U.S. Debt Negotiators Should Look to Britain

By ALEN MATTICH

The American public and its politicians can be pretty insular. But they'd do well to cast an eye across the Atlantic; specifically, toward the U.K.

That's because the British are running an economic policy much like the one currently under consideration by the U.S. authorities. How this regime of fiscal tightening against the backdrop of extremely loose monetary policy turns out could yet prove a template for the U.S. experience.

The U.K. is 12 to 18 months ahead of the U.S. on its fiscal policy tightening, according to David Rosenberg, chief economist and strategist at Toronto-based wealth-management firm Gluskin Sheff. As such, the U.K.'s current performance ought to inform the current U.S. debate, not just about the debt ceiling but about the longer-term strategy of getting the government finances back under control.

And this may not be welcome news to America's Republicans.

In a nutshell, Britain's experience suggests however loose the monetary policy, fiscal tightening is a hard headwind for an economy to surmount, especially when it's struggling out of a balance-sheet recession.

What's even more worrying is that the U.K.'s fiscal austerity program has effectively only just begun, with many of the more severe cost-cutting measures, particularly welfare reform, still to come. This is evident in some of the recent data, which show the U.K. economy is beginning to stall and may have even contracted during the second quarter; the first estimate of second-quarter growth is due today.

The latest jobs data suggest the private sector won't manage to offset cuts in public-sector employment, indicating a return to rising unemployment. At the same time, a hefty squeeze on real earnings is proving a strong brake on consumption.

Little wonder, then, that members of the Bank of England's Monetary Policy Committee are increasingly tilting in favor of further quantitative easing.

Keynesian economists will argue that the U.K.'s recent slowdown is obvious. Withdrawing public-sector stimulus before the private sector has sufficient momentum to be self-sustaining is dangerous and, following the biggest financial crisis since the Great Depression, threatens an economic downturn similar to that seen in the U.S. in 1937. Chancellor of the Exchequer George Osborne's rebuttal is that to do nothing about the biggest peace-time budget deficit in the U.K.'s history would threaten to shut the country out of the bond market, much as Greece, Ireland and Portugal have been, causing an even-deeper financial crisis. The low yields on U.K. government bonds reflects market confidence in the government's austerity program, he argues.

It's a point on which neither side is willing to concede ground, though Italy has recently shown the rapidity with which bond investors can abandon debt that only a few days earlier was accepted as high-quality.

This isn't to say the U.K. is a perfect parallel for the U.S. There are, of course, differences.

Although central bankers have focused on the problems of aggregate demand following the recession—that is, households' and firms' unwillingness and inability to maintain consumption—the U.K. seems to have more of a problem with aggregate supply, argues Tyler Cowen, a professor of economics at George Mason University in Virginia.

Over the past three decades, the U.K. economy grew heavily dependent on financial services and a few other sectors, like pharmaceuticals. Neither is likely to be much of an engine of growth from here onward. Although sterling's 25% decline since 2007 is helping exporters, the manufacturing sector has atrophied over the years and provides little impetus. Indeed, the latest trade data show the U.K.'s balance of payments deficit is widening as import growth outstrips exports.

The U.S. is both a much less open economy, and therefore less reliant on international trade than the U.K., and more dynamic.

But perhaps the biggest difference has been the Bank of England's willingness to accept high rates of inflation for very long periods. The U.K. consumer price index has been above the bank's 2% target for 53 of the past 62 months and has averaged 3% over that period.

Although Federal Reserve policy-setters are likely to be in sympathy with the Bank of England—Chairman Ben Bernanke co-authored a paper on inflation targeting with Adam Posen, an external member of the BOE's Monetary Policy Committee—it may not have the political backing to ignore inflation.

"Congress won't let the Fed think about" further monetary stimulus, Mr. Cowen argues. The Fed "lost [its] independence during the crisis." Although investors have latched on to any hint that the Fed might be prepared to provide yet another round of quantitative easing, this seems unlikely.

By contrast, the Bank of England has had Chancellor Osborne's full support, despite voters' traditional hatred of inflation. So, surging inflation notwithstanding, the Bank of England is more likely to undergo another round of monetary stimulus than it is to start raising rates. Of course, the U.S. has the additional complication of being home to the world's reserve currency, as sterling was during much of the 19th century. Recently, during times of global crisis, sterling has tended to weaken or go nowhere while the dollar has appreciated. So, while the pound acts as a safety valve for the U.K. economy, the dollar becomes a drag on the U.S.'s.

Nevertheless, despite the differences, the U.K. offers enough parallels for Americans to keep at least half an eye on where its economy is headed.

Write to Alen Mattich at alen.mattich@dowjones.com