Sunday, July 04, 2010

David Cameron may face his Major/Lamont moment

There was tension in our insurance office on Wednesday, 16th September 1992. The British government was fighting to remain in the Exchange Rate Mechanism, which pegged the pound to 2.95 Deutschmarks. George Soros, we later discovered, had started a run on the pound with a massive "short" that would soon net him one of his several billions.

The government was using the interest rate as its defensive weapon. The rate had leapt from 10% to 12% at lunchtime. Still unconvinced, the currency traders continued dumping the pound, which the government frantically bought by the billion to support its value.

Then came the moment of truth - or rather, an utterly implausible bluff, instantly called: the Chancellor shoved the rate up to 15%. While we in the office were dazedly contemplating the effect on our mortgage clients, the market knew it had won. 15% just couldn't be done. Britain was ejected from the ERM like a pip from a crushed lemon.

As every teacher, as every parent knows, you musn't threaten what you cannot perform. When you overreach, your credibility is busted. And I fear that David Cameron may be skirting very close to that point.

Cameron has let the papers know about wargame economic scenarios to cut public spending by as much as 40%, a figure that would have barely-conceivable consequences. Clearly this is to scare policymakers and departments into crystallising proposals for much lesser reductions.

Yet there is a whiff of desperation in this big-stick-waving and weekend-news-leaking, and if the markets scent fear and self-doubt at the heart of government, the hunt may begin.

The initial figure of £6 billion in savings, yet to be turned into concrete plans, was merely a stopgap to reassure the bond markets that the new government intends to get control of the budget. Compared to the accumulated and increasing public debt, this first cut is a drop in the ocean. It's held off the short-sellers for now and we retain our official AAA credit rating, which allows us to keep down the interest rate.

Unofficially, our rating has already fallen to "AA", according to the credit insurance market. If interest rates go up, debt servicing becomes much more difficult, not only for the government but even more so for the worker-consumer - private debt in the British economy is far greater and Joe Public pays above the bank lending rate, so he can support all those people in glass-and-marble offices who send him his mortgage and credit card statements.

So if the market senses a panicky bluff, up go the rates and down goes the pound, real estate, the stockmarket and the trading value of bonds.

Mr Cameron will have to talk tough, just enough.

DISCLAIMER: Nothing here should be taken as personal advice, financial or otherwise. No liability is accepted for third-party content, whether incorporated in or linked to this blog.

1 comment:

The Economic Voice said...

Good point and well made.

I think that the 40% is a paper exercise to give the government options of which departments to cut the most for the least adverse effect.

However, the 'Sir Humphrey' effect coupled with ministers not wanting to lose power will drive many to over-egg the potential effects of the cuts on their own depts making the whole exercise a waste of time.

Jeff Taylor