The government takes a huge gamble on investor confidence

By Martin Wolf

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Stuff happens. Stuff has certainly happened to both the UK economy and the government’s fiscal position. What Alistair Darling delivered on Monday was not a pre-Budget report, but a crisis budget. He scrapped the hallowed rules of Gordon Brown, his predecessor. Profligacy has replaced prudence as the watchword. But, the chancellor would insist, it is profligacy with a purpose.

The government’s aim is to restore confidence in the economy. But it is also taking a huge gamble on its ability to sustain the confidence of investors. I believe it is right to do so. But nobody can know. The risk that these monstrous fiscal deficits – with public sector net borrowing forecast at 8 per cent of gross domestic product in 2008-09, falling to 2.9 per cent only in 2013-14 – will trigger a sterling crisis, a big sell-off of UK government debt, or both, is not small. The decision to raise the top rate of tax to 45 per cent for the first time in two decades is also symbolic. If 45 per cent today, why not 50 per cent tomorrow? This is a different country.

Certainly, the report failed to admit either how far the crisis has domestic roots or how far past policies of this very government explain the enormity of the fiscal position: the UK did not have to enjoy a huge housing boom financed, in large part, by wholesale financial markets; nor did the UK have to enter the downturn with such big fiscal deficits, even if the debt position is itself not too bad.

Also worrying is the failure to admit that the economic position has been transformed. The economy is being forced through a structural shift – from soaring household borrowing, a booming housing market, a bloated financial sector and rapidly growing public spending, towards higher savings and current account surpluses. The UK has enjoyed the fat years. Now come as many as seven lean ones. It is unclear from the chancellor’s speech that the government understands the challenge. But the planned real growth of current government spending, at 1.2 per cent a year, is at least in the right direction.

The forecasts are, of course, not worth the paper they are written on. Nobody’s are. The Treasury expects recovery from the third quarter of next year, as lower commodity prices and interest rates, along with the fiscal boost start to work. The economy is expected to contract by between ¾ per cent and 1¼ in 2009 and then to grow at 1½-2 per cent in 2010. This looks optimistic, given the scale of recent shocks. The frightening possibility is that the chancellor is still understating the deficits ahead. Net borrowing for 2009-10 is expected to be 5.5 percentage points higher than forecast in the Budget. It could end up much higher still. These forecasts, then, are a gamble within a gamble – a “gamble squared” perhaps.

So how does the government expect this to work out? The cyclically adjusted current budget is forecast to reach a deficit of 4.4 per cent of GDP in 2009-10 (against an actual deficit of 5.3 per cent) and is not expected to return to balance until 2015-16. That is so far in the future as to be almost irrelevant. Cyclically adjusted net borrowing is forecast to fall slowly, from 7.2 per cent of GDP in 2009-10 to 2 per cent in 2014-15. This is red ink as far as the eye can see. Net debt, far from staying below 40 per cent of GDP, as laid down by Mr Brown, is expected to be 57 per cent in 2012-13.

The overwhelming part of these deficits is structural, not cyclical. This looks right, in view of the shocks both to the sustainable level of GDP and the fiscal revenue that any given GDP might generate. This is, in any case, the cautious approach. How then does the government expect to reduce the deficits, since cyclical recovery alone will, by definition, do relatively little? Between 2009-10 and 2013-14, current receipts are forecast to jump from 36.2 per cent of GDP to 38.6 per cent, thereby restoring all the reduction between 2007-08 and next year, while total spending is forecast to fall from 44.2 per cent to 41.5 per cent. So both blades of the scissors – higher taxes and, still more, lower spending – will be at work in the years ahead.

Will this work? This question breaks into two parts: will the government get away with it and will it secure the recovery it seeks? On neither point can there be certainty. Yet when monetary policy does not work very well, the fiscal route is a bet worth taking. Still more important, in the short term, will be successfully persuading, or forcing, banks to lend again. But even that can only be a partial answer. Nobody who looks at the UK economy today can seriously believe that the answer is much more debt. For this reason, the fiscal boost may fail to persuade people to spend: they need to save.

The era of soaring borrowing and the associated boom in finance is over. The government should indeed act as borrower of last resort at this traumatic time. But the aim cannot be to tide the economy over until households start borrowing madly again. For the same reason, attempts to pump up the mortgage market, however understandable, are largely misguided. No sane person would borrow to buy houses whose prices are so likely to fall. Even if the government does get away with its heroic gamble, the longer-term path of the economy must be quite different from that of recent years. Do the government or the British people understand the implications of such a shift? I doubt it.

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