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Belt tightening

There are four archetypes of the deleveraging process and the coalition seems to have opted for the most common

George Osborne finally delivered the Government’s comprehensive spending review last week, thereby outlining the deepestever budget cuts in Britain.

Over the next four years, this will entail cuts totalling £81bn in order to achieve the aim of reducing the budget deficit from 10.1 per cent of GDP to 2.1 per cent.

While this action by the Government is brave and necessary, the UK still needs to come to terms with total indebtedness within the consumer and private sectors that will continue to create further challenges.

According to a report published in January by the McKinsey Global Institute, the UK’s overall debt to GDP stood at 469 per cent in 2008. The Government’s share of this was by far the lowest standing at 52 per cent of GDP, with household debt at 101 per cent, non-financial business debt at 114 per cent and financial institutions debt at 202 per cent.

In the period from 2000 to 2008, UK financial sector debt grew by 77 per cent, household debt grew by 102 per cent and total household debt as a percentage of income rose from 105 per cent to 160 per cent. The compound annual growth rate of overall debt ran at 10.2 per cent in the period. What all this meant is that the UK went into the Great Financial Crisis with a highly levered economy.

This helps to explain why, since 2008, we have witnessed a deleveraging process in both the household and financial sectors of the economy.
Significant challenges remain ahead for the UK as the total stock of debt is still too high. This is why I believe that proponents of a Keynesian response to the crisis are wrong as they fail to take account of this important fact. However, it does leave the country with the problem of doing away with its mountain of debt. So what is the likely path here?

The McKinsey Global Institute’s report refers to four “archetypes” of the deleveraging process:

  • Belt tightening: episodes where the rate of debt growth is slower than nominal GDP growth or the nominal stock of debt declines, such as the US from 1933 to 1937 or Korea from 1998 to 2000.
  • High inflation: periods of high inflation that mechanically increase nominal GDP growth, thus reducing debt/GDP ratios such as Spain from 1976 to 1980 or Chile from 1984 to 1991.
  • Massive default: stock of debt reduces due to massive private and public sector defaults such as Mexico from 1982 to 1992 or Argentina from 2002 to 2008.
  • Growing out of debt: economies experience rapid GDP growth and debt/GDP decreases such as the US from 1938 to 1943 or Egypt from 1975 to 1979.

Interestingly, across 32 periods of “post-crisis deleveraging” which the report examines, the most common path fitting 16 of the episodes was through a prolonged period of aust-erity. There were eight instan-ces of high inflation, seven of massive default and just one of growing out of debt.

It seems that the UK is now embarked on the most common solution, namely that of belt tightening.

Default has been ruled out and growing out of debt is highly unlikely, at least in the near term, as the UK will flirt with a negative growth rate again over the next year.

But has high inflation been ruled out? My uneasiness with this comes from the constant background noise with regards to quantitative easing, or printing money, and the Bank of England’s unwilling-ness to dispel the threat of such action. Will this temptation prove too hard to resist?

The jury may be out with regards to the UK and suspicions will remain given that inflation was the chosen path in the period post-World War II. But for the time being, let us give credit where credit is due with regards to the UK.

What really worries me is that the message emanating from the US, which faces just as severe a deleveraging problem as the UK seems to be loud and clear in favour of high inflation. It looks like the Federal Reserve has already made its mind up.

Cambiz Alikhani is CIO Iveagh Private Investment House


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