Friday, 1 March 2013

Winning the Ugliness Contest

Once popular with all the investors, the United Kingdom is beginning to fall out of favour as the diet of austerity measures proves to be too harsh.

A beauty contest is all relative.  It is not hard to be the prettiest when everyone else is ugly.  Such was the fate of the British economy during the Eurozone crisis.  It was not in the best shape but it still looked attractive compared to the turmoil in Europe and this lured in investors who snapped up bonds issued by the government.  But, with the worst of the Eurozone crisis now over and Europe no longer being shunned, it is the United Kingdom that is the object of attention for all of the wrong reasons.

The economy in the United Kingdom did see some benefits from the debt crisis across the English Channel in Europe.  The United Kingdom was seen as a haven in troubled times when investors needed to find somewhere secure to put their money.  As a result, the interest rates on government debt dropped below 2.0% to record lows (for more on this, see Not All Investors in Bonds Have Lost Money).  This has provided some relief as, even though slightly separated from the Eurozone and its troubles, the United Kingdom was in a spot of bother of its own with government debt of 82% at the end of 2011 climbing to 89% 12 months later.

But now that Europe is not the mess it was, the United Kingdom does not hold the same allure and its faults are starting to show through.  The austerity measures which have been introduced to tackle the budget deficit are sapping life out of the economy as money goes toward paying off government debt.  Following a decline in real GDP in the last three months of 2012, Britain is set to make headlines of the wrong sort with a triple-dip recession on the cards if the economy remains weak.  The dismal state of the economy means that Moody’s stripping UK government debt of its illustrious triple A rating last week was not much of a surprise as the reasons for the downgrading – the sluggish economy and high debt levels – were obvious to all.  But the attention on the ugly side of the UK economy is adding to the calls for more to be done to stimulate economic growth.

The coalition government in the United Kingdom which is headed by the Conservative Party has been adamant in its stance that reducing the debt is the best way to perk up the economy.  But this has been increasingly called into question as the theory behind such policies has stumbled in the face of the economic realities.  Studies done by the IMF also show that cuts to government spending have more of a negative impact on the economy than previously thought (for more detail, see Time for Plan B?).  The downgrading of the debt will add to pressure for a change in tact as it may prompt investors to move their money elsewhere and interest rates on government debt will rise as a result.  The higher cost of borrowing will increase the government expenses and eat into the savings the government has made through its austerity measures.  The weaker economy will also reduce the tax revenue for the government adding to its woes. 

With the economy not looking so good in comparison to elsewhere, the government and the central bank will have a harder task to win over the confidence of investors and to come up with a suitable regime of policies to keep the economy in reasonable health.  One consolation is that the constantly changing political and economic situation in various countries struggling with the consequences of the global financial crisis means that the time that the UK economy spends in the spotlight may be short.  In the same week, an indecisive election result in Italy makes it likely that it will be dragged out in front of the international media as the new candidate for the winner of the ugliness contest. 

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