Alistair Darling is a good chancellor of the exchequer. He has presented a Budget that does essentially nothing – a good budget, given the dreadful economic circumstances. The global economic environment is the least hospitable since 1945 and a dozen years of specific British policy mistakes have left the British economy more vulnerable than almost any other to the financial crisis.
Mr Darling is doing his best to clean up the mess left by his predecessor, Gordon Brown. The fiscal profligacy of Mr Brown, now prime minister, after New Labour’s first term and his leadership since 1997 in the global financial regulatory race to the bottom have left the UK suffering from multiple imbalances. It is in its worst fiscal shape ever in peacetime – in the G8, only the US and Italy come close. It has a bloated financial sector, including a banking sector that is too large to save unless state support is restricted to the UK high street banking bits of UK-based global banking groups. It has a distorted and moribund housing sector and excessively indebted households.
During the next couple of years the UK will run public sector deficits of 12 per cent of gross domestic product or over – figures historically associated in peacetime only with developing countries or emerging markets en route to an International Monetary Fund programme. Large deficits will persist into the second half of the next decade. The structural deficit for the next few years is at least 7 per cent of GDP. Not counting the fiscal cost of the banking sector rescue, public debt will reach 80 percent of GDP two years from now.
Taking the IMF’s £130bn estimate of the fiscal bail-out burden and putting Private Finance Initiative debts on to the public balance sheet would bring the figure to 90 per cent. Real GDP is likely to fall by more this year than Mr Darling’s estimate of 3.5 per cent. The chancellor’s forecasts of growth of 1.25 per cent in 2010 and 3.5 per cent in 2011 are likely to be prayers to a (deaf) foreign god.
Public debt in excess of 100 per cent of GDP is therefore likely, even if we do not add the capitalised value of Britain’s unfunded public sector pension commitments, which are effectively contractual obligations.
Allowing the automatic fiscal stabilisers to operate in a downturn makes good economic sense if it does not spook the markets. Undertaking a discretionary fiscal stimulus also makes sense if it does not spook the markets. You will avoid spooking the markets despite £200bn worth of gilts issuance this year if, and only if, you have fiscal credibility: markets and the public must believe that you are willing and able to raise future taxes and/or to cut future public spending to stop the debt burden from rising explosively and becoming unsustainable. To be an effective Keynesian in a slump, you have to possess a reputation as a fiscal conservative. The UK government’s reckless pro-cyclical behaviour during the past boom years means it does not have this reputation.
Mr Darling has recognised this. So there is effectively no discretionary stimulus in the Budget – a mere 0.5 per cent of GDP this year. There is a small “cash-for-bangers” scheme and a few other tweaks. The weak pound and continued quantitative easing and credit easing by the Bank of England really are the only instruments left to fight rising unemployment.
There were some pointless populist soak-the-rich measures, such as the increase in the top marginal income tax rate to 50 per cent from next April. This will raise tiny amounts of additional revenue. Tax accountants, lawyers, financial engineers and tax havens all over the world will thank the chancellor for taking such good care of them. To budget an additional £1bn in revenue because of reduced tax avoidance following this major boost to incentives for avoiding and evading taxes is just plain silly.
Under the best possible scenario, taxes will have to be raised and/or public spending cut on a permanent basis by between 5 and 6 per cent of GDP to regain fiscal sustainability. The necessary permanent fiscal tightening could easily be larger. The pain will be widely felt. The ambition to bring British infrastructure back up to the level it achieved at the end of the 19th century has been postponed by another quarter-century. Education and health will suffer.
The long-term pain of higher taxes and lower public spending is not the result of public debt and deficits incurred because of a war fought by a united nation against a hated external enemy. It is the result of an economic civil war, a massive systemic peacetime economic failure, with a large domestic component. It is therefore not clear that the necessary social and political cohesion – readiness to accept joint fiscal burden-sharing – will be present. If the necessary fiscal tightening is not forthcoming because different groups and vested interests are engaged in a war of attrition aimed at shifting the fiscal burden to the other guy, markets could easily panic and Britain could face an emerging market-style “sudden stop”, with the rest of the world withholding financing from its public and private sectors.
To forestall the occurrence of a triple crisis (banking, sterling and sovereign debt), it would behove the UK to apply for an IMF Flexible Credit Line (FCL). Unfortunately, the criteria for qualifying for an FCL arrangement include “ . . . (iv) a reserve position that is relatively comfortable . . . ; (v) sound public finances, including a sustainable public debt position; . . . (vii) the absence of bank solvency problems that pose an immediate threat of a systemic banking crisis; (viii) effective financial sector supervision.” It is questionable whether criteria (iv) and (v) are met. Criteria (vii) and (viii) are obviously not met. In addition, with a £175bn annual borrowing requirement for the next couple of years, the measly $240bn or so the IMF currently has at its disposal is unlikely to make much of a difference.
Mr Darling will therefore need luck as well as skill and determination to get Britain through this Great Contraction without having to go another round in the financial crisis. I would consider the case for a government of national unity. It would help if Mr Brown – responsible more than any one for this debacle – were to resign.