Falling Pound Raises Fears of Stagnation

Falling Pound Raises Fears of Stagnation

By JULIA WERDIGIER and NELSON D. SCHWARTZ
Published: January 21, 2009
LONDON — An island nation that bulked up on debt and lived beyond its means. A plunging currency. And a financial system edging toward nationalization.


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With the pound at a multidecade low and British banks requiring ever-larger injections of taxpayer cash, it is no wonder that observers have started to refer to London as “Reykjavik-on-Thames.”
While that judgment seems exaggerated, there are uncomfortable parallels between Iceland’s recent financial downfall and Britain’s trajectory. Equally important, news that widening bank losses in Britain have necessitated another round of government life support provides a stark example to the United States.
Washington’s attempts to stabilize financial institutions have failed so far, as well. And now the Obama administration, along with the rest of the world, could watch Britain to see what a bank nationalization might look like, and what it might suggest for American banks.
Ordinary Britons have a more basic worry. After relishing the boom that transformed the drab United Kingdom into Cool Britannia, they fear that the disheartening economic stagnation of the 1970s might return.
The pound, a symbol of British independence from the Continent that is revered nearly as much as the queen, is now down nearly 29 percent against the dollar from a year ago.
There has been a steady drumbeat of gloomy economic news for months, but the mood in Britain has darkened starkly in recent days.
On Monday, Royal Bank of Scotland warned that its 2008 losses could hit £28 billion, or $38 billion, even as Prime Minister Gordon Brown announced a second bailout package for the troubled banking sector worth tens of billions of pounds. Ultimately, the British rescue effort could cost at least £350 billion, with some estimates ranging far higher.
But in contrast to last autumn, when Mr. Brown’s first bailout plan was highly praised, this package has been greeted with anxiety. While few question the need for a quick response, the sheer scale of the borrowing being discussed, as well as the existing debt levels among corporations and consumers alike, alarms many analysts and economists.
“I fully back what the government is doing, but there is a risk of being Iceland on the Thames,” said Will Hutton, an economic expert who is executive vice chairman of the Work Foundation, a nonprofit research firm. “And the more sterling falls, the greater our liabilities in terms of what we owe.”
The pound fell to $1.3618 on Wednesday, its lowest level against the dollar since September 1985, before recovering to $1.3922.
Even more than their American counterparts, borrowers in Britain turned to local banks to fuel a real estate boom that was as much a national pastime as a rational decision about what to buy. Household debt as a percentage of disposable income hit 177 percent in 2007, compared with 141 percent in the United States.
Now, with both housing prices dropping and institutions like the Royal Bank of Scotland buckling, the British economic outlook looks even bleaker than the landscape in the United States and the euro zone, the countries that use the euro.
The British economy is expected to shrink by 2.9 percent this year, compared with a 2.6 percent drop in the euro zone and a 2.1 percent contraction in the United States, according to Gilles Moëc, senior economist with the Bank of America in London.
To make matters worse, Mr. Moëc said, Britain is facing a wave of deficit spending, as tax receipts fall and the costs of unemployment benefits and other services rise. He predicts the budget deficit will equal 9.4 percent of gross domestic product in 2009, compared with 4.9 percent in the euro zone and 8.4 percent in the United States.
“It’s scary,” he said. “It reminds me of what you could find in southern Europe 15 years ago, during the worst years in Italy or Greece.”
British stocks have followed the pound lower in recent days as well. The benchmark FTSE index has fallen 2.1 percent this week, led by a plunge in the shares of many leading banks.
The government already controls a majority share in Royal Bank of Scotland, but the prospect of a full nationalization of the bank has alarmed investors, and shares of RBS have plunged 64 percent in the last three days. The prospect of nationalization haunts other troubled banks as well — Barclays is down 33 percent and Lloyds Banking Group is off 54 percent.
As in Iceland, banks, real estate and other financial services boomed in London in recent years, even as other swaths of the economy withered. In recent years, this sector has been responsible for about half of total job growth in Britain even though it accounts for only about 30 percent of the economy, according to Peter Dixon, economist for Britain at Commerzbank in London.
Consumers were also lulled into taking on more and more debt by the unusually steady economic expansion Britain enjoyed until last year, Mr. Dixon said. Growth averaged 2.7 percent annually over the last decade. “The last 10 years were phenomenally stable, with volatility at its lowest point since the 19th century,” he said.
But that prosperity camouflaged a steadily weakening manufacturing base, unlike in Germany, where the industrial sector is a relative counterweight to the outsize problems of financial firms.
For all the debt weighing down British banks, though, Iceland’s situation was far worse before the government was forced to nationalize the banking sector last fall as the krona collapsed.
British bank assets total about 4.5 times the country’s gross domestic product, but in Iceland they were 10 times as large as the G.D.P., Mr. Hutton said.
That does not mean there is not a price to pay for Britons even now. The pound has plunged before and each time is remembered as a humiliating experience that scarred the nation.
In 1976, the government was forced to approach the International Monetary Fund for help after the pound dropped below $2 for the first time. In 1992, the pound dropped out of the European exchange rate mechanism as interest rates hit 15 percent and Britain was in a recession.
A weak pound also weighs on the psyche of the British, most of whom are reducing spending while watching a flood of euro- and dollar-rich tourists hunt for bargains in their shops.
Jeremy Stretch, senior currency strategist at Rabobank in London, said Britons might learn that a weak pound can be helpful.
A weaker pound would make British exporters more competitive, for example, thus reducing Britain’s dependence on the City, as London’s financial district is known, for future growth.
Mr. Stretch also said that Britain’s current economic problems were different from the 1970s and 1990s because it was far from alone this time around.
“The salvation of the pound is that its problem is not a pound-specific problem,” he said. “At the moment, we’re looking the ugliest. But if you sell the pound, what will you buy?”
Julia Werdigier reported from London and Nelson D. Schwartz from Paris.



http://www.nytimes.com/2009/01/22/business/worldbusiness/22pound.html?_r=1&ref=todayspaper