Will Cameron's Cuts Cost the UK?

It’s no secret that the United Kingdom, like the other industrialized economies, is going through a bit of a hard spill. Growth is slow, barely above par for the year, and inflation is rising hard and fast. Inflation is rising so fast, in fact, that British law required Bank of England Governor Mervyn King to address the situation personally in a letter to the newly elected Chancellor of the Exchequer George Osbourne.

The situation has left English lawmakers clawing for potential solutions – whether feasible or not. Today the biggest hope is in the form of $9 billion in budget cuts – an idea that helped now-Prime Minister David Cameron and his coalition win the May 6 election. But $9 billion is simply staggering… and is it truly the right move given the current economic environment?

Let’s start off with the proposed budget cuts. Details of the reduction plan are utterly restrictive, with most branches of the government preparing to feel the pinch. Local governments and regional public works are going to feel the brunt of the budget plan, making due with a shortfall of $1.12 billion in national funding in the coming quarters. The astronomical number is closely followed by a further $1.014 billion in estimated cuts for administrative offices. Additionally, large reductions are set for programs in transportation and employee pensions. Policymakers have been careful to point out, however, that certain areas in education and medical services won’t be harmed. Nonetheless, budget reductions will lead to strict cost reductions that, in more cases than none, will increase layoffs – causing far more problems than solutions. Then why implement the reductions in the first place? Simply put, with investor concern growing over the recent fiscal solvency of European countries, massive cuts could be a good first step on the road to recovery.

UK Budget Cuts
Proposed Budget Cuts (in millions), Source: Financial Times

But this ignores the question that investors should be asking: If record-low interest rates and quantitative easing didn’t help Britain’s battered economy, will the government’s budget cuts work? Not a chance. Strict cuts are actually likely to choke off consumer spending further, especially in an economy that is heavily reliant on its services sector. Spenders won’t spend if they are worrying about when the next paycheck is coming to the bank. Ultimately, lower consumer interest leads to lower overall spending, higher unemployment and falling rates of growth – none of which are the hallmarks of a recovery.

Moreover, should budget cuts go horribly awry, there is no contingency plan. Ordinarily, central banks like the Bank of England fight economic turmoil and consumer apathy with interest rates. However, what can policymakers do when rates are already at record lows? Investors have seen this scenario before, and it doesn’t end pretty. Japan, the world’s second-largest economy, remains in a similar situation. Even as the country’s central bank continues to keep rates at an appalling 0.10%, consumers are still reluctant to spend. Without consumption, overall growth for the Asian economy continues to teeter around zero, still far from the glory days of the 1980s.

But how will this all affect the country’s currency, the pound sterling? Economic fundamentals are key to any currency’s movement. In a nutshell, positive growth in a country will make its investments more attractive to foreign investors – increasing the demand for that country’s currency. But the inverse is also possible. For the United Kingdom, upward prospects for the British economy are limited – leaving a lot of downward pressure for the currency in the long term. Not surprising, foreign exchange trader sentiment is in line with the bearish outlook. The Commodities Futures Trading Commission’s most recent weekly report on futures trading activity shows an overwhelming number of traders with sell positions on the British pound. The sentiment is so pessimistic, there are 8 sell positions for every 1 buy position – worth a record $7 billion. This means that traders are betting that there isn’t much to keep the U.K. economy, or its currency, moving higher in the long term.

Ultimately, it will take a bit of time to see how the current budget reduction plan will make its way through the economy and what, if any, further changes may be on the horizon. But it doesn’t look good. Budget cuts have done nothing but restrict growth for countries throughout history, making it harder to build a solid foundation of growth. Additionally, there are fewer options and strategies to apply if things go haywire. The Bank of England will have little power to do anything should budget cuts produce disastrous results. As a result, the likely scenario will support further moves lower in the British pound against other major currencies, without a break in the long term.

Richard Lee
for The Daily Reckoning