UK Economy: A Three-Way Bet to Avoid a Triple Dip

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By Martin Baccardax | January 25, 2013 10:40 PM EST

The three men with the most collective influence on Britain's economic recovery have gambled both their credibility and their legacies on an all-in bet that has yet to show any signs of a winning hand.

Chancellor George Osborne's strategy of fiscal austerity, coupled with Bank of England Governor Mervyn King's policy of quantitative easing and the announcement of a future-defining referendum on Britain's relationship with its most important trading partner from Prime Minister David Cameron, have all placed incredibly valuable cards on the table in a three-part wager that could make or break Britain's economic prospects for the next decade.

A slip back into contraction over the final three months of last year, as detailed Friday by the Office for National Statistics, sets up the real and credible prospect of a so-called "triple-dip" recession, the first of its kind outside the Second World War and the worst economic performance since modern records began nearly 100 years ago.

In some respects, however, that might be the least of the risks being taken by Cameron, Osborne and King as they struggle to right a debt-laden economy that has yet to fully recover from the global financial crisis some five years on.

The UK's coveted triple-A credit rating - the independent assessment specifically touted by Osborne himself as the benchmark by which to judge his fiscal strategy - could be lost at any moment, as each of the three major ratings agencies have warned over the past year. The justification for such a move is certainly much stronger now, not only given the weak economic performance but also the fact that Britain now sits atop more borrowed money in both real - £1.11 trillion - and proportional - 70.7 percent of GDP - than at any other time in history.

The impact on Britain's borrowing costs remains to be seen, and in truth is unlikely to be terribly dramatic, but the optics of a downgrade in the face of domestic and international criticism to what many see as a "too fast, too soon" series of spending cuts would be a punishing blow to the Chancellor's reputation, not to mention his political career.

Inflation looms?

What may take longer to materialise, but will nonetheless trouble investors and consumers, is the prospect of significantly faster inflation as a result of both the current record low interest rates and the BoE's £375bn asset purchase programme, known colloquially as quantitative easing. Compounding that concern are suggestions that incoming Governor Mark Carney may elect to switch the Bank's focus from targeting a specific rate of inflation to instead seeking a particular rate of economic growth.

Given that the current QE programme - which has monetised government debt worth around 25 percent of GDP - has failed to ignite growth, a deeper and looser programme of policies that target economic expansion would implicitly imply the tolerance of much faster inflation until consistent growth is achieved.

All this, of course, comes against the rapidly-changing political paradigm between Britain and Europe thanks to the newly-minted referendum promise made earlier this week by the Prime Minister.

The simplicity of the response from the Confederation of British Industry - which recognises the "benefits of retaining membership of what must be a reformed EU" and that the "single market is fundamental to Britain's future economic success" - belies the tremendous difficulty the Prime Minister will face in achieving the first without permanently jeopardising the second.

Even if only one of the three scenarios were to fully develop - and the most likely is the loss of the triple-A rating - the impact would be at best a mild negative for Britain's longer-term recovery.

Should that failed gamble be matched by accelerating inflation and wider foreign investor concern over Britain's place in the world's largest single market, the implications for borrowing, growth and job creation could be catastrophic.

Asymmetric Risk

And that's the biggest concern many have with the current hand being played: the downside risk far outweighs the potential gains of a getting all three of them right.

At best, the Chancellor will succeed in clinging onto a largely symbolic endorsement that lenders have, for the most part, ceased to care about. At worst his spending cuts will permanently destroy economic capacity and leave a gaping hole of underinvestment in the nation's already-creaking infrastructure.

Meanwhile, King's asset purchase programme won't be unwound during his tenure, but the results won't be apparent for many years to come, by which time most will have associated the success of any recovery to his replacement. Nor will it mitigate the growing perception of the Bank's lost independence from government influence and a too-close relationship with the City of London.

Cameron, meanwhile, can gain little more than a pyrrhic victory if by some miracle he's both still Prime Minster in 2017 and the British people choose to leave the European Union when it's at its most vulnerable - timing that's bound to weigh on the minds of European leaders as they define trade terms for the future.

At worst, he risks the isolation from both Europe's aging but affluent consumers and its younger but underemployed workforce, and the irritation of its single-most important political ally in the United States.

Far too much risk. Very little reward.

Not the smartest gambling strategy. 

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