution into
out-turn in 2001-02 (£480bn). Public                   forward planning, because current           The latter poses an additional risk for
services did not seem desperately cash-                assumptions seem to us unduly               the next government. For a start, UK
starved in the first half the decade.                  optimistic – and not just where future      production of natural gas is declining
                                                       growth rates are concerned. The first       rapidly, meaning that imports will
Moreover, both of the main parties                     of these concerns inflation, which we       increase successively. Second, energy
have, in the recent past, accepted the                 are by no means convinced will follow       policy has been bungled by successive
need for precisely the kind of cost-                   the benign course assumed in current        governments. The Conservatives
cutting that we advocate here. In 2005,                official projections. Though much           presided over a ‘dash for gas’ which, in
David James, for the Conservatives,                    has been made of deflationary risk,         addition to depleting reserves, skewed
produced a report42 in which he                        the fact remains that inflation (even       Britain’s power generation industry
identified £35bn of potential savings,                 as measured on the far-from-ideal           firmly towards gas.
equivalent to about £49bn at 2010                      CPI basis) remains obstinately above
values. On behalf of the government,                   expectations.
Peter Gershon produced a report43
pointing to similar potential savings.                 Our core thesis – to be outlined in
                                                       detail in Issue Five – is that the global
If – as we very strongly believe to                    financial system is in the grip of a
be the case – a real-terms saving                      series of ‘dangerous exponentials’,
of £80bn can be accomplished                           which include a trend towards sharply
over five years largely by cutting                     higher levels of debt and of fiat money,
bureaucracy, the benefits would be                     combined with demographic pressure
enormous. Competitiveness would                        and looming resource constraints. Put




42
     See The James Review of Taxpayer Value
43
     See HM Treasury, 2004 Spending Review, www.hm-treasury.gov.uk/d/sr2004_ch1.pdf                  strategy insights | issue four      59
britain at the crossroads | the case for fundamental change




Under both administrations, there                 functioning as an effective free-           is deeply dissatisfied. In our earlier
has been a lamentable failure to bite             market economy is clearly at risk, even     discussion of this conundrum, we
the nuclear bullet. Of Britain’s eight            if this can be addressed only briefly       suggested that politicians might
nuclear reactors, five44 - accounting for         here. This is an increasing tendency        actually try the innovation of listening
60% of installed capacity – are due to            towards coercion and surveillance. No       to the public. Were they to do this, they
close within the coming eight years, yet          less a person than then Information         might appreciate that the governing
past government vacillation has meant             Commissioner Richard Thomas warned          elite is increasingly out of touch with
that no new capacity is likely to come            in 2004 of the danger of ‘sleepwalking      the governed on a gamut of issues
on stream until 2019.                             into a surveillance society’45. One         ranging from discontent at ‘fat cat’
                                                  does not need to be Walter Wolfgang         government, to excessive taxation
The combination of local weaknesses               or Maya Evans46 to suspect that             and charging, to over-complex and
and global ‘dangerous exponentials’               anti-terror laws are being used for         petty regulation. It is well known that
obviously spells inflationary risk, but it        purposes far beyond the original            depression and de-motivation can
also spells higher interest rates, even if        intentions of Parliament. It is possible,   seriously undermine the performance
government succeeds in retaining the              indeed, to envisage a                                         of the individual,
confidence of the international bond              future in which the           ‘The future is fraught but it is perhaps less
markets (something which is by no                 British population                                            appreciated that this
means certain unless resolute action is           is subjected to ever-         with economic risk              is equally true of a
taken). This would be a multi-pronged             increasing taxation and                                       society or an economy.
threat. In addition to the ‘vortex risk’                                        at a time when the
                                                  charging to sustain                                           So efficiency, social
described earlier, higher interest rates          an administrative             pre-election debate             cohesion, economic
would cause an escalation in the cost             superstructure which                                          weakness and fiscal
of servicing government debt – which              is increasingly coercive      is characterised                overstretch seem to
already costs more than defence or                as well as unaffordably                                       point towards the
law and order - and would put further                                           by vagueness and
                                                  costly.                                                       same conclusion,
pressure on consumers both through                                              unreality’.                     which is that the UK
higher mortgage costs and falling                 This brings us to a point                                     is in great need of a
property prices.                                  raised much earlier in                                        system of governance
                                                  this report, where we addressed the         which is more efficient, less expensive,
The future, then, is fraught with                 apparent mismatch between, on the           less intimidating, less ideological, and
economic risk at a time when the                  one hand, a society that is by no means     more responsive to the broader public.
pre-election debate is characterised              as ‘broken’ as is widely supposed and,
by vagueness and unreality. And there             on the other, a population which
is one further area in which Britain’s




                                                  44
                                                     Hartlepool and Heysham 1 (2014), Hinckley Point B and Hunterston B (2016), and Dungeness B (2018)
                                                  45
                                                     See The Times, 16th August 2004
                                                  46
                                                     Mr Wolfgang (then aged 82) was a long-time Labour activist who was forcibly ejected from the 2005 party
                                                      conference (and briefly detained under Section 44 of the Act) for heckling a speech by Jack Straw about the
60        strategy insights | issue four              Iraq War. Maya Evans (25) was arrested for reading out a list of British war dead opposite the Cenotaph.
                                                  47
                                                     Our favourites from the 2008 crisis included ‘Origami Bank has folded, Bonsai Bank is cutting its branches
                                                     and Karaoke Bank is being sold off for a song’
6. practical alternatives

In any financial crisis, a grim gallows                    modest number of strikes, public            equates to more than £6,500 per UK
humour tends to develop in the                             sector workers in Ireland have largely      household48.
markets47. One of the pithiest – but, as                   accepted the need for government
it turned out, most inaccurate – such                      spending restraint. While it is too         The second perceived obstacle to
quips of the 2008 crisis was that ‘the                     soon yet to judge whether public            spending cuts is that front-line services
only differences between Iceland and                       sector employees in Greece will             will necessarily suffer severe damage.
Ireland are one letter and six months’.                    respond as phlegmatically as their Irish    But, as our analysis of the nature of
                                                           counterparts, there seems to be every       the over-spend has endeavoured to
To be sure, Ireland had faithfully                         likelihood that Greece will succeed in      explain, this assumption need not be
followed the same irresponsible                            imposing significant restraint without      correct. Essentially, the British public
economic approach which had                                system-stopping unrest.                     sector over-spends because it is over-
effectively bankrupted Iceland. But                                                                    managed. Far from improving the
Ireland has – albeit painfully – avoided                   There are, essentially, two perceived       quality of public services, this over-
the fate of Iceland, for two main                          obstacles to the implementation of          management has resulted in excessive
reasons. Since an independent Irish                        big public spending cuts in the UK, of      complication, an undue reliance on an
currency would almost certainly have                       which the first (and biggest) is a fear     arbitrary and distorting target culture,
disintegrated in much the same way as                      that public sector workers will react by    and a diversion of resources away from
the Icelandic króna, it is clear that the                  bringing government to a standstill.        front-line services.
first of these reasons has been Ireland’s                  We think that this fear is over-rated.
membership of the Eurozone. But the                        When the delayed bill for the recession     This suggests that cutting spending
second reason for Ireland’s comparative                    arrives – which it indubitably will –       will be by no means as difficult as is
resilience is that the Irish government                    public sector employees will become         generally supposed. Writing in The
reacted with commendable resolution,                       aware of two things. First, that they       Guardian49, Audit Commission chief
most notably by introducing public                         have hitherto enjoyed not only better       executive Steve Bundred explained why
sector pay restraints which, combined                      conditions of employment (and far           the need for big cuts in public spending
with a pensions levy, effectively                          superior pension arrangements) than         need by no means lead to a degrading
amounted to reductions in public                           their private sector counterparts but,      of front-line services, pointing out
sector pay of between 12% and 15%.                         latterly, have received higher average      that ‘the idea that spending cuts will
                                                           earnings as well (so that the traditional   destroy the quality of public services’
This is not a policy which we                              defence of the pension scheme,              is a ‘myth’. ‘Even if a budget reduction
recommend in Britain’s rather different                    on the grounds that it is a form of         of some £50bn fell entirely on lower
circumstances, but there is one aspect                     compensation for lower earnings, is         spending rather than higher taxes,
of the Irish story which has particular                    no longer valid). Second, it needs to be    that would still leave us with a real
significance in this context. It is                        explained that the British state has,       level of public spending greater than
the observation that, beyond some                          for many years, been living beyond          in 2003/04, when services were not
noisy demonstrations and a pretty                          its means to an extent that now             noticeably worse than they are now.




48
     The per-household equivalent of a £167bn deficit is £6,550.
49
     5th July 2009                                                                                       strategy insights | issue four      61
britain at the crossroads | the case for fundamental change




‘Efficiency, social cohesion,                     Moreover, as most public sector                           bill, but this, we think, can be best
                                                  workers know, some services remain                        accomplished by a sharp reduction in
economic weakness and                             underfunded, but the relationship                         the numbers of administrative staff.
                                                  between spending and service quality                      Entire entities – to name just one
fiscal overstretch seem to
                                                  is at best complex and in many                            category amongst many, the regional
point towards the same                            instances tenuous’. ‘So don’t believe                     development agencies – could be
                                                  the shroud wavers who tell you                            scrapped with no detriment to the
conclusion, which is that                         grannies will die and children starve if                  quality of public services. Spending
                                                  spending is cut. They won’t’, concluded                   cuts need not mean that public
the UK is in great need of
                                                  Mr Bundred. ‘Cuts are inevitable, and                     services suffer, or – contrary to the
a system of governance                            perfectly manageable’.                                    predictable protestations of some
                                                                                                            public sector unions – that the incomes
which is more efficient, less                     Mr Bundred is surely right about this.                    of such low-paid worthies as school
                                                  Moreover, we believe that the approach                    dinner-ladies or hospital porters need
expensive, less intimidating,                     to be adopted in the UK needs to be                       suffer either.
less ideological, and more                        rather more nuanced than it has been
                                                  in Ireland. For the most part, we do not                  Moreover, and since the real level of
responsive to the broader                         believe that government needs to cut                      government expenditure increased by
                                                  the wages of any public sector workers                    55%50 between 1999-2000 and 2009-
public’                                           earning less than the national average                    10, it would be remarkable if current
                                                  wage (about £21,000 per year). In this                    outlays did not include huge swathes
                                                  category, a pay freeze is likely to suffice.              of waste. As we have remarked earlier,
                                                  Rather – and in addition to tackling the                  the template for future success is
                                                  pensions problem - government needs                       often to be found in the errors of the
                                                  to look at imposing graduated cuts,                       past which, in this instance, means
                                                  restricting Irish-scale reductions to                     reversing much of the improperly-
                                                  those earning more than £30,000 per                       controlled expansion in the scale and
                                                  year. Though any future government is                     cost, not of public services, but of
                                                  going to need a pretty thick skin where                   government itself.
                                                  public sector pay restraint is concerned,
                                                  there are ways of handling the need for
                                                  cuts which can help to offset adverse
                                                  reactions.

                                                  This said, there is an undoubted need
                                                  to reduce the overall public sector pay




                                                  50
                                                       Adjusted for subsequent inflation, public spending in 1999-2000 (of £343m) equates to £437m in 2010
62        strategy insights | issue four               money, meaning that actual spending (of £676m) equates to a real terms increase of 55%.
So what is needed is wholesale reform    information technology should be the         potential resource constraint (most
of a public sector which has become      efficient conduct of administration,         notably, but by no means only, in terms
massively over-managed. Since this       not an increase in the endeavour to          of energy).
applies as much in health and in         control a population which is already
education as it does in other areas,     subject to massively intrusive systems       Britain’s public sector pension
we see no need (beyond pre-election      of surveillance. Abuse of anti-terror        obligations, unless tackled resolutely,
posturing) for ring-fencing any          powers should itself be rendered a           could turn into a fiscal time-bomb.
spending areas where the requirement     criminal offence, and made subject           Therefore, a key imperative is to ensure
for reform-driven spending reductions    to the binding oversight of the              that this obligation ceases to grow.
is concerned. In several areas – most    Information Commissioner.                    Specifically, government needs, at
notably health – government needs                                                     the minimum, to raise public sector
to start reversing a quasi-market        As well as dealing with current issues,      pension contributions to the point
process which has fragmented public      a future government needs to look            where annual income at least covers
services, and                                              ahead, and to try to       annual outgoings. Similarly, to avoid
                                                           anticipate future trends   the build-up of future financing
increased costs,       ‘The British public sector
while generating                                           which could put the        problems, we advocate scrapping PFI
little if any real     over-spends because it is           public finances under      with immediate effect, and reverting
competition and                                            renewed stress. In         to the historic policy of directly funding
                       over-managed’                       doing this, two key        capital projects.
giving the public
very little real                                           factors need to be
                                         borne in mind. The first of these is the     As well as seeking to defuse future
freedom of choice. We believe that
                                         demographic challenge posed by an            fiscal time-bombs, it is imperative that
patients, and for that matter parents,
                                         ageing population and a worsening            action is taken to prevent a recurrence
would prefer good quality public
                                         ratio between working-age and                of the borrowed boom of 2000-07
services based locally, rather than an
                                         retired people. The second is the trend      and the ensuing crash of 2008-09. The
often spurious (and impossible-to-
                                         towards ‘dangerous exponentials’,            first requirement here is to dismantle
exercise) ‘choice’ between different
                                         mentioned earlier, and which will be         the failed tripartite system. The FSA
hospitals and schools.
                                         explained in a forthcoming Strategy          has a vital role to play in ensuring
We also believe that government          Insights report. For UK purposes, this       probity and consumer protection in
needs to become far smarter where        issue points to a need to move away          the financial services industries, but
the use of technology is concerned.      from a growth-and-debt model which,          regulation of the banking system
Government employees need to             in Britain as elsewhere, is based upon       itself needs to be handed back to the
understand that laptops and data-        the assumption that the economy can          Bank of England. It is essential that
sticks are not designed to boost         continue to grow indefinitely despite        monetary targets be recalibrated to
freedom of information by being left     the confines of a finite resource set.       include asset inflation.
on trains or in cabs. The aim with       Specifically, this implies awareness of




                                                                                        strategy insights | issue four       63
britain at the crossroads | the case for fundamental change




Since property price expansion is by              would go a long way towards it).         down the surveillance and intrusion
far the largest cause of bubbles, the             Consequently, if the excessively-        route – should be scrapped, as, indeed,
government should re-impose limits                narrow difference in quantity cannot     should an NHS IT programme which
on mortgage lending, where we believe             be widened sufficiently, it could be     is on course to cost Britain more than
that a maximum multiple of 5.5 times              counterbalanced                               £20bn. There is a crying need for
proved net income, and a maximum                  by a distinction       “The UK needs to       thoroughgoing reform of local
LTV of 85%, are essential.                        of quality. In         modernise, and to government.
                                                  other words,
While bank regulation needs to                    part (perhaps as       commence a new The essence of our analysis is
be tightened, essentially petty                   much as 80%) of                               that the UK needs to modernise,
intervention in other areas needs to              benefits could be      ‘quest for national and to commence a new ‘quest
be reduced. Government needs to                   paid not in cash                              for national efficiency’51. Other
adopt a ‘self-denying ordinance’ and, in                                 efficiency’”           progressive measures could follow
                                                  but in kind. As a
addition to creating mandatory limits             result, a person                              from this, including electoral
to deficits, start to reverse the historic        who moved from benefits to work          reform (moving away from the
process of ever-greater interference in           would enjoy not only a larger income     unrepresentative first-past-the-post
the conduct of business.                          in the absolute but the significant      system), an overhaul of the welfare/
                                                  additional incentive of a greater        taxation interface (where a system
Welfare reform needs to focus                                                              of ‘negative income tax’ would be a
                                                  freedom in how this could be spent.
primarily on eliminating the poverty                                                       bold step forward), and the creation
trap. Essentially, this trap refers to            We have remarked earlier that the        of an elected (rather than, as now,
marginal changes of income which                  tax system has long incentivised debt    and ludicrously, a nominated) second
impose a severe deterrent on those                over equity capital by allowing interest chamber. But the most important
seeking to move from benefits to                  expense, but not dividends, to be        need by far is for economic and
work. One step in the right direction             offset against tax. It has been argued,  administrative reforms designed both
would be to seek to raise the income              disingenuously, by defenders of the      to reverse the economic and fiscal crisis
tax threshold to the equivalent of                current system, that removing interest   and to prevent such crises recurring in
the minimum wage (some £10,000,                   relief would damage big UK corporates.   the future.
based on current rates). This could               The solution would be simple – a cap
be paid for by dismantling the over-              limiting the interest deduction to no
complicated and capricious tax credit             more than 20% of pre-tax profits.
system. At the same time, the National
Insurance fiction should be abolished             Other desirable reforms will have
by combining NI into income tax.                  been obvious from our analysis of
                                                  the history and nature of the British
Alone, these measures might                       malaise. The ID card scheme – which,                       Dr Tim Morgan
not be sufficient to eliminate                    as well as being ludicrously expensive,                    Global Head of Research
the poverty trap (though they                     threatens to take the UK even further                      April 2010




                                                  51
                                                       The quest for national efficiency was the title of a ground-breaking 1971 study by G.R. Searle, which
                                                       examined Britain’s attempt to respond to the growing industrial rivalry of the United States and Germany
64        strategy insights | issue four               between 1890 and 1914.
appendix 1
financial and economic data

In the interests of consistency, and                    stated at purchasing power parity), the     In some instances, and reflecting a
except where otherwise noted,                           table shows budgetary information           commonality of method, this data
financial and economic data used                        summarising revenues, public                differs from nationally-published
in this report for the purposes of                      expenditure, the surplus or deficit and     numbers. All data is for the 2009
international comparison is sourced                     reported government debt at year-end.       calendar year, whereas some countries
from the CIA World Factbook.                            The table also shows exports, imports       (including the United Kingdom and
                                                        and the trade balance. Key items –          the United States) report on the basis
To assist readers with comparisons, a                   the fiscal deficit, public debt and the     of their own fiscal years. With the
summary of key data for 2009 is shown                   trade balance – are also shown as           exception of percentages, all data is
in fig. 16. In addition to GDP (which is                percentages of GDP.                         shown in billions of US dollars.


  Fig. 16: Summary economic data, 2009*
                                                  Budget                                  Trade                          As % GDP

  $bn               GDP**     Revenue       Spending             +/-    Debt    Exports   Imports     +/-      Deficit      Debt        Trade

  Canada           $1,287         $515          $547        -$33        $931      $299      $305      -$7       -2.5%        72%        -0.5%

  China            $8,767         $972         $1,137      -$165       $1,596   $1,194      $922    $273        -1.9%        18%        3.1%

  France           $2,113       $1,229         $1,445      -$216       $1,684     $457      $532     -$75      -10.2%        80%        -3.6%

  Germany          $2,812       $1,398         $1,540      -$142       $2,171   $1,187    $1,022    $165        -5.0%        77%        5.9%

  Greece             $339         $109          $145        -$37        $367       $19       $61     -$43      -10.8%      108%        -12.6%

  Iceland             $12            $4            $5            -$2     $12        $4        $3       $1      -13.2%      101%        11.4%

  India            $3,548         $123          $223       -$100       $2,132     $155      $232     -$77       -2.8%        60%        -2.2%

  Ireland            $177          $75          $105        -$30        $113      $107       $65      $42      -16.8%        64%       23.9%

  Italy            $1,756         $960         $1,068      -$108       $2,023     $369      $359      $10       -6.1%      115%         0.6%

  Japan            $4,141       $1,614         $1,997      -$383       $7,955     $516      $491      $26       -9.2%      192%         0.6%

  Portugal           $232          $92          $107        -$15        $175       $41       $59     -$17       -6.4%        75%        -7.5%

  Russia           $2,103         $205          $307       -$101        $145      $296      $197      $99       -4.8%         7%        4.7%

  Spain            $1,367         $489          $640       -$151        $813      $216      $293     -$78      -11.1%        60%        -5.7%

  UK               $2,165         $820        $1,132       -$312       $1,483     $351      $474    -$122      -14.4%        69%       -5.6%

  US             $14,260        $1,914         $3,615    -$1,701       $5,661     $995    $1,445    -$450      -11.9%        40%        -3.2%

  Memo:

  UK in £bn        £1,406         £532          £735       -£203        £963      £228      £308     -£79      -14.4%        69%        -5.6%


* PPP ** Based on CIA World Factbook exchange rate of $1.54=$1




                                                                                                      strategy insights | issue four        65
britain at the crossroads | the case for fundamental change




Disclaimer
The information in this communication is provided for informational and demonstrational purposes only and neither is it intended as an offer or solicitation with
respect to the purchase or sale of any security nor should it serve as the basis for any investment decisions. In the UK, this material is intended for use only by
persons who have professional experience in matters relating to investments falling within Articles 19(5) and 49(2)(a) to (d) of the Financial Services and Markets Act
2000 (Financial Promotion) Order 2005 (as amended), or to persons to whom it can be otherwise lawfully distributed.

Any reference to ‘Tullett Prebon’ refers to Tullett Prebon plc and/or its subsidiaries and affiliated companies as applicable.

Neither Tullett Prebon plc, nor any of its subsidiaries (collectively, “Contributors”) guarantees the accuracy or completeness of the information or any analysis based
thereon. Neither Tullett Prebon plc nor Contributors make any warranties, express or implied, with respect to the information (including without limitation any
warranties of merchantability or fitness for particular purposes) and neither Tullett Prebon plc, nor Contributors shall in any circumstances be liable for economic
loss or any indirect, or consequential loss or damages including without limitation, loss of business or profits arising from the use of, any inability to use, or any in
accuracy in the information.

Tullett Prebon provides a wholesale broking service only. It does not provide services to private clients. Tullett Prebon (Securities) Limited and Tullett Prebon (Europe)
Limited are authorised and regulated by the Financial Services Authority (“FSA”).

This publication is produced and distributed in accordance with ‘COB 12.2 – Investment Research’ of the FSA Handbook. Recipients should note that all such
publications are objective and impartial in their content unless clearly notified otherwise. The author(s) act in accordance with Tullett Prebon’s ‘Conflict Management
Policy’, full details of which can be viewed on our website at www. tullettprebon.com

TPSI 004 | April 2010
66          strategy insights | issue four
Tullett Prebon Group Ltd
155 Bishopsgate
London EC2M 3TQ
Tel: +44 (0)20 7200 7000
Fax: +44 (0)20 7200 7176
www.tullettprebon.com

				
DOCUMENT INFO
Shared By:
Categories:
Tags:
Stats:
views:1
posted:4/30/2012
language:English
pages:71