Despite the weakness of the UK economy, the Pound is forecast to rise against the Euro, due to the ongoing uncertainty surrounding the debt crisis in the Eurozone. With Greece and other countries at risk of default, and even facing the prospect of a Euro break up, the Pound Sterling looks relatively attractive – despite low growth and low interest rates in the UK.

The UK economy is slowly emerging from the worst recession since the Great Depression of the 1930s. The recovery is being helped by:

• A weak pound
• Unprecedented loose Monetary policy – zero interest rates, quantitative easing.

However, the recovery is being held back by

• Fiscal tightening – government spending cuts which have reduced confidence and reduced aggregate demand (AD)
• Slow economic growth in Europe
• Rise in oil prices
• Reduced real wages (inflation higher than nominal wage growth during 2011 early 2012)

In 2012, inflation is likely to fall as cost-push factor expire, however growth is still likely to be anemic and the Bank of England is very unlikely to increase interest rates before the end of 2012 (See: interest rate predictions)

With interest rates of 0.5% and slow growth – this would usually lead to a weak Pound. (Investors would save money in countries offering a better rate of interest) However, at the moment, there are few opportunities for investors to find high interest rates with also security of investment. For example, investors were buying Swiss Francs, but the Swiss authorities had to intervene to prevent the Swiss Franc rising too quickly.

Crisis in the Eurozone

Continued weakness in Euro since the start of 2010

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Readers Question: when I read the EU spends 50% of their GDP, what does that actually mean? That half of Europe’s taxes are spent on government projects like welfare and entitlements, like taking money from the left hand pocket and putting money in the right hand pocket? I’m lost. Could you please use credit cards or something else as an example to help me understand the principles involved in these two problems?

This is a list of government spending as a % of GDP

Some EU Examples

You can see there is a big variance. Countries in the EU tend to have a higher rate of government spending, e.g. France 53% of GDP, UK 47%. US is 38%.

To simplify this. We could assume the average citizen for a country. Let us assume the average citizen receives 20,000 Euros. In France, the citizen would pay to the government 10,000 Euros (assume 50% tax rate).

That same ‘average citizen’ would receive 10,000 Euros of government spending. Free health care, free education, pensions, the benefits of military defense.

In the US, the ‘average citizen who earns $20,000 would pay $7,600 in taxes to the government. In return the US would receive $7,600 in government spending (education, military defense, roads e.t.c).

I put the ‘average citizen’ in brackets to simplify. Of course, people pay different tax rates. Some receive more government spending than others. But, it helps to understand.

What do Governments Spend Their Money on?

• What does UK spend its money on?

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Readers Question: Could you please help me understand why high debt as a big percentage of GDP is bad, or at what point does it becomes bad? Japan is at something like 194%, and the UK at 500% (counting all debts and liabilities). Both countries are still waking up every day and going about business (I guess). What do those comparisons of debt to GDP actually tell me?

Firstly, the statistic for UK at 500% looks like UK external debt. Or more likely it could refer to the total UK debt i.e. Private + Public debt. See: UK Total Debt.

194% looks like Japan’s government debt, though Japan government debt is now over 220% of GDP. Total Japanese debt is similar to the UK.

The government often need to know and decide at which level public sector debt is a  problem.

For example, at the moment, Public sector debt in different countries is:

• Japan 225% of GDP
• UK 64% of GDP (2012) (excluding financial sector intervention
• Portugal 83% (2010 est. of GDP)
• Spain 63% (2010 est.)
• see: list of debt by Country

Also, if you look at historical national debt, the UK has had much higher debt levels. In the early 1950s, UK debt was over 200% of GDP. Does that mean the UK could triple its current government debt? Well, probably not. Circumstances are different in 2012 to the early 1950s.

From these statistics, you might expect Japan to be in the greatest difficulty because it has by far the highest levels of debt.

Yet, markets are not really concerned about Japan public sector debt levels. Bond yields on Japanese government debt are very low. See: Why can Japan borrow so much?

However, markets are very worried about government debt levels in Portugal and Spain. Bond yields on Portuguese and Spanish debt have risen significantly in the past few months. Bond yields on Portuguese debt at the end of 2011 was 13%

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