Whither UK economic policy?

February 25, 2010

David KuoDavid Kuo is director at the Motley Fool. The opinions expressed are his own.-

The day of reckoning is looming ever closer.

Political leaders are jockeying for position with ad-hoc appearances here and a flesh-pressing engagements there to curry favour with voters ahead of the general election. How long will it be before we get our first baby-kissing photo opportunity?

But as yet, none of the main parties has told the electorate exactly how bad things are with the UK economy. Instead, they pussyfoot around difficult economic issues in the hope that if they don’t say anything, then maybe we won’t ask.

The truth is the economy is running on empty. It is flat on its back having been badly winded by rising unemployment, the sinking pound, and banks that seem happier to lock away any spare cash they have rather than lend it to businesses and consumers.

The number of people claiming unemployment benefit has risen to 1.6 million – the highest figure for 13 years. The pound has fallen against the both the dollar and the euro. Two years ago, one pound was worth $1.85 and 1.29 euros.

Today it is worth 17 percent less in dollar terms and 11 percent less against the euro. Additionally, mortgage lending by banks in December quickly petered out to its lowest monthly total for over eight years in January.

Still, none of the main parties has come forth with cogent fiscal policies to address the problem of the UK’s budget deficit. The hole is already more than 12 percent of gross domestic product, which is as gaping as that of Greece’s hole.

Although the UK government may choose to ignore the dilemma, lenders are not about to overlook it. They will demand higher yields for new gilt issues as worries about the UK’s finances loom larger.

So, where is economic policy going to go in the future?

Thing is, economic policy a la John Maynard Keynes has been about as effective as pushing custard uphill with a fork. Interest rates have been slashed to the bone, 200 billion pounds have been pumped into the economy, two of the UK largest banks are now effectively state owned and public spending has spiralled out of control.

And the best that Keynesians can show for all this is a miniscule 0.1 percent growth in GDP, which may be revised up in subsequent months when more data is available.

Yet the Government believes that the solution to the UK’s problem, which was caused by excessive debt, is to borrow more. However, higher levels of borrowing means higher interest payments. This in turn means higher taxes, which will not go down well with voters.

At some stage, sooner rather than later, public spending will need to be slashed. There will be an unavoidable reduction in public sector employment, which will increase the UK’s unemployment. The private sector will be encouraged to take up the slack, but this will be gradual rather than immediate.

Balancing the books will also mean that taxes will have to go up, although the emphasis is likely to be on indirect taxes such as VAT rather than direct taxes. VAT represents around a-seventh of total tax receipts, and raising the VAT rate from 17.5 percent to 20 percent could boost the VAT take by as much as 10 billion pounds.

The upshot is that economic policy for the UK is now largely out of the UK government’s hand. They say that he who pays the piper calls the tune. And for the near future, the tune that the UK will have to dance to will be decided by our lenders. Let’s hope it’s a jig rather than a swan song.

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