Daily Archives: November 29, 2011

George Osborne has a tricky task in front of Parliament on Tuesday. He will have to admit to a much gloomier outlook, while sticking to the multi-year deficit reduction plan that he laid out last spring. His challenge is to square this circle credibly.

The new OBR forecast is certain to show a lower growth profile for the economy than that of the March budget. Quarterly outputs have been weaker and employment growth has stalled. Banks are rebuilding their balance sheets but lending to small businesses is still weak. The eurozone crisis has deepened, with a resolution not yet in sight. With such an unrelentingly negative backdrop, it is no wonder that business and consumer confidence are sinking.

Restoring confidence and reassuring the markets should be Mr Osborne’s twin objectives. A two-pronged approach will be necessary. Confidence can be built by laying out a medium-term growth strategy based on an investment revival. The markets can be reassured by stressing fiscal policy stability in the UK, which contrasts so strikingly with the policy uncertainty and political turbulence abroad.

Policy stability means sticking to the announced public expenditure cuts and pension reforms that will have a big cumulative impact on curbing government debt. It does not mean inaction or callousness in the face of slower growth. A tight fiscal stance provides the space for the Bank of England to continue with a loose monetary policy. It will help cushion the effects of the downturn. But just as Gordon Brown’s watchword while he was chancellor was ‘prudence’, Mr Osborne’s should be ‘stability’. Only time will tell if he lives up to his word better than Mr Brown did. 

It is increasingly clear that Italy’s public debt is unsustainable and needs an orderly restructuring to avert a disorderly default. With public debt at 120 per cent of gross domestic product, real interest rates close to five per cent and zero growth, Italy would need a primary surplus of five per cent of gross domestic product – not the current near-zero – merely to stabilise its debt. Soon real rates will be higher and growth negative. Moreover, the austerity that the European Central Bank and Germany are imposing on Italy will turn recession into depression.

The country’s public debt needs to be reduced now to at worst 90 per cent of GDP from the current 120 per cent. This could be done by offering investors the choice to exchange their securities either for a par bond or for a discount bond that has a face value reduction of 25 per cent. The par bond would suit banks that hold bonds to maturity and don’t mark to market. There should be a credible commitment not to pay investors who hold out against participating in the offer – even if this triggers the payment of credit default swaps.

But even a debt restructuring would not resolve Italy’s problems of lack of growth and outright recession, lack of competitiveness and a large current account deficit. Tackling those requires a real depreciation that may well demand the eventual exit of Italy and other member states from the euro.