Even in its darkest moments, the U.K. government can't have imagined a worse reception for its latest bailout package. Far from shoring up confidence in the banks, it has fueled doubts over the solvency of the entire U.K. economy. The collapse in bank shares has spread to sterling, down 5% this week amid talk of downgrades and defaults. Even so, the U.K. is a long way from turning into Iceland-on-Thames.

True, the economy is in a mess — but that is true of almost every other country. The U.K. has particular drawbacks: a large current account deficit that relies on foreign investors for funding, high private sector debt, and an historic overreliance on finance sector jobs. And the pound is no longer a reserve currency so no one is obliged to own it.

But it also has advantages. Public sector debt is lower than in most developed countries and is forecast to hit around 60% of GDP over the next couple of years — lower than many countries in the euro zone. Plus the U.K. has already received a substantial monetary and fiscal stimulus. And it still has its own currency, which is now down nearly 30% from its recent peak against a basket of other currencies — providing another massive stimulus.

The case against sterling rests on the size of the U.K. banking sector, which has liabilities of more than three times GDP. But those liabilities are matched by assets – the bulk of them currently financeable via usual bank funding mechanisms, including deposits, the bond market and central bank repurchase operations. So it is misleading to suggest that bank nationalization would cause U.K. public debt to reach 350%.

What matters is not the future size of the U.K. public sector balance sheet but the scale of the likely losses it might have to absorb via the banking system. These are sure to be substantial, whether the government absorbs them as a result of a guarantee scheme, a bad bank or nationalization — but not so large as to sink U.K. public finances.

Goldman Sachs reckons the three large U.K. banks — Lloyds, Barclays and Royal Bank of Scotland — have between them GBP350 billion of toxic assets, which includes all their commercial property exposure, all leveraged loans and around 10% of unsecured commercial loans. This is the amount it reckons the government would need to remove to feel comfortable the banks could absorb remaining losses from operating profits.

But that wouldn't mean the U.K. was on the hook for GBP350 billion. Assuming a 20% loss rate on secured debts and a 70% loss on unsecured, Goldman estimates losses — spread over several years — could hit GBP120 billion, a portion of which would be taken by the banks under the terms of the insurance scheme. But even if the government took all the losses, they amount to just 8% of GDP, leaving U.K. public debt still below the forecast 73% for the euro zone in 2011 and too low to trigger a downgrade.

That doesn't mean the U.K. is safe. Like any highly leveraged entity, it is vulnerable to a loss of confidence. And with net overseas liabilities equivalent to 25% of GDP, there is a limit to how far sterling can fall before a downgrade does become a possibility. But with an AAA rating only recently reaffirmed by S&P and a currency that already looks cheap on a purchasing power parity basis, it's hard to imagine things getting that bad. After all, other currency areas have their problems too.

China’s official urban unemployment rate jumped for the first time since 2003 and may climb to an almost 30-year high as exports slump and a slowdown deepens in the world’s third-biggest economy.

A rate as high as the government’s 4.6 percent target for this year, which was announced … today, would be the worst since 1980, official data show. Premier Wen Jiabao said yesterday that the government must do more to preserve social stability in the face of a “very grim” job outlook.

Infrastructure in a Stimulus Package

Last week we blogged on how much stimulus to GDP and employment might be expected from a version of the Obama fiscal stimulus plan. I concluded that the amount of stimulus from the spending package would be far less than estimated in a study by the incoming Chairperson of the Council of Economic Advisers (“The Job Impact of the American Recovery and Reinvestment Plan”, by Christina Romer and Jared Bernstein, January 9, 2009). The activities stimulated by the package to a large extent would draw labor and capital away from other productive activities. In addition, the government programs were unlikely to be as well planned as the displaced private uses of these resources.

The stimulus package’s plans for spending on “infrastructure” clearly illustrate both concerns. I put this word in quotation marks because of the many definitions of what is included in the concept of infrastructure. Promoters of various stimulus packages- such as the just released House Committee on Appropriations $825 billion stimulus plan- include in infrastructure not only the traditional categories of roads, highways, harbors, and airports. They also include spending on broadband, school buildings, computers for school children, modern technologies, research and development, converter boxes for the transition to digital TV, phone service to rural areas, sewage treatment plants, computerized medical records and other health expenditures, and many other activities as well.

Some of this infrastructure spending may be very worthwhile-I return to this issue a bit later- but however merited, it is difficult to believe that they would provide much of a stimulus to the economy. Expansion of the health sector, for example, will add jobs to this sector, but it will do this mainly by drawing people into the health care sector who are presently employed in jobs outside this sector. This is because unemployment rates among health care workers are quite low, and most of the unemployed who had worked in construction, finance, or manufacturing are unlikely to qualify as health care workers without considerable additional training. This same conclusion applies to spending on expanding broadband, to make the energy used greener, to encourage new technologies and more research, and to improve teaching.

An analysis by Forbes publications of where most jobs will be created singles out engineering, accounting, nursing, and information technology, along with construction managers, computer-aided drafting specialists, and project managers. Unemployment rates among most of these specialists are not high. The rebuilding of “crumbling roads, bridges, and schools” highlighted by in various speeches by President Obama is likely to make greater use of unemployed workers in the construction sector. However, such spending will be a small fraction of the total stimulus package, and it is not easy for workers who helped build residential housing to shift to building highways.

A second crucial issue relates not to the amount of new output and employment created by the stimulus, but to the efficiency of the government spending. Efficiency is not likely to be high partly because of the fundamental conflict between the goal of stimulating employment and output in order to reduce the severity of the recession, and the goal of concentrating infrastructure spending on projects that add a lot of value to the economy. Stimulating the economy when employment is falling requires rapid spending of this huge stimulus package, but it is impossible for either the private or public sectors to spend effectively a large amount in a short time period since good spending takes a lot of planning time.

Putting new infrastructure spending in depressed areas like Detroit might have a big stimulating effect since infrastructure building projects in these areas can utilize some of the considerable unemployed resources there. However, many of these areas are also declining because they have been producing goods and services that are not in great demand, and will not be in demand in the future. Therefore, the overall value added by improving their roads and other infrastructure is likely to be a lot less than if the new infrastructure were located in growing areas that might have relatively little unemployment, but do have great demand for more roads, schools, and other types of long-term infrastructure.

Of course, at some point new taxes in some form have to be collected to pay for infrastructure and other stimulus spending. The sizable adverse effects on incentives of these taxes also have to be weighted against any value produced by the infrastructure (and other) stimulus spending.

The likelihood that such a rapid and large public spending program will be of low efficiency is compounded by political realities. Groups that have lots of political clout with Congress will get a disproportionate amount of the spending with only limited regard for the merits of the spending they advocate compared to alternative ways to spend the stimulus. The politically influential will also redefine various projects so that they can fall under the “infrastructure” rubric. A report called Ready to Go by the U.S. Conference of Mayors lists $73 billion worth of projects that they claim could be begun quickly. These projects include senior citizen centers, recreation facilities, and much other expenditure that are really private consumption items, many of dubious value, that the mayors call infrastructure spending.

Recessions would be a good time to increase infrastructure spending only if these projects can mainly utilize unemployed resources. This does not seem to be the case in most of the so-called infrastructure spending proposed under various stimulus plans.