LONDON (Reuters) - In the eyes of the financial markets, Britain was supposed to be a model of successful, sustainable austerity and a safe haven in which the world's rich could buy houses and stash their savings.
The riots that turned London and some other English cities upside down this week have undermined that model, raising questions about the sustainability of spending cuts and a widening gap between rich and poor.
From many of the dealing rooms and offices in the skyscrapers of Canary Wharf, traders, wealth managers and analysts could see billowing smoke in several directions this week as rioters torched buildings and looted shops.
Order was restored in the capital at least on Tuesday night with a massive show of force by police, but they too face the drastic spending cuts that will affect everything from the military to social benefits and inner-city services.
Britain's coalition government says it remains committed both to cutting a record budget deficit and staying in power until elections due by 2015.
Investors have always had mixed feelings about austerity. They want the British government to tackle the huge deficit to slow its accumulation of debt. But they also fear that cuts will push the economy back into recession, hitting corporate earnings and tax income while raising social spending costs and actually pushing the country deeper into debt.
Nevertheless, they had generally compared British determination to cut the deficit favorably with the indecision or infighting paralyzing much policy-making in the euro zone and United States. Now, they are not so sure.
"If you'd asked me at the weekend, I would have said that with the problems of the euro zone and U.S., (Britain's) sterling (currency) might be poised to become an appealing safe haven," said Simon Derrick, head of foreign exchange at the London branch of Bank of New York Mellon.
As he spoke, from his dealing room Derrick could still see smoke on the horizon from a distant burning warehouse. "This has certainly shaken that... it's probably still too soon to say what it means for policy, but it certainly makes austerity look more difficult."
The short-term market impact looks to have been limited. Derrick said U.S. media coverage of the London riots prompted a modest sell-off in the pound late on Tuesday, but markets have largely shrugged off the violence.
Indeed, the cost of insuring Britain's debt in the credit default swaps market edged below that of Germany this week for the first time -- with investors clearly believing worries that Germany might have to bail out Italy and Spain outstripped concerns about Britain.
After unexpected uprisings shook the Middle East and North Africa earlier this year, wealth managers say billions were transferred to London in particular as nervous regional leaders and business elites raced to move their wealth to safety.
Attracted by a reputation for stability and the opportunity for a luxury lifestyle -- as well as a strong legal system and systems allowing them to conceal their wealth through trusts and other structures -- they bought property and other assets.
But this week's events have undermined London's safe haven appeal and some analysts expect louder calls for both tighter controls on unfettered wealth and a rethinking of planned cuts.
Some countries such as Latvia and Ireland have pushed through massive cuts with relatively little unrest but not everyone can pull off the same trick. The British riots could point to similar risks in other European and U.S. cities as cuts start to bite.
ONLY THE BEGINNING?
"I don't think the implications of this have been fully thought through or accepted yet," said Pepe Egger, western Europe analyst for London-based consultancy Exclusive Analysis.
"What we have here is the result of decades of growing divisions and marginalization, but austerity will almost certainly make it worse. Yes, the police can restore control with massive force but that is not sustainable either in the long term. You have to accept that this may happen again."
Speaking to Reuters late on Tuesday, looters and other local people in east London pointed to the wealth gap as the underlying cause, also blaming what they saw as police prejudice and a host of recent scandals.
Spending cuts were now hitting the poorest hardest, they said, and after tales of politicians claiming excessive expenses, alleged police corruption and bankers getting rich it was their turn to take what they wanted [ID:nL6E7J91RM].
"They set the example," said one youth after riots in the London district of Hackney. "It's time to loot."
Unsurprisingly, the criminality produced a swift popular backlash. Vigilante groups patrolled some streets, while media and social networks were deluged with demands for tough action.
This itself could pose one of the greatest initial challenges to spending cuts. Prime Minister David Cameron made it clear all necessary resources would be available to the police, but the government also says it will still stick to its plans to cut police spending by roughly a fifth.
POLICE CUTS CHALLENGED
That contrasts with the 1980s approach of Margaret Thatcher, who slashed public spending and took on trade unions in the face of unrest but plowed money into the police and military.
Support for police cuts is dwindling. London Mayor Boris Johnson, a leading member of the ruling Conservative party, called on Wednesday for them to be watered down.
Analyst Louise Taggart at security consultancy AKE said that in time urban unrest worries could make it harder to cut other programs as well, including sorely needed education and community services. It went well beyond Britain, she said.
"Across Europe, we've already seen some incidence of civil unrest," she said, saying it would almost inevitably impact policy. "There's definitely a likelihood that similar scenes might erupt when austerity cuts really start to be felt."
If slashing spending is less of an option, Western states may have little option but to pursue ever more rounds of quantitative easing, effectively printing money whilst keeping benefits, wages and spending programs largely static.
That could bring its own problems -- not just inflation hitting the savings of the rich and the buying power of the poor but also increased tensions between Western states and emerging economies such as China that hold their debt.
"The most likely path from here is for no changes being made and moving into inflating the debt away -- unfortunately" said Steen Jakobsen, chief economist at Saxo Bank.
However, he warned that this alone would not restore social or financial stability without more fundamental systemic change. "For a society to grow and move forward all social classes need to benefit from growth," he said.
(Editing by David Stamp)