“Come and keep your comrade warm
I’m back in the USSR
Hey, You don’t know how lucky you are, boy
Back in the USSR
Oh, let me tell you honey.” {The Beatles/Back in the USSR}

Thursday 10/12/2009

Yesterday, Alistair “Eybrows” Darling delivered a masterclass in politics on the occasion of presenting the Pre-Budget Report at the House of Commons:

‘How to avoid tackling difficult subjects: the art of scapegoat-ism and self-preservation’

There is something rotten in the United Kingdom. Borrowing is expected to be £178bn in the current fiscal year (previous Alistair estimate was £175bn) and £176bn in 2010-11 (previously £173bn), when the public debt ratio is projected to rise to 78% by 2014 and the GDP growth -or lack thereof- for 2009 has been forecast at -4.75%, (previous Alistair estimate was -3.25% to -3.75% in the Budget).  Fiscal deficit correction under the current measures and forecasts is expected to be rather slow over the next few years.

Remember Alistair’s boss and predecessor proclaiming his “vision [being] of a Britain where there is not stop go and boom bust but economic stability; a Britain which is business-friendly, and where there is enterprise, opportunity for all“? So much for that..Even in 5 years from now the planned public spending is forecast to remain oversized and the cyclically-adjusted current deficit  -one of Mr Brown’s golden rules was to keep it at 0- will still be 2% of GDP (5½% this year).

It is no wonder that the rating agencies -who become increasingly proactive on sovereign risk, which we are convinced will shape 2010 events- are making noises on the justification for and sustainability of the current AAA UK rating. “Eyebrows” must have got by now a firm grasp on the implications of such a development, as well as on ways to fight against it. There have been quite a few cases in the past 30 days- Greece, Dubai & Spain but also Ireland and its painful fiscal measures.

Unsurprisingly though, the British Chancellor has delivered a political rather than fiscal budget, avoiding to tackle public spending issues that would (even further) hurt Labour’s prospects for the upcoming (by June 2010) elections. He (initially successfully) disguised this major shortcoming from the -apparently easily impressionable- public by offering a public sacrifice of national enemy ≠1; the ‘bankers’ (a ludicrously vague title; a bit like calling everyone in a football stadium a footballer).

Instead of writing anything further on the Pre-Election Report that “Eyebrows” delivered, I will post a few excerpts from City economists (yes, bankers) commentary on the event.

But first, on more thing. The gilt market hinges a lot on the fiscal credibility of the Treasury. With a very heavy issuance profile and nothing credible from the Chancellor, the winter of 2010 may prove to be a winter of discontent for the gilt market.

Today, the show started with a juicy sell-off. Mind you, the fact that the gilt traders (yes, bankers) have been punished by the Treasury for their despicable crimes against the hard working folk of this country doesn’t help..

CITY COMMENTARY

“Sustainability postponed, credibility risked” …The PBR is unlikely to dispel concerns about the UK’s public finances. The government’s fiscal plans will see the public debt ratio continue to rise for the next five years at least. Although the government’s room for manoeuvre may have been constrained by the political cycle, its reluctance to announce more aggressive consolidation measures carries economic risks. Question marks are likely to persist regarding its willingness to impose the requisite adjustment, and the UK’s AAA sovereign credit rating and the currency are likely to remain vulnerable.” {Barcap}

“The PBR appears to be aimed at reviving Labour’s core support rather than seriously tackling the UK’s medium-term fiscal problems. The PBR extends the “tax, borrow and spend” fiscal trend of recent years, with slight upward revisions to the deficit forecast for 09/10 and 10/11, further tax hikes on top income earners and slight rises in planned public spending in 10/11. Moreover, it does not produce credible and detailed plans to return the UK to a sustainable fiscal stance in coming years. In our view the PBR seeks to create a fiscal fiction that the deficit can be resolved solely by tax hikes on a relatively small share of the population (‘the few, not the many’) and without painful public spending cuts. The revenue forecasts again look over-optimistic, and there are no public spending plans after 2010/11 – only vague forecasts. The Chancellor pledged to protect spending on health, schools and the police, but gave no sign where the axe will fall. Given the record of recent years, this lack of clarity is likely to fuel scepticism whether the Chancellor really is committed to spending restraint. Rather than produce a serious and credible fiscal consolidation plan, the Chancellor’s aim looks to be chiefly political: to reinforce Labour’s core vote and try to deprive the Conservatives of a majority in Parliament after the next election. The Conservatives need to be at least 10% ahead of Labour (roughly) to get a majority in Parliament (the required lead increases if the Lib Dems do well). Recent polls suggest that the Conservatives are indeed about 10% ahead of Labour, but polls also suggest that Labour’s core support is significantly higher than Labour’s current voting intentions (whereas the Conservatives’ voting intentions are well above their core support). Thus, Labour’s political strategy look to be aimed at making the election tribal (hence the “class war” rhetoric); to avoid hurting their own core support (hence no early fiscal tightening); and to portray the Conservatives as a party that wants to cut public spending for ideological reasons (to detach floating voters from the Conservatives). This approach seems to be working in political terms: three of the last five polls have pointed to a hung parliament. But, in market terms, it implies no preelection commitment to fiscal consolidation and a growing risk that there will be a hung parliament – which also could prevent early fiscal consolidation post-election as well.” {Citi}

“The UK press has concluded that the relatively slow pace of tightening, which doesn’t begin in earnest until 2011, reflects politics more than economics – there’s a general election next spring. It’s hard not to see the same motivation in the new retroactive levy on banks’ bonus payments. The Treasury says the measure is (a) designed to encourage more capital accumulation by banks, (b) justified because “banking profits have been facilitated by significant taxpayer support”, (c) justified too because £25,000 – the level above which the levy applies – is also the level of median earnings in the UK. It also says the levy will bring in £550m. The claim that anyone in a bank whose bonus is more than the median income – the pay of half of all UK workers and more than half of public-sector employees is above that level – has earned it only  through “excessive” risk-taking or taxpayer support is, to paraphrase, a bold one. (As it happens, real output per employee has risen by 79% in financial services over the past decade; the comparable measure of productivity in public services has fallen by 6%). The vast majority of UK-based banks did not receive any support from UK taxpayers – though the PBR is careful just to say “taxpayers” in general, leaving it open as to whether they live in the UK or elsewhere, there is no proposal to reimburse other countries for the support they may or may not have given. And, especially when a lot of careful thought is going into new, global regulatory framework for banks, this is hardly the optimal way to encourage more capital accumulation. The government says this is a “one-off” tax.  That’s what governments always say about retroactive taxation. And yet, coming after similar levies on pension funds, utilities and oil companies, this is becoming something of a habit for the UK government. If it increases the perceived likelihood of more such “one-off” measures in future, the levy has serious implications for the incentives to locate business in the UK – non-financial as well as financial – and, as a result, for the cost of capital and terms of trade. This effect is impossible to quantify and, as regards its impact on the exchange rate, probably dominated by other, cyclical effects over any forecasting horizon (we continue to think those are generally positive). But the longer-term risks are clear. The Treasury has said it expects a significant reduction in bonuses paid out this tax year. It still thinks that the levy will bring in £550m. But that’s a pretty small dent in the deficit (it pays for about 7 hours of government spending). And it’s likely to be outweighed by the loss in income tax. Suppose, for example, that total bonus payouts would’ve been £6bn without the levy (this estimate is from the CEBR), with half that total paid in cash the other half in unvested equity. The Treasury says it expects actual payouts of £1.1bn (£550m/50%), a reduction of close to £5bn. With half that amount lost in cash payouts, the Treasury is effectively foregoing £1bn (40% x £2.5bn) in income tax. Net of this amount the levy is a revenue loser.” {GS}

” One thing this Chancellor (and his predecessor before him) has is consistency – he consistently gets his sums wrong. Government borrowing has been higher than forecast every year except one since 2001. Maybe his colleague Mr Balls will give him a remedial arithmetic course for Christmas. After such a track record of consistently being too optimistic on the outlook for the public finances, expecting the public to believe the latest set of numbers is a bit like expecting the public to believe in Santa. As expected the PBR was primarily a political stunt, littered with landmines for the Conservatives. The effect of the discretionary measures amounted to almost GBP4bn of loosening in fiscal year 2010-11, switching around to a GBP11bn per year tightening in 2011-12 and 2012-13 (or 0.7% of GDP). Most of the discretionary measures that were announced had been leaked and hence did not surprise. More specifically, there was even more pain for high earners and sweeteners for the elderly. There was some green spin, support for jobs, education and training. A year ago the Chancellor announcement of a new 45% income tax rate on earnings over GBP 150k per year. By April, the new tax rate was shifted up to 50%. The latest instalment in the PBR was a 50% tax to be paid by banks on bonuses above GBP25k. This is perhaps the best demonstration of how the Chancellor is putting political points scoring ahead of the more important job of fixing the public finances. The scheme will generate just GBP550mn. Far more time was devoted to this than the GBP3bn (almost 6 times bigger) increase in the borrowing estimate for 2009-10. For all the hype, the political shenanigans and bashing of bankers, the big picture is there is a massive hole in the public finances and that was not plugged by the PBR proposals. As a percent of GDP, (adjusting for the improvement in economic growth in the next year or so – i.e. cyclically adjusted) there is a borrowing requirement of 10% of GDP. That is approximately GBP140bn to GBP150bn. On top of that, given the rise in the government’s interest burden (from around 2% of GDP to 5% of GDP) as a result of a surge in outstanding debt, there is a massive hole to plug. Put another way, over the next 4 years, the government’s (overly optimistic) forecasts for the public finances show that borrowing will rise by over 40% of GDP. That is the issue and it was neglected in favour of attacking bankers. In order to narrow the deficit sufficiently to stop debt rising as a % of GDP requires tightening of more like GBP30bn per year. The government has emphasised efficiency savings. The government can find all the efficiency savings in the world, but it is never going to find GBP140bn to GBP150bn. Substantial spending cuts and tax hikes are what is needed. What usually happens at Christmas is that several of the children’s new toys break. One thing you are guaranteed with this Chancellor is that when one of his forecasts break down, as they invariably do, he will immediately replace it with another – unfortunately, equally dodgy. Thus we saw yet another upward revision to the projected fiscal deficit this year – from GBP175bn to GBP178bn. The measure that was deliberately given the most exposure measure announced raises a mere GBP550mn. Judging by the media response this was a highly successful tactic, which has deflected attention away from the key issue. It was a missed opportunity to take steps to prevent a downgrade in the UK’s credit rating.” {BNP}

BNP’s piece is naturally our favourite.

break a leg

cw