'The Cycle Is No Worse Here than Anywhere Else' Why Britain May Fare Better Than Expected

Britain's finances are indeed a mess, but the economy is no worse than the rest of Europe and the United States -- and housing is even picking up speed.
Von Stanley Reed und Kerry Capell

Is Britain in danger of once more becoming the sick man of Europe? A return to the chronic economic malaise of the 1970s and 1980s is easy to imagine, given the government's frantic efforts to save the country's biggest banks and restore confidence to a demoralized public. On top of everything else, Standard & Poor's on May 21 shocked the country and the world by warning that Britain's soaring public debt might eventually force the ratings agency to withdraw its AAA seal of approval.

S&P says Britain's recently passed budget "underscored that U.K. public finances are deteriorating rapidly," with debt now looking likely to approach 100 percent of gross domestic product by 2013, rather than the 83 percent the ratings agency had earlier assumed. But by many measures the British economy doesn't look any worse than that of its European neighbors or the US. The once-moribund housing market is showing signs of life, while retail sales actually recorded a sharp 4.6 percent increase in April, possibly influenced by a balmy Easter. "The cycle is no worse here than everywhere else," says Ben Broadbent, U.K. economist at Goldman Sachs in London.

The S&P move has some economists scratching their heads. Jamie Dannhauser, senior economist at Lombard Street Research in London says the U.S. and Britain "will suffer far less severe recessions than Japan, Germany, and others. The idea of singling out Britain as a desperate case is ridiculous," he says. Goldman, in fact, forecasts that Britain will top the big mature industrialized economies in growth next year with a 1.9 percent uptick in GDP, compared with 1.2 percent for the U.S. and 0.7 percent for the 16 countries comprising the euro zone. Some British companies, such as Richard Branson's Virgin Atlantic, which reported a near doubling of pretax profits for the fiscal year through February 2009, to $109 million (€79 million), already are bucking the gloomy trend, though Virgin warns this year will be tougher.

A Currency Comeback

In the currency markets, where the economic prospects of nations are assessed by traders every minute, Britain has been on the rebound after taking a severe beating. The pound sterling plummeted an extraordinary 35% from its peak in November 2007, but since March it has climbed back about 17 percent, to $1.60 (€1.16).

The market probably has overshot, as it often does. But being outside the euro zone and not living under the monetary policy of the sluggish European Central Bank may be helping Britain. The sharp decline in the pound made British exports more competitive last year-slashing the current account deficit by almost half in 2008, to 1.7 percent of GDP or $38 billion (€27 billion). Because most British mortgages are pegged to short-term interest rates, the Bank of England's relentless hacking away at rates to 0.5 percent has trimmed many homeowners' expenses. The BoE's moves contributed heavily to last year's 6.6 percent nominal rise in household income by putting more money in homeowners' wallets. "The monetary transmission process works faster here than in other countries," says David Woo, an economist at Barclays Capital in London, who notes that many of his colleagues are now paying almost no interest on their mortgages.

As an open economy with one of the world's top two financial centers, Britain responds quickly to global trends. The recent surges in bond issuance, oil prices, and world stock indexes are bound to translate into hiring and higher pay in Britain's financial sector. Huw van Steenis, banking analyst at Morgan Stanley (MS) in London, says profits before write-offs at European banks in the first quarter of 2009 were up a fat 27 percent. The "self-belief" of bank CEOs is recovering, he says, and once again "the best people have three or four [job] offers."

Deficits Could Cost Labour

So what is S&P worried about? The Labour Prime Ministers Tony Blair and Gordon Brown reversed the trend of the Thatcher years, increasing government spending by about 5 percent of GDP -- all for what appears now to have been little gain in areas such as health care and education. In addition, S&P estimates Britain's bank bailout costs at $160 billion (€116 billion) to $230 billion (€166 billion). Yawning deficits could test Britain's ability to meet its fiscal obligations.

In the past, British governments such as Thatcher's made the tough decisions needed to straighten out fiscal messes. As S&P notes, an election must be held within the next year, and the polls suggest that Brown and Labour will be swept out. In that case, the recovery now under way could be combined with the budget discipline of a new Conservative government. "If comprehensive measures are implemented to place the public finances on a sustainable footing," S&P says, the agency would be prepared to back off and change its outlook on the U.K. rating from "negative" to "stable." The saga of Britain's recovery is far from over.

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