Hamish McRae: The Budget must not be viewed simply in terms of Brown's rules

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The Independent Online

There are really two ways of looking at the Budget, now less than two weeks away. One is to think about it in the terms defined by the Chancellor himself - of golden rules on borrowing and debt, tweaks to the tax system to make it more favourable to enterprise, extra spending on pet projects and so on.

There are really two ways of looking at the Budget, now less than two weeks away. One is to think about it in the terms defined by the Chancellor himself - of golden rules on borrowing and debt, tweaks to the tax system to make it more favourable to enterprise, extra spending on pet projects and so on.

There is nothing wrong with this. It has been greatly to Gordon Brown's credit that he has achieved a high degree of macroeconomic stability over the past eight years and that has been partly a result of the disciplines and priorities that he set himself. But it is a rather pernickety way of thinking about the country's fiscal management. It looks as though some reclassification of spending from current to capital by the Office of National Statistics may well enable the Chancellor to argue that the "only borrow for capital spending over the economic cycle" rule is intact.

But this is accounting. It really does not matter much in fundamental economic terms whether he just squeaks by on the golden rules or just misses them, just as it does not matter much whether France and Germany are just inside or just outside the Maastricht borrowing limits. What does matter is the big picture.

The other way of looking at the Budget is to do just that - an approach that is particularly appropriate this year as the Budget is only a couple of months ahead of the likely date of the general election. What we need to know is whether macroeconomic stability is likely to be maintained, whether we are getting value from the Government for the services it provides, and whether living standards will go on rising. These are much more useful tests for voters than self-imposed golden rules.

Macroeconomic stability first. Growth has been good. It was a little more than 3 per cent last year and the current consensus forecast is for about 2.5 per cent this year. We will get the new Treasury forecast in the Budget. It will be intriguing to see whether the Treasury is above consensus again, bearing in mind that the officials have in recent years been more right about growth than the City scribblers.

The big issue, though, is the extent to which growth has been puffed up by high borrowing by both individuals and the Government, and therefore might be unsustainable. If the spectre of a housing crash forcing people to pare back their borrowings hangs over individuals, the spectre of the need to increase taxation to correct the fiscal deficit hangs over the Treasury.

For what it is worth, the HSBC economics team reckoned that there was a 25 per cent chance of a housing crash this year. I suspect the chances of higher taxation after the election are rather greater than that. The worrying thing there is that strong growth has not increased tax revenues by enough to make much of a dent in the fiscal deficit. With growth of 3 per cent last year, very low unemployment and an economy that must be close to full capacity, we ought not to have a deficit of 3 per cent of GDP. Not good.

What matters is not whether fiscal policy is inside or outside the rules. What matters is that there ought not really to be much of a deficit at all at this stage of the cycle. The goal of continued macroeconomic stability can be reached consistently only if fiscal policy is consistent, and there must be concerns as to whether it is at the moment.

In the Budget there will be no obvious new taxes - that is a no-brainer just before an election. The thing to look for will be changes in tax practice that have the effect of increasing revenue: aka stealth taxes. But since we are all now trained to look for these, I suspect that the scope is quite limited. More likely will be a squeeze on public spending, but presented as growth in spending because it will come from greater efficiencies.

That leads to question two: are we getting value for money? It is extremely hard to measure the output of the public sector. Most countries don't even try, and instead measure inputs. So if the state spends more money on a service, it is assumed that more of the service is being provided.

Unsurprisingly there are two views. The Government and its supporters would argue that services have become better and there is no debate that a huge increase in public spending has taken place. The Opposition and its supporters would argue that a lot of the additional money has been wasted. Public sector employment has gone up a lot (first graph) reversing to some extent the cuts under the Tories. So there is no dispute about that.

There is some disagreement about the efficiency or otherwise generated by these extra people. The next graph shows how inflation in the public sector (measured by the GDP deflator) shot up, reaching 8 per cent a year - a serious deterioration on the performance under the Tories, when inflation in the public and private sectors was much the same. On the face of it this suggests that the public sector has delivered bad value for money. But as noted above it is hard to measure quality of output and I think it will be some years (and a lot of digging into the data) before we can really determine whether the waste has really been as bad as these figures suggest. Voters, meanwhile, will have to make up their minds.

One of the curiosities of the moment is that despite strong economic growth, most people seem not to feel much richer. On paper it looks as though living standards are rising but the growth seems to be tailing off. The third graph shows what has been happening to consumption on two measures: overall consumption and retail sales. Retail sales (left-hand scale) suggest that things are still swinging along OK - slightly slower growth but still clearly positive. But retail sales account for only about one-third of consumption. That makes sense, for we tend to spend more and more money buying services rather than buying things in the shops. The broader measure, consumption (right-hand scale), has slipped back and while still positive, is only just.

So yes, we are still increasing our standard of living, but more slowly than in the past: hence the feeling of slight gloom around, or having to run harder to stay in the same place.

We should not moan. At least living standards are not falling, as they have been in Germany for the past four years, and we have banked huge rises in our living standards since the early 1990s. But people can be unreasonable. It is no good telling people that they are richer if they don't feel that way and I suggest that in political terms the Chancellor may be in some difficulty here.

We will see soon. Or more likely we will see after the election, whoever happens to be running our finances then.

By the way, were the Prime Minister to sack the Chancellor after the election (and him leave the Cabinet), that would according to HSBC, be a negative shock: bad for sterling and all that. But the chances of that are ranked at only 10 per cent. So there.