Who would lend to a bankrupt Britain?

Alistair Darling’s budget forecasts assume that Britain can keep borrowing all it wants for the foreseeable future.We may not be so lucky, says Irwin Stelzer

Federico Sturzenegger and Jeromin Zettelmeyer are not exactly household names. They are, respectively, professor at the Universidad Torcuato di Tella, and an adviser to the International Monetary Fund. Some months ago, as I watched Britain roll up debts that would have been unthinkable only a few years ago, I moved their book, published in 2006, from a back shelf to the top of my desk. Where it sat, unmolested, until two things happened.

First, rating agencies got nervous about the quality of the sovereign debt issued by the UK. Next, Dubai World asked its creditors for time to meet its obligation to pay interest on $26 billion of its $80 billion of debt. So Debt Defaults and Lessons from a Decade of Crises (MIT Press), seemed worth a second look.

It was. Defaults by sovereign governments have been with us since at least the 4th century bc, when ten of 13 Greek municipalities defaulted on their loans. France (eight times) and Spain (six times) hold the record for defaults between the 16th and the end of the 18th centuries. ‘Only in the 19th century, however, did debt crises, defaults, and debt restructurings — defined as changes in the originally envisaged debt service payments, either after a default or under the threat of default — explode in terms both of numbers and geographical incidence.’

This history becomes increasingly relevant in the wake of Wednesday’s Pre-Budget Report — which told us that the government will need to borrow a cool £243 billion from the City by the end of this financial year, as it builds up a debt pile now expected to hit 1.47 trillion by 2014/15. This mountain of debt has been created by Britain’s insatiable welfare state, spending to cope with the recession, and a tax system heavily dependent on corporate profits and high-earners.

As Messrs Sturzenegger and Zettelmeyer say: ‘All lending booms so far have ended in busts in which some of the beneficiaries of the preceding debt inflows defaulted or rescheduled their debts.’ This is especially true of countries that have substantial off-balance sheet liabilities. ‘These “skeletons”... have a habit of showing up in crisis times, when debtors are forced to make an inventory of their overall liabilities,’ they say. Think unfunded pension liabilities, obligations of quasi-public bodies, the implicit obligation to bail out entities the failure of which might cause systemic collapse. With such ‘skeletons’ Britain is richly endowed.

Now, enter what the markets are saying. The Wall Street Journal reports that two years ago it cost $5,000 per year to insure $10 million of British government debt against default for three years. It now costs $52,000 to buy such insurance — and $72,000 to cover that risk for five years. That is $30,000 more than it costs to insure BP’s debt, and $50,000 more than to insure Germany’s. So the markets think it is more likely that UK plc will default than BP plc. Or McDonald’s. Or Gap.

It is, of course, a long way from here to a British default. Much will depend on whether spending can be contained. The outlook is not good. Even George Osborne’s plan to attack spending, not with an axe but with a paring knife, is under attack from his colleague, Ken Clarke, who is warning him not to get ‘too adventurous’ in attacking spending.

Labour’s plans need not be considered: either they will lose the next election, in which case their plans are irrelevant, or they will win, in which case Gordon Brown is unlikely to find a spending cut that will not interfere with economic recovery or offend some constituency — putting default back in the running as a possibility.

So prudence — you remember Prudence — dictates that we not count on spending cuts of sufficient magnitude to begin reducing the much-watched debt-to-GDP ratio, predicted by a very optimistic Treasury to peak at 78 per cent in 2014/15 (it now stands at 59.2 per cent, up from 44 per cent in 2007), not including ‘skeletons’. That leaves the government with three choices.

It can increase taxes even more than now contemplated. But taxes are already so high that an increase will accelerate the departure of many wealth producers, and encourage workers to prefer the sofa and a weekend football match to overtime, especially if extra income is almost entirely offset by increased taxes and a loss of benefits.

Or it can rely on inflation to allow it to repay its creditors with mounds of depreciated pounds. The Treasury is issuing massive amounts of new debt, and the Bank of England is obligingly printing money with which to buy up that debt. Not quite on the scale of the Weimar Republic, but enough to drive prices up and the value of the pound down.

So far, inflation has been tame due to the excess capacity in almost all sectors of the economy, including most especially in the jobs market. But as the economy picks up, pricing power returns. True, a recovery will somewhat increase the flow of funds to the Treasury, but not sufficiently to cut deeply into the deficit. Solution: run the printing presses overtime.

Finally, the government might call in its old friend, the International Monetary Fund, to do its dirty work. A new Tory government, having reacted with mock horror to what it finds on the Treasury’s books, could ask for help in cleaning up the mess that the Brown government left in its wake. But this is hardly at the top of David Cameron’s wish list.

Of course, it might not come to this. There might be bipartisan agreement to reduce the size of the public sector and its generous compensation schemes. There might be agreement to snatch from the middle class some of the benefits it now receives as a bribe to ensure its continued support for the welfare state. There might be a deal to reform the tax structure so that it no longer overly taxes jobs, risk-taking, and entrepreneurship. And pigs might have wings.

I exaggerate. All of these changes are within the reach of a new British government. Watch the market for default insurance to see whether investors believe that the Tories will form the next government, and if so, whether Osborne can win his battle with Clarke, and David Cameron has the spine to do what he knows needs to be done to put Britain back on the path to fiscal sanity.

Irwin Stelzer is US columnist for the Sunday Times and director of economic policy studies at the Hudson Institute.