After the U.K. Downgrade (Wall Street Journal)

George Osborne is banking Britain’s future on high-speed rail and green energy. Lost decades, here we come writes CPS Research Fellow Rupert Darwall for the Wall Street Journal. 

To view the article at its original posting, visit the Wall Street Journal

“For a generation after the searing experience of Britain’s 1976 IMF bailout, successive chancellors of the exchequer believed it critical to sustain confidence in sterling. The reaction to the loss of Britain’s triple-A rating suggests this era is over.

Retaining confidence ought to be at a premium. Inflation is stubbornly above target and forecast to remain so. The pace of fiscal consolidation, despite calls to slow it down, could scarcely be slower. This year, net public borrowing—adjusted for one-offs—is expected to fall by £1.1 billion. Instead, Chancellor George Osborne insisted that the test of economic policy was keeping interest rates low.

In this, Mr. Osborne has an ally in Mark Carney, the incoming governor of the Bank of England. Mr. Carney has declared that monetary policy is not “maxed out.” The current governor, Mervyn King, is more circumspect. Despite voting for more quantitative easing, Mr. King noted that the increase in the bank’s balance sheet is greater relative to GDP than that in the United States, Japan or the euro area. Loose money works by bringing forward spending from the future to the present. “As time passes, larger and larger doses of stimulus are required.”

The governor went on to argue that there has never been a better time to boost the supply capacity of the British economy and increase the rate of return on new investment. Yet the government’s policies are doing the opposite, leading Britain into Japan-style lost decades without the bulwark of Japan’s trade surplus—but with the addition of a looming energy crunch.

In the 1990s, Western economists advised the Japanese that they needed to aggressively write off impaired bank loans. When it was put to Mr. Osborne that he should restructure state-controlled Royal Bank of Scotland, the chancellor candidly admitted that it was “presentationally” too difficult and blamed the banks for the sluggish state of the economy.

Along with Japan’s ultra-low interest rates and political timidity in cleaning up the banking system, Britain’s politicians are pinning their hopes of economic revival on building a new railway line. “This can be a critical engine for growth that will help to revolutionize Britain,” a junior rail minister enthused on a recent visit to Japan, oblivious to the evident failure of rail investment to reinvigorate the Japanese economy.

Even based on official numbers, the £34.5 billion HS2 project barely generates enough benefits to cover its anticipated costs. The surest thing about rail projects is that their revenue forecasts won’t be met. Whatever way the financing is initially structured, HS2 will end up adding to public sector debt while earning a derisory return.

More immediate and far more damaging is the negative supply shock on its way from the energy sector, as the U.K. begins a conservatively estimated £95 billion transition to less efficient and less productive green energy. When the U.S. was assessing the impact of modest emission reductions in the run up to the 1992 Rio Earth summit, the Council of Economic Advisers examined the response of the U.S. economy to the oil shocks of the 1970s. Carbon emissions were flat, but so was the economy.

That comparison bodes ill for the U.K. On a low-growth scenario set out by the energy regulator Ofgem, carbon emissions are projected by 2020 to fall by 18%. Electricity bills, meanwhile, are expected to increase by 22%. Higher energy costs are already keeping inflation above target, hitting households’ ability to reduce their indebtedness.

But this misses out the full macroeconomic impact of the green-energy crunch. The Bank of England and the Office of Budget Responsibility have not factored in the contraction in the U.K.’s productive capacity and lower trend growth, which will increase the burden of Britain’s rising debt. Nor was it mentioned by Moody’s when it downgraded U.K. government debt last month.

As the U.S. enters an era of cheap, abundant energy, the test of U.K. energy policy is to keep the lights on. Ofgem chief executive Alistair Buchanan disingenuously portrays this looming disaster as a consequence of cheap coal driving gas-fired plants out of commission, plus the financial crisis hitting the financing of windpower. Those nasty bankers again!

Why isn’t the U.K. benefiting from cheap coal? Because coal is deemed too dirty. In 2008, NASA scientist James Hansen and Greenpeace successfully campaigned against the construction of the £1 billion Kingsnorth coal-fired power station. Meanwhile EU regulations required the phasing out of older coal- and oil-fired stations. As panic began to mount within Whitehall, the government asked the generating companies whether the U.K. should seek a derogation. Given the pricing power that supply constraints give them, they predictably told the government it was too late.

In the 1970s, the British economy suffered a negative energy shock thanks to OPEC and the National Union of Mineworkers. In this decade, a similar shock is coming courtesy of green NGOs and government ministers. According to Mr. Buchanan, the battle to avoid the lights going out requires higher prices and “energy demand reduction.”

This is a toxic combination for an economy that needs both to rebalance toward exports and to reduce debt burdens by growing disposable income. If the government finds it too politically difficult to change course, then for the U.K. economy, worse is yet to come.”

To view the article at its original posting, visit the Wall Street Journal

Date Added: Wednesday 6th March 2013