Tuesday, 6 October 2009

Osbourne gets started with the Tough Medicine

"... on the back of a Bullingdon club membership card. Osborne is a lightweight wielding a heavy axe aimed at hardworking families"
Derek Simpson, joint general secretary of Unite in response to how the recent proposed Conservative cuts were for formulated

"It cannot be right to single out public sector workers to pay the price of putting it right ... Those who did so well out of the boom should now be asked to make their fair contribution through higher tax rates for the highest earners."
Brendan Barber, TUC's general secretary

It's taken a while but substance is beginning to emerge from the main political parties about how the deficit will be reduced. After months of talk with no action George Osbourne and the Conservatives have finally thrown out all caution to the wind, announcing what are unpopular polices. The public sector are now taking note that's its not just the private sector that has to take the pain from the recession. With the Governments finances in disarray its time to get to the heart of the real issue, the state is simply too large for society to afford.

George Osbourne and the Conservatives have said that any public sector worker on an annual salary over £18,000 a year will now face a pay freeze during 2011 with caps on pensions. Greeted with the usual workers union militancy, or cries that the conservatives are the same bunch of public school toffs, the real issue however is, how will this square with the public? There is a risk that this policy along with others such as raising the pension age marginally, may alienate sections of voters who are regular Tory supporters. With such a lead in the polls, have the Conservatives committed politicide?

I personally think its a very good move, if disagreeing on the policy. There are still some disillusioned members of the public that believe we need to spend more on public services, but many now realise spending cuts are a reality, its either that or huge tax rises to pay for it. By safeguarding existing jobs, but cutting pay, the Conservatives appeal to many in the private sector who have had it rough of late by enacting similar pay restraints already witnessed by many in the private sector onto public sector workers. I also think they appeal to public sector workers as they are not proposing to cut any jobs. This is an honest approach as people realise cuts have to come, as opposed to Labour's rhetoric of bottomless pits of money to spend. If they did come to power then they need to build a platform of trust with the public and state their intentions clearly otherwise industrial relations would become more fragile.

The problem is the size of the current deficit. We won't get real substantial policies until after the next general election because if a party announced the cuts that would be required, it really would be handing the opposition the election on a plate. The cuts proposed under usual circumstances would be huge, but in the context of a 12-14% GDP deficit they hardly register. That's the problem, cuts take time to implement as I have mentioned before, however the UK does not have time. Official public debt is around the 60% level already. Within a year it will be above 70%. By the time the public sector pay freeze is due in 2011 it will be well above 80% probably nearer 90%, a level which the market will become ever more uncomfortable with.

The other problem is interest rates. They are as low as they can go and the only way for them to go in the future is upwards. The Government bond market is the next bubble. It has been in a bull market for well over two decades now and at some point in the future this will turn leading to increases in the returns investors ask for. With all the debt building up, interest payments on the debt rise, however even if the government did manage to balance the books in the next decade, when interest rates rise so do the interest payments diverting available funds away from departmental spending. This in itself can cause another budget deficit, as increased spending on the debt can get out of hand. Recently the UK has been moving away from selling longer term bonds to shorter termed ones, this is what is known as a rollover issue. As the bonds are issued in shorter terms when they expire if interest rates are higher then the government has to resell the debt at higher rates and pay more and more, causing a further squeeze to occur. There's also the issue that the UK relies on foreigners to buy our bonds, around 40% of them are now owned by non UK citizens. If overseas investors think that the UK is insolvent the printing presses may have to be ramped up further still, even if inflation gets out of hand in the years to come (see my previous post regarding the bond bubble for this process).

How can you claw back the deficit we have? We can't even look at history as the highest we came post Second World War was only half the level now. During periods of war its incomparable as a war economy means rationing, major hardship, sacrifice and in the end massive inflation after it ends. What about Latvia or some other Baltic nation? They currently have a currency peg so its hard to make comparisons as they attempt to try an internal devaluation. Recent polices such as public sector pay cuts in the region of 30% is real pain, not a freeze on pay. That's what's happening there, but then this is what real fiscal restraint entails. Bailed out by the IMF they have no other option in the short term. Their loan priced in Euro's ensures no default by the printing press, unlike the Wests approach. Latvia 'only' has around a 9.5% deficit.

Of course we won't get 30% pay cuts in the future, the politicians will let the currency take the pain. Members of the public have become conditioned to associating rising asset prices and wages as wealth, rather than increases in purchasing power. Its the latter the government will go for.

I personally don't agree with the Tory policy of capping pay in the public sector to avoid job cuts. The problem is it doesn't fix anything as the real problem is that the UK's public sector has become too large in recent years. Rather than addressing the root problem, cutting labour used by the public sector and re-deploying it into the productive private sector, the politicians wish to keep the current system on life support, a classic stagflationary policy. Preventing labour redeployment into other more productive purposes will cause further stagnation.

How much does a pay freeze really save? If the private sector is still weighed down with the same public sector then how can this really help in the long term? Another recent Tory policy was to cut the tax paid by small businesses for people they hire and this illustrates the above point perfectly. Government can't create jobs and wealth, only the private sector can perform that function. Don't get me wrong the government could take half the unemployed people, give them jobs to dig holes, then get the other half to fill them back in - unemployment problem solved! The problem is this doesn't create wealth, its governments role to create the conditions for people to create jobs for themselves and that means getting out of the way. Only the private sector can increase productivity and this was a policy I strongly agreed with.

The problem with the deficit is the fact that the irreversible damage was done years ago. Labour were running budget deficits during the largest credit boom in history. I remember at the time mainstream commentators such as the BBC's Evan Davis mentioning it on a regular basis, even hinting subtle messages that the financial shenanigans would come back to haunt us. It's for this reason that I see no way back. Politicians will continue dithering, with no real rush of urgency to get their books balanced. Why? Because they only act when a real crisis comes along, when the market calls time. Thatcher carried out her cuts under a backdrop of a genuine broke Britain. As recent as one hundred years ago, Britain had been the largest creditor-export nation in the planet, however just over half a century later that all changed. No sound investor would lend the nation money, with only the IMF, a bureaucratic organisation, were the only ones that paid for Britain's fiscal prolificacy. A period of strikes, industry failure, rampant inflation - whoever will be in power after the next election won't have these in the back of their mind. Not yet anyway. I see Cameron as more of a Ted Heath Prime Minister rather than Thatcher, Labour messed up in the 60's but Heath didn't really tackle anything. Then Labour got in later during the seventies and messed things up again. This drove Thatcher to do what she did, the decay had gone on for too long. Osbourne has begun with policy cuts, but real action will only take place once the real crisis unfolds.

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