Variant Perception

Austerity in the UK: A False Sense of Security

Variant Perception
June 2015

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A false sense of security

1) The UKs economy is increasingly beginning to resemble how it looked prior
to the financial crisis this is not healthy and leaves the UK vulnerable to
another crisis
2) UK growth did eventually return around 2013, but this was not because of
austerity, but in the absence of austerity despite what the political rhetoric
made out
3) This has led to a false sense of security. Austerity which is only now
beginning to kick in threatens to put a light under the UKs structural
vulnerabilities. This could lead to another recession, or another
financial crisis

The UK economy prior to the financial crisis

The UK economy before the Great Financial Crisis (GFC) was based on the
availability of easy credit both for consumption and houses. Mortgage
approvals surged and this fuelled the rise in house prices.
In the UK, consumer confidence and house prices have a very tight relationship
(right chart). As banks lent freely, house prices went up, people spent freely
and economic growth optically looked strong.

Source: Bloomberg and Variant Perception

2015

UKs economy was highly reliant on finance, RE

Before the GFC, the government was hugely reliant on tax from three very
interlinked sectors: banking, business and real-estate. The chart on the left
shows that a third of income tax receipts came from finance and real estate in
2006.
Similarly, just under one half of corporate tax receipts came from banking and
business services in 2007.

Source: HMRC and Variant Perception

2015

However, a robust economy was a mirage

The subprime crisis in the US gathered pace in 2007. Vast numbers of
mortgages in the US had been issued to completely inappropriate borrowers.
Suddenly, banks around the world grew wary of lending to one another as noone knew who was holding what. The financial markets began to freeze. The
UK economy with its huge banking sector found itself in the eye of the
storm.

Source: Variant Perception, https://hrominemgt7019.wordpress.com/

2015

The first UK bank run in 140 years

The first major sign something was seriously amiss in the UK was when word
got out that Northern Rock was facing liquidity issues, and required Bank of
England support. Depositors began to panic and the result was the first bank
run in the UK since Overend, Gurney and Co in 1866.
Northern Rock was nationalized. But there was more to come. After Lehmans
bankruptcy in 2008, it looked like some of the UKs biggest banks
categorically too big to fail might go under. Cue the largest UK banking
bailout in history.

Source: Bloomberg and Variant Perception

2015

Public debt in the UK looked low and stable . . . .

What was entirely misjudged in the UK (and many other countries) was using
public debt to gauge a countrys economic health.
However, it was in the private sector households, firms and especially banks
where debt was building up. Total debt in the UK public+private was not
only large, it was the biggest in the world in GDP terms. Total debt in the UK
was 4.5 times income, with government only a fraction of this.

Source: Bloomberg, Macrobond and Variant Perception

2015

. . . but not for long - debt skyrocketed

To prevent the banks from collapsing, Gordon Brown nationalized them, saving
the world in the process. The Bank of England also launched a QE programme
in 2009 to stabilize the banking sector. Both policies essentially socialized the
losses emanating from the private sector.
The net result was a public debt to GDP that mushroomed higher very quickly,
to its highest since the post-WWII period. The budget deficit went from 2.5% of
GDP to over 10% in short order.

Source: The Grauniad; Macrobond

2015

The Coalition and Osbornes Plan A

The Coalition was formed in 2010, with one of its main goals to bring the UKs
spending back to within its means. The aim was to bring the structural budget
deficit back to balance by 2015, and to stem the increase in the debt to GDP
ratio.
Although Osborne refused to countenance a plan B, he effectively
implemented it around half way through the last parliament. The deficit target
was missed by growing magnitudes from 2012, without any outwardly
change to the rhetoric of austerity.

Source: Variant Perception, OBR, ONS and Macrobond

2015

10

UKs growth was a serial disappointment

It became apparent that growth estimates were overly optimistic. Generally,
the earlier the forecast, the more optimistic it was, and the further from reality it
turned out to be. This necessitated scaling back planned spending cuts to
avoid a return to recession.

Source: ONS and OBR

2015

11

A poverty of austerity
The UKs growth eventually did bounce, but in the absence of projected
austerity. Real government spending only went negative on an annual basis in
early 2013, and then only briefly. It has only recently gone negative again. On
the previous two occasions public spending did contract, this was followed by a
recession.
Splitting up GDP into its public and private constituents, we can see again
public GDP was only negative for a short time. Since March 2014, it has been
growing again.

Source: Bloomberg and Variant Perception

2015

12

Real austerity only recently began to kick in

The UK did eventually show some encouraging signs of growth, but without
nearly as much austerity as was generally thought. Government spending in
relation to GDP only began to come down in 2013, and it is only very recently it
has gone below its 10 year average. Real austerity is only beginning.
And growth would have returned at some point. Economies are like springs, the
more they are compressed, the more they can bounce. The economist Victor
Zarnowitz in his book on business cycles expressed it as: the deeper the
downturn, the sharper the upturn.

Source: Bloomberg and Variant Perception

2015

13

UK growth has been underwhelming

Despite the fanfare that greeted the UK economys recovery, growth has been
lacklustre compared to other developed countries. Countries that have not
faced spending cuts have tended to perform better than the UK.
Also, there are signs growth is fizzling out again. GDP for the first quarter of
this year was the lowest since the previous near-miss recession in 2012.

Source: Sunnation.co.uk, Bloomberg and Variant Perception

2015

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Why has growth disappointed? Too much debt

The major reason is the stubborn presence of debt. No government wants to
inflict default and bankruptcy on its electorate to clear the system. JeanClaude Juncker, President of the EC, put it: We all know what to do, we just
don't know how to get re-elected after we've done it.
Thus debt in the UK remains high. A growing debt pile sucks up larger
amounts of income for interest payments, diverting it away from projects that
may help return growth to a sustainable footing. According to McKinsey, total
debt to GDP in the UK is 30 percentage points higher than it was in 2007.

Source: ONS, OBR, Macrobond and Variant Perception

2015

15

A return to bad old habits

Furthermore, it is not encouraging how the UK is growing again. Many of the
bad old habits from before the crisis are evident again. Aside from the financial
sectors return to many of the risky products that exacerbated the last crisis such as junk bonds, leveraged loans, covenant-lite lending etc - consumers are
going on a borrowing binge once more.
Consumer credit and credit card debt growing quickly. The UK has not yet
kicked its addiction to credit.

Source: Bank of England, Bloomberg and Variant Perception

2015

16

. . . and some even worse ones

Even though banks are extending consumer credit, credit conditions are tighter,
freezing some borrowers out.
Step in peer-to-peer lenders such as Zopa and Wonga. The UK is now third
largest market for P2P lending (after China and the US), and the largest per
capita.

Source: Peer2Peer Finance Association

2015

17

Employment has superficially improved

It is not surprising there is still strong demand for consumer credit given the
stagnation in wages. Real wages are over 5% lower since 2008.
Public sector wages are down less than private sector wages, but this gap will
close as austerity gains traction. Already we can see the sudden lurch down in
public-sector wage growth in March.

Source: Bloomberg and Variant Perception

2015

18

Make-up of jobs market changing

The unemployment rate in the UK has steadily fallen since 2012.
However, part-time work continues to grow, and the number of self-employed
has lurched higher since 2013. This may help explain the so-called
productivity puzzle in the UK, where productivity has been stagnant since the
financial crisis.

Source: ONS, Bloomberg and Variant Perception

2015

19

Taxes have disappointed

Lower productivity is impacting tax receipts. Unemployment is almost back to
pre-crisis levels, but income tax receipts as a proportion of total tax has not
recovered. Income tax is also down as a percentage of GDP. Similarly with
corporate tax receipts.
Lower taxes makes balancing the books more difficult.

Source: ONS, Bloomberg and Variant Perception

2015

20

Housing has been looking frothy

Housing continues to remain very resilient. Annual house-price growth was up
to 12% last summer, and is still growing at almost 5%. London house prices
peaked at over 25% year-on-year last summer, and are still growing at 12%.
Demand-juicing policies such as Help to Buy, while supply problems are
unaddressed, are keeping housing from the effects of gravity. Add in the lowest
mortgage rates in history, and you have a recipe for frothy housing markets,
also seen before the last crisis.

Source: Bank of England, Bloomberg and Variant Perception

2015

21

Housing supply is terrible

In the US, a very good lead of economic activity is building permits. Not only
does this involve building the house, once people move in they typically spend
money on improvements, new furniture, carpets, etc. The economy tends to do
well about a year after the rise in building permits.
In the UK, house-building has been low and falling. Fewer houses are being
built in the UK now than at any time in the last 60 years. Not only would more
house building boost growth, it would restrain house prices, and reduce
debt, in itself a handbrake on growth.

Source: CLG, Bloomberg and Variant Perception

2015

22

Risks today: UK a major borrower

The UK is vastly dependent on the kindness of strangers. It has the worlds
largest current account deficit in USD terms, after the US.
Also, despite the Chancellors intentions, the budget deficit is still over 5% of
GDP. Take the two together, and the UK stunningly has the largest twin
deficit in the world, worse than Turkeys, South Africas or Brazils.

Source: Bloomberg and Variant Perception

2015

23

The pound in your pocket at risk

Todays current account deficit is over 5% of GDP. In previous decades a
deficit over 1% was enough to make headlines, and one over 3% sufficient to
trigger a sterling crisis. In 1976, when the UK had to apply to the IMF for a
bailout, the deficit had only been as low as 3-4%.
The EU referendum poses a further risk. The EU is the UKs largest trading
partner, and is the source of the bulk of the UKs current account deficit (CAD).
The prospect of the UK leaving the EU may draw attention to/worsen the CAD.

2015

Source: Private Eye, ONS and Variant Perception

24

Dependent on the kindness of strangers

Unlike Japan, which is largely self funded and runs a current account surplus,
the UK is dependent on foreign lenders. Non-residents buy many gilts, and
account for 25% of gilts outstanding this amounts to 400 billion worth of UK
government debt.
If they become skittish and decide to dump UK debt, this would result in sharply
higher interest rates, which would immediately feed through to the overextended housing market and the wider economy.

2015

Source: BoE, DMO and Variant Perception

25

Planned cuts for this parliament

Current projected spending cuts will take public spending to virtually its lowest
as a percentage of GDP in the post-war period. Furthermore, the savings are
expected to come primarily from cuts to public services, with hardly any from a
rise in receipts.
Given the increasingly precarious and imbalanced nature of the UK economy,
the scale of cuts proposed could push the UK back into recession. This, along
with the EU referendum, may be enough to draw attention to the UKs dire
current account. This would be bad for sterling and the economy. There is
a reasonable chance proposed cuts will have to be reduced once again.

2015

Source: OBR and Variant Perception

26

Fixing the roof while the sun is shining

The Chancellors plan for budget surpluses to be run in normal times is
misguided. Budget surpluses do not have an unblemished record of promoting
growth. There are (perhaps tellingly) few modern-day examples of budget
surpluses, but there is some evidence not conclusive, but nor can it be
dismissed surpluses are followed by weaker or even negative growth.
Running a surplus in normal times also poses problems. Economic data is
often heavily revised so judging whether times are normal at the current
juncture will be very difficult.

Source: Macrobond and Variant Perception

2015

27

Potential for political instability

In the Major government 1992-97, the Conservatives had a thin majority of 21.
This majority was steadily eroded as warring factions over Europe clashed, and
several scandals came to light.
Todays government has an even thinner majority of 12. With Europe again set
to dominate, the slender majority will lead to increased political fragility which
may spill over to economic volatility.

Source: CREST, Observer

2015

28

Conclusions
Structural vulnerabilities in UK have not been addressed, and are
getting worse
UK growth returned not because of austerity but in the absence of
austerity this has perhaps led to a false sense of security with
attempting austerity in this parliament
Slowing growth may activate the UKs latent structural problems,
which increases the risk of recession, or another crisis
One relatively easy solution that would help address some of the UKs
structural problems is more house building

2015

29

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