Eerie calm before Britain’s election

May 5, 2010

— James Saft is a Reuters columnist. The opinions expressed are his own —

To look at sterling and gilts, you would hardly know that Britain is sailing into a general election which will likely deliver a weaker government with a diminished ability, if not will, to grapple with high debts, an uncertain role in the global economy and an aging population.

It is impossible to say what will be the result on Thursday, nor what deals may be made between the surging Liberal Democrats, a bedraggled Labour party which will still have a significant wodge of votes and the Conservatives, who must be both hoping that their hour has arrived and that that hour does not prove to be Monday morning at 8 a.m., pouring with rain and all the trains are late.

There is a huge range of scenarios — a weak minority or majority government or a coalition of some form — but the common denominator across almost all likely outcomes is that all raise the risk of a weak government unable or unwilling to push through aggressive deficit-reduction measures.

And an aggressive, credible and clearly enunciated plan is exactly what is needed. Even before the horse trading and compromising begins, all three parties’ plans lack either scope or specificity. Specificity about what will be cut or who will be made to pay more may well arrive, but it is likely to be at the expense of scope. Unless of course, Britain gets a sharp goading, as did Greece and the euro zone, from the financial markets.

Although pat comparisons between Greece and Britain cannot be made — Britain can devalue the pound and set its own interest rates — on some significant measures Britain is in a worse situation than Greece’s. Britain’s fiscal deficit is forecast at 13.3 percent of GDP in 2010, according to the Bank for International Settlements, worse than Greece, Ireland or any other major country you care to name.

Investors are reassured by the fact that Britain has an average debt maturity of 14 years, and appear to be betting it has time enough to work its way through its issues. Unusually, uncertainty this time does not seem to be unsettling investors. It is not hard to see that changing once the results are in.

Even before you consider the political complications of a weak or unstable government, Britain has an interesting set of problems with which to contend. First off, what is Britain for? Britain has done well out of the increase in globalization and the concurrent rise in the financialization of the world economy, successfully positioning London as perhaps the preeminent banking capital.

London boomed while the manufacturing sector withered and the British regions got by on a mix of property speculation and state transfers. That accommodation probably can’t last; financial intermediation has shrunk and will probably shrink more and, while globalization as a force is far from spent, the focus is moving east and south and China itself will capture more and more of the gravy, both in trade and financial services.

Britain then is a bit of a mix of the worst of Europe and the United States, with a hollowed-out manufacturing core, tremendous debts taken on during the crisis, a huge banking system relative to GDP and, coming over the horizon, the very serious issue of having an expensively aging population.

A recent paper by Stephen G. Cecchetti, M.S. Mohanty and Fabrizio Zampolli of the BIS lays out in stark detail the debt challenges faces major states and shows exactly how bad things may get for Britain:

If fiscal policy or age-related spending do not change, Britain by 2040 is looking at a debt-to-GDP ratio north of 500 percent, or about double Italy’s. Even if Britain manages to shave 1 percent of GDP off of its fiscal imbalance a year for the five years from 2012, government debt to GDP will still balloon to about 350 percent by 2040.

Clearly that situation is not tenable. Creditors will have routed British debt long before that forecast comes close to reality. Voters too are not going to like what is coming their way; longer working lives and a diminished flow of transfers and services from government.

And this is exactly where the post-election day risk will become manifest. Creditors are not now voting with their feet on British debt, but neither is anyone talking realistically with the British electorate.

If, as seems likely, it becomes apparent in coming weeks and months that the government in charge is not going to succeed in moving forward this conversation, it is reasonable to expect investors to begin imposing a risk penalty on British assets.

(At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund.

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