Lessons From The United Kingdom

Includes: EWU, FXB
by: George Liu

On Tuesday, January 22nd, the Bank of England Governor Mervyn King declared that the United Kingdom's (NYSEARCA:EWU) 2012 Q4 GDP will be significantly weaker than the reported Q3 GDP. On the surface, this statement is understandable: the U.K.'s 0.9% Q3 GDP growth was due to the U.K.'s hosting of the Olympics, a significant one-time economic boost. However, if examined further, the BOE's weak projections for the 2012 Q4 GDP figures are representative of a larger, more troubling trend: the significantly detrimental effects of the U.K.'s implementation of fiscal austerity.

Under George Osborne, the Chancellor of the Exchequer since May 2010, the U.K. has adopted a series of harsh austerity measures that have, in some cases, cut up to 30% off of the budgets of various government departments. Osborne promised that his policies would not only put the United Kingdom in sound fiscal order but would also generate healthy economic growth.

His policies have resulted in neither. Before Osborne came into office, the U.K. was steadily recovering and GDP growth was recovering, as shown through this graph.

(Click to enlarge)

And then Osborne's austerity measures took effect:

(Click to enlarge)

(Again, the huge 0.9% increase in 2012 Q3 GDP is largely attributed to the economic effects of the Olympics.)

As a result of the austerity measures, the United Kingdom recently experienced its longest double-dip recession in 50 years. Moreover, the U.K. Office of Budget Responsibility forecasts a 2012 GDP decline of 0.1%, which comes after a stagnant 0.7% growth in GDP for 2011. The recovery of the U.K. economy is also noticeably slower than that of many other industrialized countries: the Bank of England notes a cumulative rise in output from the middle of 2009 of only about 3 ½% compared with 6% or more in many other countries.

One of the main pillars of Osborne's austerity measures was the maintaining of the U.K.'s AAA credit rating; ironically, because of the anemic economic growth and slow fiscal progress resulting from these measures, many economists now expect the U.K. to lose its AAA rating from at least one credit rating agency. Osborne's austerity plan also failed to pass one of the U.K. government's self-imposed debt-cutting goals. Similarly, Osborne's vow that the U.K.'s debt-to-GDP ratio will peak at 70% has been broken: the U.K.'s current debt-to-GDP ratio is 75% and is expected to rise to nearly 80% in 2015.

In light of the implementation of austerity measures throughout the United Kingdom, large bodies of research have shown that austerity measures combined with a recessionary economy do not work. For one, the United Nations recently issued its "Word Economic Situation and Prospects 2013" report, which urges an end to "counterproductive austerity programmes in industrialized countries" and notes that the "Euro zone's debt crisis and austerity policies continue to tamp down growth."

The IMF also recently concluded in its Fiscal Monitor report that attempting to cut the deficit too aggressively can actually increase a country's debt-to-GDP ratio. It declared that austerity has caused significant economic damage and admitted its projections about the fiscal multiplier (which had boosted the IMF's aid-for-austerity approach with countries such as Greece) were significantly off. As a result, while IMF economists expected that cutting a euro from the budget would cost around 50 cents in lost growth, the actual impact was calculated to be approximately 1.50 per euro. This research comes on top of remarks by IMF Managing Director Christine Lagarde that seem to indicate a subtle yet significant change in the IMF's stance on austerity: at an annual IMF meeting in October, Lagarde declared that "reducing public debt is incredibly difficult without growth" and advised countries not to sacrifice growth for austerity.

Despite the increasing evidence of the ineffectiveness of austerity in a recessionary economic climate, Osborne's fiscal crusade shows no signs of abating; recently, he even signaled that austerity measures will run through at least 2018 in light of its ineffectiveness.

Osborne's stubborn adherence to austerity could benefit savvy investors. The projections for U.K.'s economy aren't rosy; the Office for Budget Responsibility recently guided down 2013 GDP growth estimates to 1.2% from a previous 2%. The continued economic weakness resulting from Osborne's austerity will most likely force the Bank of England to continue its quantitative easing; recent hints by BoE governor Mervyn King make additional easing seem like an inevitability. As of now, a play on the future weakness of the pound sterling (NYSEARCA:FXB) seems like a wise choice.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.