Lord Flight is Chairman of Flight & Partners Recovery Fund, and is a former Shadow Chief Secretary to the Treasury.
It has been heartening that the UK economy has performed much better than the Establishment predicted. This is likely to continue to be the case for a year or two, resulting largely from the impact of Sterling’s depreciation.
Looking beyond this, however, Britain’s public finances are still incurring a deficit of £70 billion per annum, adding to the cumulative debt of £1.7 trillion for future generations to service and repay.
The EU economy giving cause for most concern is Italy. The forensic report by Italy’s Mediobanca sets out in minute detail why Italy is ‘running out of road’ after 18 years of economic depression resulting from its membership of the Euro.
There is the worrying possibility of a full blown debt crisis in an economy which is too big to rescue: its economy is ten times that of Greece. The Report believes that the optimal moment for Italy to leave the Euro has already passed, and it will become progressively more costly so to do and prohibitively so within four years.
If Italy wants to break free of monetary union it needs to get a move on. It can still switch half of its €1.9 trillion of traded debt into Lira under the legal prerogative of Lex Monetae, on roughly neutral terms; but this will decline as new debt with collective action clauses replaces old bonds. The Italian Treasury looks set to run out of buyers while the new rules on tangible equity will force Italian banks to slash holdings of Government Bonds by €150 billion.
This will, moreover, be against an international background of increasing real interest rates where the Italian economy is stuck in a no growth, deflationary trap.
The ECB has already purchased €210 billion of Italian debt – more than equal to the entire Italian Budget deficit for last year. Tapering may leave Italy without the key buyer of its debt. As the ECB steps back, Italy faces an ownership “problem” on €1 trillion of debt.
Do they then offer debt restructuring on friendly terms within the monetary union; or do they hold out and wait for the political storm sweeping Italy to smash the Eurozone? The former is the cleanest way of managing Italy’s debt, but Italy needs a cheaper currency to resuscitate its economy.
In the meantime €220 billion has left Italy, ending up in mutual funds in Germany and Luxemburg where the Bank of Italy’s liabilities to the ECB under the Target 2 clearing system are now a record €360 billion – mostly in turn owed to the Bundesbank.
Turning to the real economy, it is seven per cent smaller than it was before the Lehman Brothers’ crisis. Two lost economic decades threaten to herald a third. Youth employment exceeds 40 per cent and some southern regions have unemployment across all ages of above 50 per cent.
By contrast, the UK Government currently has no problems in financing its debt, at an interest cost which is one per cent below that of the US Government. Time is, however, running to sort out our public finances. It looks unlikely that growth is going to be sufficient, of itself, to eliminate the ongoing deficit (although the Resolution Foundation is predicting a £12 billion and increasing improvement in the deficit this year from higher tax receipts).
Public sector debt has more than tripled from a pre-crisis level of 28 per cent of GDP to 90 per cent of GDP today, at a total of £1,700 billion. The tax take has crept up to 37 per cent, the highest level for over 30 years, where past experience has shown it difficult to increase the take much above this level without this being self-defeating and damaging the economy.
The annual fiscal deficit has reduced from 10.2 per cent in 2009/10 to a current 3.8 per cent of GDP, but still represents an annual shortfall of £70 billion. Deficit reduction targets have also been consistently missed.
It has been the three Departments of Welfare, Health and Education which have driven rising public expenditure, and now account for two-thirds of all of it. Of the £260 billion of Welfare spending, approximately 50 per cent is accounted for by the State Pension. This will need to be frozen. Health expenditure has grown at four per cent per annum in real terms for the last 60 years, and now amounts to £145 billion per annum. It was only £18 billion when John Major left office.
We have been fortunate with the reduction in interest rates which has meant total debt servicing costs have scarcely risen since 2005, but should interest rates return to 2005 levels, this would double the current £70 billion deficit.
The hard truth is that the Government needs to get a move on with cutting spending by some £50 billion a year over the next two years, and a significant part of the cuts will need to come from the hitherto ‘protected’ areas of Welfare, Education and Health.
The danger is that the current ease with which the deficit is financed will mitigate against biting the bullet of cutting spending, until a crisis forces the Chancellor’s hand. It will not be satisfactory if Philip Hammond leaves the deficit to continue of the order of £70 billion a year when this figure could easily double in a less benign economic climate with rising interest rates.