Serious problems ahead for the British pound

December 21, 2010 – Last week the British pound fell 3.0% against the US dollar. Some say it was because of UK bank exposure to Spain, which Moody’s warned could be downgraded. Others blamed the UK’s close economic link and heavy debt exposure to Ireland, which Moody’s did actually downgrade last week by 5-levels to Baa1. This low grade is barely above junk status.

These downgrades in different corners of Europe no doubt had some impact on Sterling’s weakness, but there is I think another factor closer to home. It is the growing awareness of the runaway spending and borrowing by the British government.

Despite all the rhetoric and promised cuts in spending by the newly elected coalition, the hard fact is that government spending and borrowing continue to soar – and look as if they are spiraling out of control. The following chart illustrates the magnitude of the problem as UK government debt nears £1 trillion.

Earlier this year, UK government revenue (the blue line) once again began to grow. It was an indication that the British economy was on the mend after the billions spent on the bailout of Northern Rock and the UK government’s rescue of most of that country’s major banks in the aftermath of the collapse of Lehman Brothers. But look closely at the above chart. Expenditures (the red line) remain on the same well-established upward trajectory, climbing higher every year. This growth in spending is unabated, and is now rising at about the same rate as revenue growth. As a consequence, the country’s deficit has barely shrunk from the record level reached at the depth of the financial crisis.

Note too the accounting sleight-of-hand at the end of 2007. How is it possible that UK government debt grew back then even though the budget deficit was negligible?

Following in the footsteps of Greece and other basket-case sovereign debtors so adept at creative accounting, UK government accountants glossed over the Northern Rock bailout, the net effect of which made the deficit in 2007 look smaller. Convenient accounting like this cannot possibly instill confidence in UK government bondholders.

The bottom line is that the UK’s huge deficit is not sustainable. It will lead to ever greater amounts of so-called “quantitative easing” by the Bank of England, and inevitably this money printing – the turning of UK government debt into British pound currency – will sooner or later lead to hyperinflation.

I had always thought that the US dollar would hyperinflate and collapse before any other major currency. Lately, I am not so sure. Government spending and borrowing in the UK look even worse than the dire levels being reached in the US. Therefore, the dubious distinction of being the first currency to hyperinflate in the months ahead may end up going to the British pound.