Why Government Cuts Are Necessary

All around us there is a lot of opposition to the government cuts which the UK government and other Western Economies are currently pushing through. These cuts are very important to maintain economic strength though and we have to endure some significant short term pain for long term gain. Let me explain.

Focus on the UK Government

The UK government is currently running a massive annual budget deficit, indeed at the end of 2009 the public borrowing requirement was 11.5% of GDP. This means the government is spending vastly more than it receives in tax revenues each year. In addition the UK already has government debt which is forecast to be 94% of GDP by the end of 2011. Each year the UK is adding to its debt pile and as the debt pile gets larger and larger it becomes more and more difficult to service. If the UK continues as it is doing there will become a time when its borrowing won’t even cover the interest payments on its debt. Then, of course, the UK economy is in a world of trouble, and economic armageddon is on the horizon.

If at the end of 2011, as forecasts suggest, the UK government debt stands at 94% of GDP this will clearly not be sustainable. Even more concerning is that the proposed cuts in government spending will only shave 1.3% off the annual budget deficit each year from 2011 and 2015. This means our debt to GDP ratio will keep going up and up. In a decade’s time, forecasts from the Bank of International Settlements suggest our debt to GDP ratio could between 150 and 200%!

What does this mean?

Sooner or later the bond buyers of the world will wake up and realise that it is not a wise investment lending money to a government which is so indebted for such a poor yield. When this event comes, it will mean only one thing, the UK will be forced to raise interest rates so that it can offer a better return on its bonds to incentivise investors to fund its debts. Of course, raising interest rates will be mean that the economy will grind to a halt again as it will hit all the UK homeowners on variable rate mortgages. This, of course, could result in a further bout of quantitative easing which would be very much inflationary.

What can countries do when they have too much debt?

Well they have 3 choices, which are all pretty bad.

1. They can inflate it away
2. They can default on their debt obligations
3. They can devalue their currency- making their debts worth less in foreign currencies.

At the moment the UK appears to be using a combination of 1 and 3. UK CPI inflation is more than double the Bank of England’s 2% target, it currently stands at 4.5%. The pound is far weaker than it was only a few years ago. Back in 2007 a pound bought you $2.10, that figure now stands at $1.65. Likewise in 2007 a pound bought you 2.49 Swiss Francs, today it only buys you 1.5. Oh well, at least all this might mean a boost to the Cornwall tourist industry!

What does this all mean for UK investors?

Prepare for inflation. Invest in real assets- commodities, precious metals and real estate. It might be sensible to diversify the currency of your asset holdings too. As I have said before, look for strong currencies with well run governments. The Swiss Franc and Norwegian Krone look good bets to me.

Inflation vs Deflation

This is the hot debate in the investment community.

Deflation would favour fixed income investments and cash. Inflation would favour commodities, precious metals and resource related stocks.

For the UK I think inflation will be the problem. Our deficit as a % of GDP is one of the highest in the world, and even if the Conservative government push through all these spending cuts our deficit as a % of GDP will still be on a very unsustainable path. For the Eurozone I think deflation will be more of a problem because of the lack of any quantitative easing and the Eurozone’s inflexible exchange rate.

Compared to the size of our money supply the UK’s quantitative easing program was massive, larger than that of the US in relative terms. This only spells one thing, inflation.

There are few options remaining in order to solve this mess for the UK- we could default on our debt, we could inflate our debt away or we could depreciate our currency so that our debt commitments are worth less to foreign holders. I think we will see a combination of inflation along with a depreciating currency which means we will be importing inflation too!

To protect yourself from weakening sterling it would be wise to put some money in strong currencies- these include Norwegian Krone, Swiss Francs and the Australian Dollar. Exposure could be gained through foreign currency denominated accounts with high street banks, ETF’s, foreign denominated assets or simply holding foreign cash.