Is spending really going to save us?

It’s pretty much accepted now that the UK economy is headed for tough times. Even Alastair Darling, whose glasses must be so rosy that he has trouble telling red from green, expects negative economic growth in 2009, with all the misery of business failures and redundancies that this will bring.

The policy response to this impending recession is straight out of the Keynesian macroeconomic textbook; a combination of fiscal stimulus aimed at restoring the vigour of the UK consumer, bullying the banks to resume lending to homebuyers, consumers and businesses at the heady levels of 2007, and accelerated government spending. All of the above to be financed on the nation’s credit card.

It is questionable whether the prescription is strong enough to have any effect on the ailing UK economy. I also wonder whether the prescription is the right one.

The UK economy is in the grip of a huge hangover. After years of living the high life on borrowed money, the bill has arrived and the ‘morning after the night before’ isn’t proving to be very pleasant. A ‘hair of the dog’ to defer the pain is an attractive option but will it just make the final reckoning even more painful?

In the last few years, the UK has been consuming more than it earns. Consumer debt has mushroomed and the housing market has blown up into a big bubble on the back of cheap interest rates, increasing income multiples and loans to value of up to 125 per cent. The UK savings rate has been declining over the same period.

As UK savers have not provided the banks with the deposits to lend out in this credit explosion, the banks have looked to the wholesale money markets to fill the gap between deposits taken and loans advanced. A significant proportion of this funding came from overseas, particularly those countries providing us with the commodities and manufactured goods on which we’ve been splurging with our credit cards.

These chaps have decided that they don’t like what they see in the UK economy and want their cash back. As a result, UK banks can’t borrow on the wholesale money markets (and hence can’t lend – despite the protestations of the government) and sterling has collapsed as this ‘hot’ money is exchanged out of sterling into other ‘safer’ currencies.

In this context, rather than behaving like a junkie desperately in search of one last ‘hit’ of debt, would it not be better to go ‘cold turkey’, face reality and move to a position where, as a country, we consume what we can actually afford to pay for? An increase in savings rates will slowly restore the banks’ balance sheets so they can begin lending again (although not at the over-heated levels of the last couple of years). The recent fall in the pound will actually improve the competitiveness of UK manufacturing, both in the UK and abroad.

Government spending aimed at helping UK companies recruit and train staff to develop products attractive to export markets, along with a reduction in payroll taxes to reduce the cost to businesses of keeping people in employment, strikes me as being a better prescription for the patient than one last fix of the rampant consumption that put us here in the first place.