Economic View: The Chancellor's destiny is already set in stone

As Alistair Darling prepares his first Budget, both his job and the health of the economy are in thrall to the depth of the decline in house prices
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The Independent Online

So it is Alistair Darling's first Budget on Wednesday and – who knows? – maybe also his last. The online politics website did a poll of its subscribers last week which revealed that a large majority thought he would be sacked within a year.

That's a bit rough, partly because he has been dealt a pig of a hand by his predecessor and partly because it is even more clear now than it was a few weeks ago that the world economy is going into some sort of downturn. There have been mounting signs that the US housing market is getting still worse and the figures on Friday showing falling employment there rather confirmed that the US is close to recession. Whatever view you take of the Chancellor's competence you cannot hold him responsible for this country's fiscal position or the state of the world economy. But politics is not fair.

What the bad news from the US has done, though, is to focus minds on the likelihood of the UK going down the same route. That is really the big issue, of greater direct importance than the fiddling that Mr Darling will do in the Budget. If our housing market goes into a similar state of collapse as in the US, then our economy will follow and our public finances will be in even more trouble.

So our housing market is perhaps the best place to start when thinking about the Budget – and here is an area where facts are more helpful than opinions.

We know a few things. One is that the peak of the cycle was in October or November last year and that since then there has been a gradual slight decline in prices. Another is that activity has declined, with fewer mortgages being issued, and when they are, on tougher terms, fewer site visits etc. Still another is that a lot of mortgages made in the past two or three years are being re-fixed at higher rates. Put all this together and, as you can see in the first graph from a study by Credit Suisse, there is a strong probability that house inflation will go clearly negative this summer. That will have quite a psychological impact on home buyers and sellers alike. By the end of 2008, the forecasts of a fall year-on-year of perhaps 5 per cent seem plausible.

The greater difficulty is to know what happens after that. There will be a gradual decline in the cost of borrowing, with interest rates down to 4.5 per cent, maybe 4 per cent, by the end of the year. But even such a fall may not stimulate demand very much. The Bank of England can reduce its rates, but until and unless market conditions return to calm, the rates banks have to pay for money will stay stubbornly high. The other graph shows the gap between official rates and money market ones. The latter have actually risen in the past four or five weeks, despite a cut by the Bank.

Mortgage lenders can only make new loans if they can attract additional deposits, and in any case their first priority must be to refinance existing borrowers. So they are rationing new loans by making the terms more onerous: a larger initial deposit, fewer loans for buy-to-rent and so on. Even when the markets become calmer, expect lenders to remain cautious because they will feel they cannot be sure that markets won't freeze up again.

The most important question seems to me to be what happens in 2009. If prices fall by 5 per cent or less this year, that will not have huge knock-on effects on the economy. Sure, growth in consumption will come down as people are no longer willing or able to borrow to maintain their spending. Equity take-out, which has boosted household incomes by up to 5 per cent in recent years, will wither away. But some growth in consumption still seems reasonable: perhaps 1 per cent a year rather than the 4 per cent people have become used to. But if, as for example Capital Economics predicts, prices fall by another 8 per cent in 2009, then the blow to the economy would be more severe.

Evidence from the US suggests that there is a lag of at least nine months between house prices starting to fall and there being much impact on the economy as a whole. Apply that to the UK and growth should continue solidly through the first half of this year, maybe longer. Most independent forecasts now put growth this year at 1.5 to 2 per cent and I would expect this to be the range that the Treasury forecasts in the Budget. But I expect also that the Treasury will put in a higher figure for 2009, perhaps 2 to 2.5 per cent. If the housing market recovers a bit next year, or at least does not fall further, that is plausible. If prices go on falling, it is not.

Almost all the forecasts I have seen suggest that growth next year will be higher than this. But Roger Bootle, economic adviser to accountants Deloitte, has a lower number – 1.5 per cent in 2009 against 1.7 per cent in 2008 – and I expect to see more of these rather dismal forecasts come through later this year.

And there lies the biggest threat to the Chancellor's sums. The borrowing requirement for this year may or may not be above the upwardly-revised £38bn revealed in the pre-Budget report, but it is very hard to see a lower number coming in for 2008-09. If the Treasury does come in with a lower number, don't believe it. Tightening policy this year will make no sense, so I suspect he will have to acknowledge that fiscal borrowing will go up, not down.

Budgets are always a mass of detail and this one will have the added spice of showing to what extent the Chancellor has listened to protests about capital gains tax and the treatment of non-doms. There will be further confusion as a result of the accounting treatment of Northern Rock. But what ultimately matters is not the extra pennies on booze, nor the odd few millions on yet another initiative that is dumped in a few years. What matter are the big numbers of the economy and the public finances. What is happening to growth? What is happening to tax revenues? What is happening to government borrowing? And the single most important factor will be house prices.