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U.K. can't keep blaming Europe for dismal economy

LONDON (MarketWatch) -- Growth is flat. The central bank is pumping emergency cash into the system. Retail sales are declining, and house prices outside central London are falling. The U.K. might have the Olympics to look forward to this summer, but not much else.

Its economy is in terrible shape and shows no sign of recovering. Who's to blame for that? Those terrible people on the other side of the English Channel. Everyone from Prime Minister David Cameron to Bank of England Gov. Mervyn King to just about every City economist keeps blaming the euro crisis for the U.K.'s unending recession.

It's a plausible enough story, particularly for a politician or a central banker in a tight corner. There is just one snag.

It is nonsense.

The U.K.'s problems are entirely homegrown, and could be fixed at home as well. Until the British start getting to grips with that, there is little chance of its economy, its currency or its stock market improving.

The U.K. is hitting the mid-point of the year in a dire state. We learned last month that the economy shrank 0.3% in the first quarter of the year (more than the 0.2% contraction originally estimated). That followed a 0.3% drop in output in the final quarter of 2011, making it the first double-dip recession since 1975 -- hardly a period in the country's economic history anyone would wish to revisit. With exports dropping 8.6% last month, it is unlikely that is going to be turned around any time soon.

Longest recession on record

Four years on from the credit crunch, there is little sign of a sustained recovery, and plenty of signs of more trouble ahead. This is already the longest recession on record. At the same point in the 1930s, the economy was booming.

Of course, it doesn't exactly help having a major economic crisis unfolding on your doorstep. To that extent, the politicians have a point. But in truth, the euro crisis can't really explain how badly the U.K. has been doing.

Take Germany for example. It is hardly insulated from the euro crisis: it is right in the thick of it. But Germany grew by 0.5% in the latest quarter, and is forecast to grow by around 1% in 2012. Not great. But better than the U.K.

Or take Sweden or Norway, two developed economies right on the edge of the euro zone, but outside the single currency. Both of them might be expected to be as badly hit as everyone says the U.K. is. But the figures do not bear that out. In Sweden, the economy grew by 0.8% in the latest quarter, and should expand by more than 1% for the year as whole. Likewise Norway. It is expected to grow by 2.7% this year. In Britain that would count as boom.

Or how about Iceland? It's right on the edge of the euro zone and it was hit by a huge financial crisis and the collapse of its banks as well. How's it doing? Surprisingly well. Its economy grew by 2.4% in the latest quarter, and by 1.9% in the quarter before that. The currency is appreciating and the central bank has even been raising interest rates.

Despite what you sometimes read, the U.K. does not depend that much on trade with the euro zone, and certainly not with the peripheral states that have suffered the worst from the crisis. Britain doesn't make much any more, and what it does make it doesn't necessarily sell to Europe. Exports account for 26% of U.K. GDP and the euro zone accounts for 46% of that, so exports to the euro-zone are roughly 13% of GDP. Put that way, 87% of the economy has nothing to do with the euro.

So why is it doing so badly?

Structural challenges

Government spending has exploded to more than 50% of GDP, and shows no sign of coming under control. Regardless of whether you think that is the right number or not, it is clear from all the numbers that the U.K. public sector has zero productivity growth, and may well have declining output. It is very, very hard for an economy to grow when half of it is not contributing anything to lifting GDP.

Next, debt is too high. According to McKinsey research, British debts total more than 500% of GDP once corporate, personal and government debt are added together. Only Japan is more in hock. Some countries -- most notably the U.S. -- are steadily reducing their debt levels. Britain hasn't even started. All the latest evidence suggests that very high debt levels restrict economic growth. Most of the rise in consumer spending in the last decade was financed simply by borrowing more and more. That isn't available any more. So consumers can't spend more until they earn more, and they can't do that until their productivity rises.

Thirdly, two of Britain's four main banks -- Royal Bank of Scotland and Lloyds-TSB -- now seem to be in permanent state control. Both are becoming a massive drain on resources, and there is little reason to think that either will recover whilst they are run by the government. The more time passes, the less likely it seems they will ever return to private ownership.

Lastly, the Bank of England has committed itself to following the Bank of Japan on the road to precisely nowhere. Japan has spent a decade with near-zero interest rates and regular blasts of quantitative easing. The result? An economy still stuck in the doldrums. While it may be defensible as an emergency measure, there is little evidence either QE or near-zero rates can produce a sustained recovery -- and by discouraging saving may well make the economy more feeble.

Blaming the euro zone is a convenient excuse for the U.K. In fact, its problems are home-grown. Until that is recognized, no progress will be made -- and you don't want to own British equities (UKX) , or sterling (GBPUSD) .