Hamish McRae: If the deficit escalates, we can borrow our way out of trouble. But Brown will be in too deep

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It was the OECD's turn to put the cat among the pigeons last week. Along with the International Monetary Fund, it does about the best official economic forecasting work there is – not always right, but measured and sensible in both the predictions themselves and its judgement about them. So when it comes out with a projection for UK growth next year way below that of the Treasury, coupled with a strong criticism that Britain has had too loose a fiscal policy for several years, it deserves to be taken seriously.

But this criticism does need to be set in the context of the global slowdown; we are not alone here. In some respects, we do have a more tricky problem than most other developed nations and the Government must bear the responsibility for this. But in other respects, we are not too badly placed. What matters most of all is the profile of the world economy in the coming couple of years.

The two points made by the OECD are sketched in the graphs, with the numbers coming from the new OECD Economic Outlook. As you can see, the UK had the strongest fiscal position of any of the large developed economies in the late 1990s. That was partly because when Gordon Brown came to office, the UK's public finances were rapidly improving – an improvement sustained by his own decision to hold down public spending in his early years in the Treasury. Now we have the second-worst fiscal position after the US, with the deficit projected to reach 3.8 per cent of GDP this year and only improve to 3.7 per cent next. As you can see, most other countries have used the period from 2003 to now to cut their deficits, dramatically so in Germany and Japan. We haven't.

That puts us in a difficult position if growth falters. The OECD projects 1.8 per cent growth this year, which is just within the Treasury range, from 1.75 to 2.25 per cent. But next year, the OECD thinks, growth will slow to 1.4 per cent, whereas the Treasury thinks it will rise to 2.25 to 2.75 per cent – a forecast that looks less and less likely by the day. Were we to have a further slowdown next year, the expected improvement would go out of the window. Indeed, if house prices continue falling at the present rate, we will be struggling to get to 1.4 per cent growth. On Friday, analyst Global Insight revised its forecast for 2009 down to 1.2 per cent. It thinks house prices will fall by 12 per cent both this year and next.

That is big but not so far out of line with other forecasts. Some new work by UBS comparing the UK position now with house price crashes elsewhere in the world over the past 20 years puts the likely decline at 15 to 20 per cent. This all takes a while partly because people won't accept that the value of their homes are falling as fast as they are. Meanwhile, any decline is compounded by a tightening of credit as lenders take falling prices into account in determining the size of the loan they are prepared to make. Only when prices can clearly be seen to have bottomed can the market form a base for recovery – and this takes time. So we have the prospect of another three years of declining prices – which I don't think is on the radar for many people at the moment, and is a factor that will depress consumption for this period.

But this does have to be put in perspective, and not just because other countries are experiencing housing slumps too. I was at the OECD in Paris last week when the new forecasts were unveiled, and the concern there was not particularly about the UK. Sure, we were singled out for our failure in fiscal policy but the slowdown expected was no more serious than that for most other economies. The projections for the US were worse than ours: 1.2 per cent for 2008 and 1.1 per cent for 2009. For the euro area they were almost exactly the same: 1.7 and 1.4 per cent.

In meeting these challenges, we have one advantage and one disadvantage compared to continental Europe. The advantage is the ability to set appropriate interest rates. While any significant cut this year is off the cards, the OECD did assume three quarter-point reductions next year. On the Continent, by contrast, it looks as though the next move will be up, not down. The possibility of a rise in rates will scare the property markets of Europe, with Spain and Ireland looking most exposed.

It is the old problem that the European Central Bank has to set a single rate for very different economies, with the result that the rate is inevitably wrong for some, maybe most of them.

The disadvantage is that our fiscal position may slip very fast. The borrowing requirement is the difference between two huge numbers and all it needs is each to move in the wrong direction for the requirement to balloon. If the OECD is over-optimistic about growth (and it acknowledged that the risks to its forecast were on the downside), we face a deficit rising to 4 per cent of GDP and beyond. I am afraid that may happen. So what then?

It would be more important in political terms than in economic ones. I would have thought that were the fiscal deficit to balloon, the Prime Minister's position would become very difficult indeed. It would be recognised as his responsibility and, because he has set his store as a prudent fiscal manager, it would destroy that credibility. You begin to wonder whether it would be wise for him, for personal and for health reasons, to continue in office.

But in economic terms we can borrow our way out of this, provided – and this is crucial – that new fiscal controls are brought in to replace the present discredited ones.

The idea – Gordon Brown's idea – of setting fiscal rules was an important advance. The problem was that those rules were bent under pressure, in particular with a surge in off-balance sheet financing and the repeated changing of the definition of the economic cycle. So the next government will have to modify the rules to ensure two things.

One will be to engineer some external scrutiny over fiscal policy. It is not realistic to move to an independent fiscal commission on the lines of the independent Bank of England, but some element of that would greatly boost confidence and also improve long-term outcomes. The other will be to change the rules so that the deficit rules take the economic cycle explicitly into account. The OECD publishes inflation-adjusted deficits, which could be used as basis for the new rules.

But that is all for the future. Right now the path of the economy over the next three of four years is becoming clearer: the duration of the dip looks longer, even if outright recession is indeed avoided.

The truth about offshore shifting

Offshoring means shifting British jobs to people in lower-cost foreign sites and hitting UK employment? Well, no and no.

There are two common perceptions about this shifting of jobs overseas. One is that most of the jobs go to places such as India and China where labour costs are much lower. The other is that the UK suffers net loss of jobs. Both are wrong, according to research by the Globalisation and Economic Policy Centre at the University of Nottingham. The centre looked at data from more than 66,000 UK firms between 1996 and 2005 and came up with two rather surprising conclusions.

The director of the centre, Professor David Greenaway explains: "People fear their jobs are being exported to countries where labour is cheaper, but the picture is far more complex than that and much more positive.

"It would seem that firms that offshore part of their production process or service provision overseas become more efficient. This boosts productivity and turnover and as a result these firms grow and end up employing more people at home, not fewer."

The university calculates that the policy had resulted in the creation of 100,000 extra jobs and an increase of £10bn in company turnover.

There is a further confusion. Most of the jobs that are shifted offshore are not going to lower cost locations: they go to similar places, such as continental Europe, where the skill-mix is more appropriate. Meanwhile other jobs are offshored to Britain, when the skills are here.

According to Professor Greenaway, "The lesson for policymakers is that offshoring is to be embraced, not feared, but that we need to continually invest in upgrading the skills of British workers."

That must be right. The issue, though, is quite what role the Government should play. But that is another huge issue. Something for the Nottingham team to look at next?

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