Brown's Future as Prime Minister Hangs on Pound: Matthew Lynn

Dec. 5 -- It may become the most calamitous premiership for at least 100 years. Less than six months after taking over from Tony Blair as U.K. prime minister, Gordon Brown has already stumbled through a series of disasters. He is, to use a popular word in the financial markets, a subprime minister and he leads a subprime economy.

Brown has taken a beating. As he knows from his 10 years as chancellor, so long as you can deliver a prosperous economy and keep public spending flowing, you can survive just about anything. If you can't, you start to look like sliced sausage.

Whether Brown succeeds may well depend on foreign-exchange markets. If the pound stays strong, the U.K. can ride through some choppy waters. If the currency weakens, the economy will start to decline and take Brown down with it.

There is little doubt that the outlook is grim.

Brown is embroiled in a scandal over secret donations to his ruling Labour Party. The Electoral Commission last week said it will ask police to investigate Labour financing. A week earlier, Chancellor Alistair Darling was forced to make two emergency statements to the House of Commons: one explaining its failure to sort out the mess over failed bank Northern Rock Plc, the other explaining how the government managed to lose two computer disks containing the financial records of 25 million people.

That came after the saga of the election that wasn't: Brown's aides spent the fall discussing a snap election, only for Brown to cancel it at the last moment when the polls turned against him.

Tarnished Reputation

Within a few weeks, Brown has blown his reputation for leadership (the election), competence (the disks) and now integrity (party funding). It is no big surprise that he's trailing in the polls. A YouGov survey last week in the Daily Telegraph put the opposition Conservatives 11 percentage points ahead. Labour's popularity is at a 19-year low, another poll said.

And all of that happened while Brown was still meant to be in his ``honeymoon'' period.

Unfortunately for him, he hasn't faced his real crisis yet: the economy.

The Nationwide Building Society reported last week that house prices dropped the most in 12 years in November, recording a 0.8 percent fall. Meanwhile, debt has soared out of control. Almost a third of British homeowners face ``serious financial difficulties'' as mortgage lenders raise rates on borrowers that they consider ``high risk,'' the market research group Mintel said last week.

Interest Rates

Whether the Bank of England's Monetary Policy Committee responds to that with a cut in interest rates this week remains to be seen. ``They continue to view activity in relation to the performance of the economy in the first three quarters of the year rather than recognizing that the credit crunch has produced a decisive break with this performance, and over-indebted consumers do not have access to the same amount of credit as before,'' Stuart Thomson, who manages 23 billion pounds ($47 billion) in bonds at Resolution Investment Management Ltd. in Glasgow, Scotland, said in a note to investors.

In reality, the British economy has been kept afloat by a housing bubble, which has been supported by a currency bubble.

That may be about to change.

So long as sterling remained strong at more than $2, the British economy could maintain an appearance of strength. With the pound still high, the Bank of England can engineer a couple of cuts in interest rates from their current 5.75 percent. That should at least stabilize the housing market and keep consumers confident enough to keep filling up the malls.

Inflation Impact

But what if sterling started to fall -- not dramatically, but to a more realistic $1.60 to $1.70?

If that happened, the U.K. would be stoking inflation: Britain relies on imports, which would become more expensive if sterling fell. The Bank of England would be forced to keep interest rates on hold. It might even have to boost them to defend the currency. That would have a ruinous impact on the housing market and consumer confidence. It could tip the economy into recession, which would encourage currency markets to punish sterling even more. A vicious circle would have started, and that can be impossible to break.

Could it happen?

Many economists see sterling as suspended in mid-air. The U.K. has massive trade and budget deficits. For the past year, the markets have been pummeling the dollar. That will stop soon. Already, the U.S. trade gap is narrowing, and soon a German- style export-led recovery will be under way in the U.S. The currency markets will need a new target -- after all, traders have to sell something to stay in business. Sterling looks like a sitting duck.

It might well be the fragility of Brown's government that provides the trigger for an attack on sterling. Brown's problems are only just starting. It will be the foreign-exchange markets that finish him off.