WITH HINDSIGHT, the most astonishing thing is that Britain thought it could remain outside the euro for as long as it did. As a vulnerable island, dependent on a bloated financial services sector, without any significant exports and lacking a reserve currency, there was no way that Britain was ever going to ride out the crisis of 2009-10 on its own. City of London types used to say that the only difference between Iceland and Ireland was one letter and six months. Well, the UK was a year behind and had nothing to write home about either.
As delinquent banks such as Royal Bank of Scotland, Barclays and Lloyds ended up being taken into state ownership, Britain's finances were trashed. The combined liabilities of the UK banks was £4.4 trillion, three times Britain's GDP, so public debt rocketed. Moreover, before the formation of the National Government in 2010, the then prime minister, Gordon Brown, had handed the banks over £1 trillion in loans, guarantees, buy-backs and shameless bungs. The national accounts became as a reliable as a sub-prime mortgage.
Borrowing as a proportion of GDP reached 10% in 2009 and was heading into the stratosphere as the country collapsed into economic recession.
Nearly a quarter of the government's revenue - which had come in the form of stamp duty on houses, corporate taxes and income taxes - simply evaporated as house sales plummeted, businesses collapsed and workers became unemployed. The welfare bill soared as unemployment rose to 3.5 million in spring 2010. Britain's public debt was further burdened by new international accounting rules which required that the government own up to tens of billions in PFI schemes and place them on the public books.
The unfunded cost of public sector pensions added another trillion to the British accounts, leading to an astonishing projected public sector combined debt approaching £3.5 trillion. This could never realistically have been repaid and the international markets soon started selling sterling as fast as they could. Even before the recession began, the pound had lost a third of its value, but as it plummeted below parity with the dollar, the government suddenly realised that the stability of the national currency still mattered. Import prices shot up; public debt could not be financed; banks registered ever greater write-downs as the value of their overseas loans increased as sterling fell.
Perhaps Britain might have still been able to muddle through, had it not been for the Bank of England's decision to indulge in "quantitative easing" - or printing money. In desperation, the government urged Mervyn King to introduce a crash programme of expanding the money supply by direct purchasing of bonds and assets, underfunding government spending and other measures which had the effect of pouring trillions of pounds into the economy. The government was hoping to create inflation to reduce the value of public and private debts - but the international markets aren't stupid and they dumped sterling in record amounts. As the printing presses hummed and pensioners saw their savings evaporate, the government insisted there was light at the end of the tunnel. Trouble is, it was the light of an oncoming train.
The true causes of the sterling crisis of 2010 will be argued over for decades, but what is not in doubt is that the so-called "benign neglect" of sterling was a foolish policy. The government and the Bank of England had hoped that a fall in the value of sterling would lead to an export-led recovery, just as it had in 1992, when the pound dropped out of the European Exchange Rate Mechanism, and in 1932, when Britain left the gold standard and devalued the pound. On both occasions, British manufacturing rose to the challenge and took advantage of the low pound to sell in overseas markets. But the difference this time was that British manufacturing had largely ceased to exist, having fallen to 14% of GDP even before the crisis hit. Moreover, so indebted were many British companies that the collapse of sterling led to a wave of corporate defaults as firms could no longer rely on foreign lenders.
Finally, the global depression and the re-appearance of protectionism shrank opportunities for foreign trade.
Britain had become over-dependent on financial services, and while there was still demand for banking services, many of the more profitable activities of the City, like hedge funds, securitisation, mergers and acquisitions, and private equity deals were destroyed by the credit crunch.
The image and reputation of British banking had become irremediably tarnished by the activities of banks such as Royal Bank of Scotland and HBOS, which became a by-word for irresponsible and imprudent banking practice.
The continuing collapse of the housing market wiped out much of the rest of the financial services sector and led to mass redundancies in lawyers' offices, estate agents and even surveyors. Only the auction houses experienced a boom.
By 2010 it was clear that Britain was in a very serious decline. The choice facing the government was: default on its loans - like Russia in 1998, calling in the International Monetary Fund - which would have led to massive public spending cuts and huge increases in interest rates; or joining the euro. Default was unthinkable, the IMF route would have made the recession 10 times worse by throwing millions of public sector workers on the dole and introducing Icelandic interest rates of 15%. So the government saw no option but to enter negotiations for joining the euro.
At first, there was resistance from Eastern European and Mediterranean states which felt Britain was getting a get-out-of-jail-free card. But the French and Germans were so keen to complete the jigsaw of European Union that they agreed to Britain entering on a generous exchange rate. Instead of 15% interest rates, the UK adopted the European Central Bank rate of 2.5%. Britain's debts didn't go away, but since they were now underwritten by the entire EU, confidence was restored in the UK's finances. There were still millions unemployed, but membership of the euro boosted exports.
Britain's crisis is not over, and there are major problems, especially in Scotland where the economy has been devastated. But the UK heaved a collective sigh of relief in January 2011 when the pound, and all its history, was finally put to rest.
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Meanwhile, back in 2009 ... what are the government's other options? By Westminster Editor James Cusick It will take "four to six weeks" for the government to work out the details of its last bank bailout scheme. According to the new Treasury minister, Lord Myners, the government could then be facing another crisis in early March if it miscalculates the premiums on the insurance scheme to cover the banks' toxic assets.
With the economy contracting at its fastest rate since 1980, the pound at a 23-year low against the dollar, unemployment heading past two million and predicted to pass three million before the end of the year, and no sector of the UK economy seemingly immune from the slump, the government options look to be narrowing.
However, apart from petitionary prayer, there are other key options that are being considered.
1 Stabilisation: Predictions by Myners that more bail-outs remain a possibility indicate one of the government's more immediate hopes is for any sign of stability rather than outright recovery, which will be far off.
The Bank of England has left itself little choice but to cut interest rates again. On February 5, a further cut of half a percentage point, at least, is likely. Inflation, already at an all-time low, will fall again. Inside the Treasury there remains firm hope that the fiscal stimulus packages will finally begin to take effect. But falling demand and a reluctance by banks to return to old, and discredited, levels of international lending, makes stabilisation still an item on an economic wish list.
2 Reform of the global financial system: This may be the golden key needed to open the door for a return of confidence. The G20 meeting in London in April, which Brown will chair, is the opportunity for him to demonstrate his now much-repeated mantra that the recession wasn't his fault, but was a global financial failure, and therefore a different kind of "boom and bust" than anything dealt with before.
3 Obama as the new Roosevelt: It may be as high as a trillion dollars, though Congress in Washington DC is already getting cold feet about the scale of Barack Obama's version of the "new deal". But whatever the final numbers are, Downing Street and the Treasury will be hoping the trickle-down effect turns into a quantifiable rescue-laden tsunami that will boost UK recovery.
4 The return of "old style" conservative banking: Brown wants to see a return to basic banking, free of the sophisticated gung-ho practices that became part of the unregulated boom. But to deliver back-to-basics banks, Britain still needs its banks to survive. Lord Myners has let it be known that "nationalisation" is not the answer. Brown soon has to put our faith back in the banks and the banks' faith back in themselves. In what time frame can this begin to happen? Ask around, but no-one has an answer to this.
5 Quantitative easing: Britain's best hope of recovery may yet lie in simply printing money to boost a potentially deflationary economy in recession. If money markets remain frozen, property prices stagnant and the banks still unwilling to risk their capital, quantitative easing - the professional economists' definition of switching on the printing presses - will be the government's final weapon. This is happening in the US already and it can't be far off from happening here. It has long-term implications, but then, as Keynes said, the long-term is for other generations when recovery is needed now.
Sunday Herald , Scotland
25/01/2009
