Hamish McRae: Fiscal credibility is on a knife edge – and this spring could be nasty indeed
Sunday, 13 December 2009
It is, in a funny way, easier to see what will happen in two to three years' time than what will happen in the next two to three months.
That applies to the world economy, for in a couple of years' time the recovery will be secure, whereas this coming spring it may hit a nasty wobble. But it applies particularly to the UK economy, and the uncertainties were, if anything, increased by the pre-Budget report last week. The point has been widely made that the report was more a political statement than an economic one.
The politics are discussed elsewhere in this paper, so just one thought on that here. It is that it is strange that Gordon Brown, for it is his decision, should be prepared to set aside all the effort made by John Smith, Tony Blair and himself back in the early 1990s to convince a sceptical electorate and sceptical markets that Labour in office would be financially responsible. John Smith's charm offensive on the City, Tony Blair's commitment to no change in the basic and higher rates of tax, and Gordon Brown's fiscal rules were all designed to embed in everyone's mind that Labour in office would not make the mistakes it had made in the 1970s. Now that entire effort has been blown to bits and a new leader will, in five, 10, 20, or whatever it is years, have to embark on the same journey all over again. It will inevitably be harder next time, given what has happened.
We now have the highest fiscal deficit, relative to GDP, in the world, and a programme to get that deficit under control that is at the limits of the credible. The independent Institute for Fiscal Studies gives the Government a less than even chance of meeting its own deficit reduction plan, a plan that itself will surely have to be tightened. The story that Alistair Darling wanted to correct the deficit more quickly but was overruled by Gordon Brown and Ed Balls was denied by No 10, but it rings right.
Things are now on a knife edge. That is why it is so hard to predict what will happen in the next few months. It may be that we will scramble through to the general election without any financial shock. But it is quite possible that there will be a sudden loss of confidence in our economic management, with a plunge in the pound and a sharp rise in long-term interest rates. If we do get through, it will be because everyone expects that the new government will act swiftly to correct the deficit. If not, it will be because of a new chunk of adverse news (eg, a downgrading of our sovereign debt, or a further deterioration in the deficit), or because there are expectations of a hung parliament.
It is a curious time. The expectation of a change in government means that power has already begun to shift. The Government still has the levers of power in its hand, but nothing much happens when it pulls them. It can do a few things, as we saw this week with its emergency tax on bankers. Just how effective this will be is not at all clear, the danger being that it does raise some little revenue now but at the cost of a much larger loss of revenue in the years ahead. At any rate the civil service is preparing for the transition, as it is constitutionally obliged to do, and it will seek to make that transition as honourably and competently as possible.
If power has started to shift, so too has responsibility. Last week the Tories announced that the former Treasury chief economic adviser Sir Alan Budd would head their new Office for Budget Responsibility and that will give the office, and their approach to fiscal policy, much greater credibility. That may be enough to preserve market order through to the election but this all feels very fragile and I simply don't think it is possible to make any predictions about the spring. I don't like the look of what is happening in Greece, and concern about sovereign risk could spread quite suddenly.
If you look forward two or three years it is all much clearer. We will have begun a period of fiscal consolidation. You can have a debate about the appropriate balance between tax rises and spending cuts. You can argue about the timing of when this process should begin. But there is no question of the scale of the task ahead, as the main graph, from Citigroup, indicates.
The bank has done some calculations on the scale of fiscal consolidation over the next 10 years needed to get debts to 60 per cent of GDP by 2030. You might think this is a pretty unambitious target. For the UK it would be a 10-year slog merely to get our debt down to one-and-half times the level it was two years ago. But look at the scale of the task: cuts in spending and/or tax rises equivalent to 12 per cent of GDP. That is terrible. We are worse than Greece, worse than Ireland, worse than Spain. The only country worse than us is Japan, which has a target of getting debt down to 80 per cent of GDP.
If most of the developed world is in a fiscal mess, note how most of the emerging nations have come through in much better shape, as the right-hand chart shows. Interesting, isn't it, that "new" economies can teach the "old" ones how to manage their finances?
In a couple of years' time we will have begun that task. The deficit cannot be eliminated in the life of one parliament, though there is a genuine debate as to how quickly to try and get it under control. My own feeling is that if you know you have to do something you had better get on with it. The economic models may predict that larger deficits generate more growth. but that has not happened in Japan since the early 1990s or, indeed, here in Britain for the past couple of years. In any case, there are plenty of examples of fiscal consolidation actually triggering a period of sustained growth.
So, before you despair, remember – sharp fiscal squeezes in Canada, Sweden and India in the early 1990s, and in the UK in the early 1980s, all created the basis for sustained rapid growth.
I have been rereading the speech by Manmohan Singh, then the new finance minister of India, when he presented his emergency budget on 24 July, 1991. He started by pointing out that the new government had inherited an economy in deep crisis. The budget deficit was more than 8 per cent of GDP and the current account deficit was 2.5 per cent of GDP. He set out a programme of fiscal responsibility and other reforms that laid the basis for India's subsequent boom. As a result, it looks as though India, unscathed in this downturn, will become the world's third-largest economy after China and the US within 20 years.
This is how he finished his speech. "Sir, I do not minimise the difficulties that lie ahead on the long and arduous journey on which we have embarked. But as Victor Hugo once said, 'No power on Earth can stop an idea whose time has come.' I suggest to this august House that the emergence of India as a major economic power in the world happens to be one such idea. Let the whole world hear it loud and clear. India is now wide awake. We shall prevail. We shall overcome."
Bit different from the sort of stuff we get from Messrs Brown and Darling, isn't it?
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