Somethings rotten in the state of Britain

Written by Bloomberg | Updated: Oct 30 2009, 04:03am hrs
Matthew Lynn

Germany has clawed its way out of recession. France is growing again. The US is starting to expand. Even Ireland isnt contracting anymore. And yet the UK economy keeps getting smaller. Gross domestic product dropped 0.4 % in the third quarter. At this rate, even Iceland will pull out of recession before the UK does.

PM Gordon Brown keeps boasting he has the right policies to guide the country out of the woods. The truth is that they arent working. Before it can recover, the UK needs a 180-degree change in direction. It must curb budget deficit, support the pound, stop printing money, and cut taxes. This is now the longest recession since records began in 1955. While the rest of the world recovers, the UK hasnt. There is no sign of life in manufacturing, nor much in retail or services. The pound edges closer to parity with the euro every week: When it does, expect it to go into freefall.

It isnt hard to figure out why. The UK economy was puffed up on a wave of borrowing and speculation. According to Goodbody Stockbrokers, UK households have debts worth 183 % of disposable income. That is the highest of any major economy. Even the US is only on 134 %. In France, it is just 100 %, and in Germany 99 %. The UK used to have a private debt problem. Now it has a private and a public debt problem. A collapse in tax revenue coupled with rising welfare bills to pay for the increase in unemployment has led to a widening gap between what the government receives and what it pays every month.

In September, it ran a 14.8 billion-pound ($24.6 billion) deficit, the biggest ever recorded for that month. The half-year shortfall was the largest since records began in 1946, when the country still had the small matter of World War II to pay for. The UK is disappearing under a tidal wave of borrowing. So far, the response from the government and the Bank of England has been straight out of the economics textbooks.

Interest rates have been cut, the government maintains spending and allows the deficit to balloon, the pound depreciates against the euro, and quantitative easing has pumped cash into the system. The economy has been stimulated, stimulated and stimulated again. It has failed to respond.

So whats the answer Yet more stimulus More debt Printing more money Devaluing the pound by another 30 % Yet, as any doctor will tell you, when the patient doesnt respond to the treatment, its time to change the medicine. In reality, the UK needs a total change of direction. It needs to do four things to get it back on the road to recovery.

First, stop printing money. There is no evidence to suggest the programme of quantitative easing has done anything other than re-ignite another bubble. Stocks are soaring, banks are minting money, and the property market is starting to fizz again. But the UK didnt need more debt-financed froth. It needed to start building new industries, and printing money isnt helping that.

Two, get the budget deficit under control. At more than 12.5 % of GDP, the UK is running up debts at an unsustainable rate. Everyone knows that taxes must rise to pay for it, and services are going to be cut as well. All it does is undermine confidence, and stop people spending now, because they know they will have to pay higher taxes further down the road.

Three, support the pound. A modern, advanced nation cant devalue its way out of trouble. The idea that the UK is going to suddenly build lots of factories that compete with Eastern Europe and China on price is ridiculous. Britain can export plenty of things, but they are high-end, design and technology-intensive goods and services. Those products depend less on prices. There is no sign of exports picking up as a result of the pounds collapse. All it does is destroy confidence.

Four, cut taxes for business. The UK used to be the low-cost destination in Europe. It has squandered that position, ceding ground to Ireland, Switzerland and just about everywhere else. Right now, the UK is raising taxes. How is that going to help

The UK went into this recession in terrible structural shape. It was too reliant on banking and financial services, its competitiveness had slipped, the state was expanding in size, and it was building up too much debt. Getting out was always going to be a long, painful slog. Instead, it has been going for the quick fix of an artificial stimulus. The trouble is, its not a fix and its not working. The only way the UK can save itself is with radical changes.