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The Road to Plan B? Some thoughts on the forthcoming Autumn Statement

November 29, 2011

How the City  can Play a Future Global Role

Mark made the following speech at a couple of City meetings this week:

The coalition’s spending programme for the duration of this parliament was supposed to have been settled conclusively in last November’s pre-budget report. On that basis next week’s Autumn Statement was designed to be a routine affair.

Instead the government is investing substantial political capital in the hope that this set-piece parliamentary event will promote UK economic growth beyond its recent anaemic levels. We are unlikely to hear the Chancellor admit that his admirable strategy for deficit reduction – namely to eliminate the UK’s structural deficit by 2015 – has already been blown off course. But it has. So whilst Plan A stands intact, I believe we should expect this autumn report to herald an aggressive series of initiatives for industrial intervention and growth on a scale not seen since the 1970s.

To date during the tenure of the coalition I reckon too much has been made of the alleged ‘necessity’ of its programme of austerity. As we have seen, the Alice in Wonderland economics of near zero interest rates have allowed the UK, along with much of the Western world, to continue borrowing at levels unimaginable before the financial crisis struck. The true ground for the economics of austerity is moral. It is simply unethical for the current generation of Britons to continue borrowing in order to consume at these unsustainable levels whilst wilfully passing on their debts to future generations.

So how is the austerity strategy going? Well, let’s look beyond the rhetoric of ‘savage cuts in public spending’ at the facts. In the past twelve months UK government current spending has totalled £613.5bn – the highest figure in history. We are still expected to borrow £125bn in this tax year. Insofar as it can boast of achievement, the coalition has been able to recalibrate the public finances in such a way that we are now borrowing £1 in every £5 we spend collectively, rather than the £1 in every £4 that UK taxpayers borrowed in 2009.

In truth we are now digging that cumulative debt hole just a little less slowly than in the recent past.

In view of the increasing public sector disquiet, I fear it will prove incredibly difficult to impose the necessary political will to execute the planned level of spending cuts. All of us Britons have become accustomed to a generously funded welfare state, built up especially strongly over the past decade or so on money part borrowed and resulting from the apparent expansion in the UK tax base that resulted from a property-driven boom.

Small wonder that so much now rests on achieving the other pillar of the deficit reduction plan – economic growth. Indeed £83bn of the planned £159bn deficit reduction plan hinges upon achieving sustained economic growth up until 2015. These aspirations were predicated in June 2010 on the basis the UK would achieve compound growth of between 2.7% and 2.9% per annum over the entire course of the parliament. As we all now know, growth over the past year has stalled to roughly one-third of this projected level and future predictions for the near term look similarly grisly.

Moreover, one of the untold challenges that the coalition government faces in its growth strategy is that over the past decade and a half roughly 60% of domestic expansion in the economy has arisen courtesy of the financial services industry, the public sector or in the property and construction field. These are three activities in which the present squeeze will be most profound, not least as each of these areas has been largely debt-funded during that time. Yet it is difficult to see the essential other types of economic activity in which super-charged levels of growth can be achieved once we have discounted the main drivers of our most recent boom.

This is why the UK government is investing so much hope, hype and faith in next week’s Autumn Statement as the pivotal moment from which recovery can be kick-started through a programme of expansion. I am convinced this will amount to a distinct departure from previous policy. Large-scale, headline grabbing infrastructure projects (such as High Speed Rail; a vast roll-out of broadband capacity to every corner of the UK and possibly even a revival of the London Estuary airport idea, an aviation policy fit for the twenty-first century) have already been showcased. So too a radical liberalisation of the planning regime as well as a clear commitment to press ahead with building the new generation of nuclear power stations more rapidly. This would be private sector expenditure and labour intensive and kick-start employment. Now that the £75 billion second batch of Quantitative Easing has highlighted the exhaustion of any macroeconomic options for growth, I predict that supply side reform, especially in the small and medium sized (SME) sector, will now be firmly to the fore. The aim must be to increase workforce flexibility and retain skills and talent through a variety of measures, possibly geared to relaxing employment regulations for companies employing fewer than (say) fifty people.

For too long SMEs have been a largely ignored, Cinderella sector of the UK economy. Yet undisputedly they act as the single most important engine of job creation, already accounting for over 13 million jobs in Britain and by most calculation two-thirds of all new employment creation. Allowing SMEs to take on extra employees over the next two tax years without paying National Insurance might help stimulate growth without costing the Treasury too much. An NI holiday might even be extended to all employees under 25.

The key here is the boosting of demand, which links directly into the granting of credit from the banks. Whilst continued depressed levels of demand might help assuage inflationary concerns, it is nevertheless vital for the UK economy that companies large and small are dissuaded from battening down the hatches. Indeed we may already be witnessing a sea-change in historical over-consumption in the UK as a result of the squeeze on living standards. However, job creation also requires the lifeblood of credit. Expansion cannot take place without new sources of finance and the stark truth is that lending to SMEs has been falling since early 2009.

For this reason I believe the most eye-catching aspect of the Autumn Statement will centre on ‘credit easing’.

Amongst City commentators there was some bemusement when George Osborne signalled in his Party Conference’s speech that he intended to go down this route. It all seemed like ‘back of the envelope’ stuff, but I am aware there has been feverish activity on this front as the government seeks to take more direct involvement in the lending process. Two possible vehicles are a private sector institutional Investment Fund to lend alongside banks and a securitised bond market made up of Collateralised Loan Obligations. Where the government comes in is to keep interest charges at a reasonable level and provide some protection against default.

To operate effectively, credit easing will also require the provision of credit insurance (up to, say, the first 20% loaned) to help underwrite the prospect of default in the area of more apparently risky lending.

I wonder whether the Chancellor may be tempted to use the majority state-owned Royal Bank of Scotland as the vehicle for this activity? If credit easing were to be promoted by the creation of a newly-formed National Industrial Bank this would take months, perhaps even years, to be properly up and running. By contrast, RBS already has the infrastructure, execution-skills and distribution network, not to mention the expertise (in large part) to give the UK economy a rapid adrenaline shot.

This competitive advantage may become crucial if the Eurozone economy deteriorates rapidly. Indeed no amount of supply-side tinkering, red-tape removal or employment law easing will assist if external demand in the EU (which accounts for 54% of our trade) plummets. Then employment-creating investment through credit easing may prove essential. In the event of the necessity for such shock-therapy, credit easing to the UK economy, RBS would be uniquely well equipped. It is 83% publicly owned and already accounts for over 40% of UK SME lending. RBS guarantees to renew their overdrafts at the same rates as long as a company’s credit profile is unchanged. RBS already keeps upfront fees to a minimum and does not make changes to penalise the early repayment of loans.

If I am correct in believing that the coalition government recognises the need substantially to stimulate demand in this jittery environment of economic uncertainty then an ambitious credit easing programme would almost certainly best be achieved through the existing infrastructure of a largely state owned entity. In this economic climate the competition law concerns alongside potential opposition of minority shareholders in RBS are likely to be muted.

There is one historical parallel for the dash for growth that I am convinced we shall see in the Chancellor’s forthcoming speech, and it goes back almost exactly four decades.

On 21 March 1972 Anthony Barber’s second budget was widely, almost universally, well received. The critics of what later became known as the ‘Barber Boom’ only spoke out in opposition later. At a time of rising unemployment and sluggish growth, the 1972 budget was unashamedly designed to provide a massive boost to demand (all sounds rather familiar?!). Income tax and sales tax were slashed. A vast array of incentives for industry, including generous tax allowances for machinery and extensive regional investment grants. It was as if Christmas had come early and several times over for ordinary taxpayers and business folk alike.

Naturally commentators at the time ought to have realised that all this feverish activity brought with it an enormous risk of inflation. In the years ahead indeed this is precisely what came to pass. Yet at the time the dash for growth was justified by the need for government to urge the economy onto faster growth and it was widely assumed that the resulting gains would rapidly allow for the additional public borrowing to be repaid.

There are striking parallels with today’s outlook. I have spent much of the past two years warning about inflation and diminishing living standards. Frankly it has been Bank of England policy (presumably with a blind eye from the Treasury) over this period that a little inflation in the system is a risk worth taking to keep interest rates at rock bottom levels. For those of us who believe in ‘sound money’ this is always a mighty dangerous thing as it helps to relieve the burden of debtors at the expense of savers. You may have noticed that government is the biggest debtor of them all.

Currently I fear there is complacency, bordering on recklessness, on the part of the Bank’s policymakers that inflation will fall dramatically from its current 5.6% early next year when the twin effects of rising global commodity prices and the VAT rise fall out of the calculation. The justification for the demand surge that I suspect will underpin the Chancellor’s statement is an underlying concern that the UK may otherwise be about to embark upon a Japanese-style lost decade of deflationary stagnation.

Like Anthony Barber almost forty years ago, George Osborne may have praise ringing in his ears on 29 November. The real test will be reaction in around eighteen months’ time. If inflation has crept up and neither employment nor growth has significantly been enhanced then we will be back into a debilitating cycle of stagflation – a truly ‘back to the 1970s’ phenomenon.

Here is the real danger. This radical change in policy direction comes at a time of seismic change and unpredictability in the global economy as extreme uncertainty reigns in the Eurozone (our main export market), China and the south-east Asian economy – which is showing some signs of running out of steam. Meanwhile our domestic banking system still grapples with reform courtesy of the Vickers Review and European regulation.

Not that George Osborne has much room for manoeuvre. His task is to instil a sense of hope, optimism and a future promising better times. Yet the broad economic backdrop remains bleak, especially in the Eurozone where continued uncertainty is the most likely path for the year ahead.

Whilst the Chancellor needs finally to level with the UK public about the seriousness of our economic situation and the need for ‘blood, sweat and tears’ sacrifice, he must also avoid the perennial tactical temptation to blame the last government. True it may be, but I fear that to the great majority of Britons this line is wearing thin.