The UK has announced the largest spending cuts since World War II. The government plans to eliminate half a million jobs in the next four years, curtail retirement plans, create new taxes on banks and cut department sizes by about a fifth.
Before we get into what this might mean, let's talk about why it's necessary. Normally, you'd expect governments to embark on fiscal austerity projects when its debt begins to eclipse its growth. Britain has a moderate debt burden relative to GDP. Why is it cutting so aggressively?
At 70 percent, Britain's public debt to GDP ratio is no worse than healthier European economies like Germany and Austria. But when you look at public and private debt combined, the picture gets very bleak very quickly.
According to a McKinsey Global Institute report, the UK is "world's worst offender for private and public debt in comparison to GDP after Japan." The ratio of household debt to income yawned to 160 percent in 2008, even worse than the United States. With its legion of international banks exposed to the subprime mortgage crash, Britain essentially suffered something very much like the United States: years of overspending and financial wizardry coming to a crashing halt in 2008.
But if the United States and Britain share similar pasts, they're embarking on divergent paths of recovery. While the Obama administration has pushed for moderate stimulus and high deficit -spending following the 2009 Recovery Act, Britain is taking a stiff-upper-lip approach to crisis budgeting to prove to its lenders that it will spend the next hundred billion more carefully.
History does not afford many fair side-by-side comparisons, but this should be an interesting case study. My fear for the UK is that investors are looking for lights at the end of the tunnel, and if the UK's recovery slows as a result of this belt-tightening, that tunnel to full recovery gets longer.
Crises starting in the financial sector tend to end with exports, and Britain trades first and foremost with the European continent, much of which is under-going its own cuts. The risk here is that Europeans cut back their spending all at the same time, each neighbor beggaring his neighbor, until every country becomes a beggar. The European consumer can't recover if the entire continent squeezes its families for cash simultaneously.