When Ken Clark suggested that a hung Parliament may prevent a robust fiscal plan being agreed post election (which may force the UK into a scenario where we may need to go to the International Monetary Fund), he was roundly attacked by the other main political parties. But was he right?
The issue of debt
Simply, when you borrow more money than you can afford to repay, your credibility may be questioned. If you went to your bank and asked to borrow some money, your Bank Manager may well agree to lend an amount to you - but will normally do so at a higher rate of interest than you would earn on savings (this is the bank's profit for risking to lend you the money). After a period of time, the Bank Manager will want to see you pay the money back. If you can’t do that today, they would probably invite you into the bank to give you an opportunity to explain how you will do so in the future (this is like the fiscal plan that the international finance markets are looking for immediately after the election). If the bank manager is not happy with your plan, he may well suggest that you should do more to repay your loan or even raise the amount of interest you should pay for the loan as a recognition of the increased risk the bank is taking. This raising of interest rates is the equivalent of the rating agency downgrading the credit rating that they set to indicate to investors how safe their investment is in your country.
So what if the UK’s credit rating is downgraded?
The problem would be that the cost of the money we have already borrowed will go up significantly, making the measures required to balance the books even more severe!
So could the fear of contagion spread to the UK?
The international financial markets are concerned at levels of debt, not the individual currency. At first glance, the UK and Greece have very similar debt levels, yet the economies are very different. The UK has greater capacity to repay the debt, but this depends on whether the international financial institutions agree with this view!