Back to the Seventies?

Why a Decisive Election Outcome is Imperative - We Need 'Action This Day'

LONDON, May 5, 2010 - The British electorate needs to be decisive on 6th May, since
it is imperative that government signals positive intent to the markets by
taking immediate and resolute action over excessive public spending and a
spiralling national debt. In the midst of stormy economic seas, the very last
thing that the British ship of state needs is squabbling on the bridge and
demoralisation in the engine-room.

"Never make forecasts," Sam Goldwyn famously said, "especially
about the future." His advice is particularly apt just days before what is
surely the most unpredictable British general election for more than 30
years.

But one assumption can, we think, be made with considerable
confidence. It is that no party is likely to emerge from the election with
anything better than a wafer-thin majority. A "hung parliament" - in which no
party has an overall majority - has long seemed the likeliest outcome. A
too-close-to-call race is fascinating stuff for political pundits and
aficionados of the Eurovision-style tensions of election night. But - at a
time when Britain is running an unprecedented budget deficit, and sovereign
debt is in the firing line throughout the developed world - what are the
likely implications of indecision for the economy and investors?

Potentially bleak, we believe, in that an effective and
determined government has seldom been more essential than it is in 2010. By
far the best scenario for Britain would be the return of a strong government
prepared to cut public spending by GBP20bn annually, thereby putting the
nation's finances on the road back to sustainability and, far more important
in the near term, signalling to the markets that living beyond the country's
means has been an aberration, and is not going to become the norm.

Indecision, on the other hand, would be the worst possible
outcome. A failure to take resolute action within a maximum of three months
could point towards a full-blown currency and rates crisis.

Back to the future?

What might an indecisive result mean? Well, precedent here is
limited, but it is not non-existent. The last time that a British election
produced a hung parliament was in February 1974, when flared trousers,
flowered shirts and platform soles were de rigueur, and Suzi Quatro had just
ousted Mud from the top of the pop charts. If the cultural differences
between now and 1974 are vast, the similarities, both economic and political,
are almost uncannily exact. More importantly, the sequel to that
near-dead-heat was extremely uncomfortable, contributing as it did to the
fiscal deterioration which culminated in the IMF bail-out of 1976.

The economic similarity is that, like that of 1974, this
year's election takes place in a very troubled macroeconomic climate, and the
political parallel is that, while the incumbent government was unpopular, the
opposition had failed to mobilise enough support for a decisive victory. But
it is the subsequent course of events, rather than the immediate
similarities, which should cause investors most concern.

The February 1974 election resulted in political instability,
such that a second election had to be called in October. The policy paralysis
and the lack of effective decision-making of that eight-month period segued
into a rapid deterioration in the public finances, such that, within two
years, the 1976 sterling crisis forced the UK to go cap-in-hand to the IMF
for a last-ditch bail-out. It couldn't happen again - or could it?

Well, yes, it could. Though many other issues have grabbed
popular attention, the 2010 vote is as near as it gets to a single-issue
general election, even if no leading politician has been sufficiently bold
(or perhaps foolhardy) to tackle that issue head-on. The issue is, of course,
a budget deficit which, at almost 12% of GDP, is unprecedented (and which, by
contrast, makes the 7% deficits of the mid-70s look like storms in a pretty
small tea-cup).

Let's state the issues with absolute clarity. Between 2000 and
2008, Britain enjoyed an economic boom that we now know was almost entirely
illusory, and resulted from a property price bubble which, given the derisory
level of domestic savings during the same period, was necessarily built
almost entirely upon wholesale borrowings from abroad. Far from recognising
the essentially illusory nature of this economic spurt, government proclaimed
an end to "boom and bust", and lived up to (indeed, far beyond) Britain's
apparent means by increasing public expenditures by more than 50% in real
terms. When, inevitably, the bubble burst, the fiscal tide went out, leaving
the public finances high and dry.

Last year, government spent 48% of GDP but received only 36%
in taxes and other revenues. At almost 12% of GDP, the British deficit is
comparable to that of Greece, and worse than either Spain or Italy. Indeed,
the observer might at times be hard pressed to understand quite how the UK
has, so far at least, got away with such profligacy without seeing its
currency and its bond prices come under much greater pressure.

Time-limited defences

As we explained in a recent report[1], sterling has been
supported by 'three props', each of which is time-limited. The first of these
'props' has been quantitative easing (QE), whereby government has created
GBP200bn of new money. According to the government, QE has not amounted to
the monetising of debt, and the symmetry between QE and the government's
CGNCR[2] cash-raising requirement (of GBP201bn) is simply a coincidence.
Right.

The second prop has been the political situation itself.
Realising that tough decisions were unlikely to be taken with a general
election looming, international markets have treated sterling with
considerable tolerance, assuming that decisive action would follow
immediately after the election. Third, it has been widely assumed that the
major deterioration of sterling over the last two years would promote an
export-led recovery.

Now, each of these props has reached its sell-by date.
Repeating the QE expedient would carry levels of market and inflationary risk
that can surely be regarded as unacceptable. With Britain's anaemic recovery
far weaker than those of other developed economies, even a stale bull could
put little if any faith in the devaluation stimulus argument. Most
pertinently here, the 'political hiatus' defence obviously won't work after
6th June.

In short, swift and decisive action is needed if Britain is to
avoid paying the full price for past fiscal irresponsibility. And the
prospect of a hung parliament - or, for that matter, of a wafer-thin,
barely-workable majority for one party, which would be almost as bad - makes
such swift and decisive action frighteningly unlikely.

Fighting the wrong war

While the imperative national need is for deficit reduction, a
hung parliament would be far more likely to produce party posturing and
policy prevarication.

For one thing, a distinctly possible implication of the 1974
precedent is that a hung parliament will be unworkable, such that a second
general election might follow the first within months. If politicians even
suspect that this may be the case, they will remain on an election footing,
which means that no one will risk courting electoral unpopularity by taking
tough decisions.

Some commentators have scouted the hung parliament dangers,
and have persuaded themselves that a 'balanced parliament' could be a good
thing. This, we think, is about on a par with Pollyanna placing her faith in
'the glad game'[3]. While most European systems of governance do indeed
produce coalitions of varying degrees of effectiveness, the British political
system is essentially confrontational, and is not suited to consensus
politics.

    Fig. 1: External debt, selected countries, end-2009*

                  External debt  External debt as  External debt per capita
                          ($bn)          % of GDP                       ($)
    UK                   $9,088              423%                  $148,708
    France               $5,021              238%                   $78,382
    Germany              $5,208              185%                   $63,258
    Spain                $2,410              176%                   $59,469
    Greece                 $553              162%                   $51,486
    Portugal               $507              218%                   $47,348
    US                  $13,450               94%                   $43,781
    Italy                $2,328              132%                   $40,051
    Canada                 $834               65%                   $24,899
    Japan                $2,132               52%                   $16,777

    *Source: CIA World Factbook

Moreover, the UK electoral system is dangerously unbalanced -
if each of the main parties was to garner 30% of the vote, for example,
Labour would win 315 seats, compared with 206 for the Conservatives and just
100 for the Liberal Democrats[4]. (The sheer absurdity of this arithmetic
should be borne in mind by anyone who thinks that the UK does not need
electoral reform).

Any investor who believes that the UK can afford a lengthy
period of indecision ought to bear the following in mind. First, Britain's
reported national debt (of GBP761bn, or 54% of GDP) understates the true
scale of government obligations which, including public sector pensions and
PFI[5] commitments, we calculate at GBP2.1 trillion (150%).

Second, the oft-cited benchmark of national debt is not the
key issue anyway. Debts owed within a country do not pose an unmanageable
problem, and the real scale of the fiscal challenge should be calibrated by
looking at debts owed to overseas investors.

At the end of 2009, Britain's external debt was $9.1 trillion.
At 423% of GDP, this overseas indebtedness is far worse than that of France
(238%) or Germany (185%), let alone Greece (162%) or Italy (132%). External
debt equates to $149,000 per British citizen which, again, is far higher than
the equivalent numbers for Spain ($59,000), Greece ($51,000) or Portugal
($47,000) (see fig. 1).

Therefore, it seems abundantly clear that decisive action is
required immediately after the election, irrespective of the outcome. Many
possible political permutations have been suggested by commentators but,
where the investor is concerned, the overwhelming issue is neither labels nor
personalities. The requirement is - in the words of Winston Churchill - for
'action this day'.

Dr Tim Morgan

Global Head of research

    ---------------------------------

    [1] See Tullett Prebon Strategy Insights, Issue Four, Britain
        at the Crossroads - The Case for Fundamental Change
    [2] Central Government Net Cash Requirement

    [3] Pollyanna, written by Eleanor Porter, was published in 1913. The
        "glad game" meant that, if Pollyanna pretended that everything was
        fine, a happy ending was assured. It is not a good investment
        philosophy.

    [4] For seat calculations, see BBC website,
        news.bbc.co.uk/1/hi/uk_politics/election_2010/8609989.stm

    [5] Private Finance Initiative

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