The UK, in 1979, was a mess.
In 1976, the then-Labour government of James Callaghan became the first developed-nation member of the OECD to have to beg the IMF for a bail-out after economic collapse. The top tax bracket was 83%, excluding tax on dividends and interest, while the bottom bracket was 33%. The European Economic Community (precursor to the EU) made an additional $3 billion available on top of the $3.6 billion from the IMF.
The damage of high taxation, high wages and terrible red tape was causing businesses to collapse and, as they fell, government nationalised them.
The Britain that Margaret Thatcher “won” 30 years ago, in 1979, was wracked by daily strikes by millions of unionised workers. Their wage packets, under the Labour government, were being increased by 30% annually but with no concomitant increase in efficiency or production.
The setting for a battle royal was in place. No-one doubted that getting England back to work would require incredible hardship. Few felt it would be possible.
Most of the problems were caused by state expenditure and promises that were completely out of control. When asked, by a very hostile “meet the press” panel on Panorama on the BBC in 1977, whether the Thatcher government would be opposed to unions, she replied, “Unions are not confronting government. Government doesn’t pay for anything. People do.”
“If they’re going to earn their increases then jolly good luck to them, and jolly good luck to anyone who earns their increase. We all need them. If not, then those increases have to come out in higher prices or in higher unemployment.”
It was a turning-point for the economic fortunes of the UK.
Now we are in the grip of an economic crisis that threatens a similar disaster, this time to the world.
The seeds of the credit crisis
There are two crises at work.
The first is caused by a shortage of liquidity. Businesses regularly use short-term finance to cover daily costs like stock, and wages and so on. This allows them to cover the variance between product sales and business expenses. However, the credit crisis has not only reduced the absolute amount of cash for lending, but also made banks and investors with cash somewhat paranoid.
The knock-on effect of limited liquidity has seen consumers stop spending, companies cut production, and millions of people around the world lose their jobs.
Export-driven economies, like Germany, Japan and China, have seen catastrophic falls in production even though they had virtually no exposure to the subprime credit mess.
The second crisis was one that has been around for a while; that of overcapacity and weak business models in a number of large industries. The most obvious of these is the motor industry. GM, Ford and Chrysler were in plenty of trouble long before the credit crisis, however, their marginal businesses have been crushed by falling demand.
All of these things have come together in a moment of horror for legislators and the general public.
There is a lot of debate about how to solve the problem. Where businesses are unable to provide liquidity, governments believe they should step in to ensure that liquidity flows. However, at the same time, governments are attempting to support larger businesses that they feel are “too big to fail” with direct subsidies and bail-outs.
While central bankers look to loosen lending policy, governments are raising big stimulus packages to finance their new industry subsidies.
It is estimated that some $ 3 trillion of additional state expenditure will have to be raised over the next 12 months to support these promises.
This money is not going to come from taxpayers just yet. They will certainly have to foot the bill into the future, but – in the short term – that money has to come from somewhere else.
Paying for the rescue
Ordinarily, the US runs a deficit of around $ 300 million a year (at least, since George W’s tax cuts in 2001) and has a total deficit of around $10.6 trillion, or 76% of GDP (and 212% of annual tax revenues). New spending plans will increase that deficit by $1.75 trillion in 2009/10 alone.
Ordinarily, a few hundred billion dollars can be sold as sovereign bonds on the capital markets. Ordinarily.
These are not ordinary times. There are few investors around with hundreds of billions of dollars to spend all in one go.
Which is why Hillary Clinton, US Secretary of State, was in China “begging” the Chinese government to keep buying US bonds. The Chinese already own around $700 billion of these and may be very concerned that the US could either default, or devalue the dollar, leaving the Chinese with the losses.
China has reserves of around $1.3 trillion in cash, and a rapidly cooling economy as factories fall idle and millions of workers are laid off. They need to get those factories working again.
At the same time, President Barack Obama’s stimulus plan contains obvious protectionist “Buy American” provisions that would further weaken China’s manufacturing.
When debtors fail, their creditors get to set strict terms for compliance. America, as the world’s biggest debtor, now requires the world’s biggest exporters – particularly China, Japan and Germany – to pull together to finance this bailout.
None of them may be completely convinced that the US will not default on the debt, or that a weakened dollar won’t wipe any meaning out of those investments. However, they all need a market for their goods.
Over the next ten years, it is likely that China and India will add some 300 million people to the ranks of the world’s middle class. That is the equivalent of adding another America to the planet.
China might just bargain on building access to that new market and keep its factories running by selling to the US in the short term.
If the US wants China’s money, then expect China to set the terms of any future trade agreements.