British economy battered and bruised

EDITORIAL – The British are battered and bruised. A combination of bank paralysis and world recession is painful for an open economy that is peculiarly reliant on international finance.

Gross domestic product shrank by 1.5 per cent in the fourth quarter of 2008 and 77,900 more people were on the dole in December than in the month before. As public deficits balloon, there has been talk of sterling and fiscal crises. These risks are real but distant.

The pound has recently crumbled away. Sterling fell a further 7.3 per cent this week, briefly reaching a 23-year low of $1.35 against the dollar. As Jim Rogers, a former business partner of George Soros, noted, weakening was to be expected. Upward pressure on sterling from oil and financial services has, indeed, been easing. Mr Rogers, however, was wrong to claim that the UK has “nothing to sell”. Manufacturing is still a serious force and larger as a share of GDP than financial intermediation. The pound hardly looks overvalued.

In any case, so long as it does not turn into a rout, Britons should welcome a weaker currency: it will aid recovery. It makes imports dearer for domestic consumers while UK exports become cheaper to consumers abroad. Britons will now find their foreign holidays are rather more expensive. But they can take cheer from the fact that the French finance minister has complained about the advantage the weak pound is giving them. Indeed, times when sterling is weak have, historically, been good times to buy into UK equities.

A further point of popular concern is the public finances. Too loose before the crisis started, the fiscal position will deteriorate as the flow of social security payments deepens and tax revenues dry up. On top of that, bank recapitalisation and lending guarantees create large up-front costs and potentially massive contingent liabilities.

This has created a flurry of angst about the UK’s ability to fund itself. But Goldman Sachs estimates that, even on a cautious basis, making good bank losses would cost 8 per cent of output. On that basis, after saving the banks and paying for unemployment benefits, the UK would still have a lower stock of national debt as a share of output than the eurozone.

Investors seem to agree with this analysis. Bond yields on UK sovereign debt are still remarkably low. Indeed, the difference between the costs of British debt and ultra-safe German debt is below its long-run average. Meanwhile, the two main credit rating agencies have been robust in defending the UK’s reputation as a borrower.

The government must take these sorts of crises seriously. The flow of serious debt issuance is only just beginning and, if investors are spooked, conditions could deteriorate quickly. But these risks must be put into perspective. They remain both far-off and unlikely. The Financial Times