Hamish McRae: Shock follows shock around the world – but, so far, the recovery is still on track

Economic View
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Events put us all in our place. We fuss about each twist of the economy, the nuances of a new statistic, the implications of some policy initiative – and then, bang, something comes along that makes all our judgements seem at best a bit petty and at worst utterly wrong.

And so it is right now. The British budget this week will have three or four interesting elements to it. One will be how much better the fiscal deficit will be this year – perhaps £10bn less than projected. Two will be what the Chancellor does about this, if anything. Three will be any changes to the economic forecast. And finally there will be some politically motivated tweaks.

This matters. It matters to us, obviously, but also, more broadly, it matters that this medium-sized but significant economy gets its house in order. It is better for the world to have a well-functioning Britain than one hobbled by debt and dissent.

But it does not matter nearly as much as the world having a secure supply of reasonably priced oil; or a recovering Japan; or a eurozone that is not fraught with impending sovereign default; or a continuing recovery in the US; or half a dozen other huge issues facing us.

You see the point. We can all have reservations about what is happening in the UK. I suppose mine, in a nutshell, is that we are getting the macro-economic policies right but may be getting the detailed application of those policies wrong. But we should see everything here in the context of the wider world economy, which has taken a bit of beating over the past couple of weeks.

Before going any further, let's just assert again that the human tragedies in Japan and in North Africa and the Middle East matter vastly more than any economic negatives. We all know that. There are, though, massive economic consequences and these have to be considered. If the Japan situation is much clearer than it was a week ago, that of North Africa and the Middle East is less so.

In the case of Japan, the back-of-an envelope calculation last week that this could cost the country 5 per cent of GDP seems now to be the right order of magnitude. Or at least it will be, barring some further catastrophe beyond our reasonable expectations. All past experience of coping with natural disasters suggests that lost output is made up reasonably swiftly. And so it will be here. Infrastructure can be mended; the dead can not. The great economic legacy of the tsunami will be the impact on the nuclear power industry worldwide, and nothing can be done about that.

If we know more or less where we stand with respect to Japan, we know much less about the implications for world energy supplies of the unfolding events in Libya, Bahrain and Yemen. My instinct is that this period will come to be seen in a similar light to the oil shock of 1973-74. The price of oil quadrupled and the world had to learn about a new power called Opec. Whatever happens to oil supplies in the next few months, the pressure will mount for the rest of the world to cut its risks – just as it did after 1973-74. North Africa and the Middle East together sit on two-thirds of the world's proven oil reserves. It is not sensible to be so reliant on the region. So the pressure will be on – not only to develop other sources of oil and alternative fuels, but also to conserve far more effectively.

Other stories of the past few days that may turn out to have a significance beyond immediate headlines include the patch applied by the eurozone leaders on the sovereign debt crisis. Greece got a lower interest rate on its bail-out but Ireland didn't, apparently because it refused to cut its 12.5 per cent corporate tax rate. On any long view that was wise, for the country's relationship with the corporate world is even more important than its relationship with its European creditors. One lot will continue to invest and generate jobs; the other will get paid back and that will be that. The long-term importance of this is that further moves towards a single eurozone tax system will be blocked. There will be sovereign defaults in Europe, that we know. But there won't be common tax rates.

Two other things struck me. One was that China seems to be getting its economy under control. The great problem has been that the domestic investment boom it triggered to offset falling demand from the rest of the world itself threatened to get out of hand. So China has been clamping down on bank lending by, among other things, increasing reserve requirements. It is hard from a distance to catch the feeling for detail but I see that Capital Economics thinks the inflationary pressures are no longer quite so pressing, which is encouraging. The point for the rest of us is that the world needs its second-largest economy to carry on growing, but it must be stable, sustainable growth.

You might almost say that for the US this is a real recovery, not an artificial one – I say almost because there is one artificial element, which is the fiscal boost. Unlike the UK, the US has hardly begun to tackle this.

This leads to a final question: what do these shocks do to the recovery? The fear is that they might derail it. Were oil to go to $150 a barrel that might happen. Equity markets were already soft before the earthquake and tsunami, as the main graph shows. I think the economic recovery remains intact and the market recovery on Friday reflects that. We are not through this yet, though, and that makes a tricky backcloth to this week's Budget.

The generation gap between services in return for taxes paid is a pernicious threat

Say the expression "intergenerational equity" and most people switch off. That is a pity because along with those other clunkers "opportunity cost" and "comparative advantage" it is one of the most important economic concepts.

It means fairness between generations and is given particular importance by the ageing populations of developed countries and the reliance on pension schemes where each working-age generation pays the previous generation's pensions. Whereas in the 1950s there were four or five workers for every pensioner, soon there will be two.

The result is that present retirees do very well out of the state, while the upcoming generation will do very badly. Student fees make matters worse, ditto the rising national debt and the government's various off-balance-sheet spending. There have been studies of this and the general calculation was that a person now retiring in a typical European country would get around £50,000 more out of the state than he or she paid in taxes, while someone entering the workforce now would pay the same amount more.

Last week the National Institute published a thorough study, Generational Accounts for the United Kingdom, looking at spending on health, education, social welfare, pensions and so on. The basic calculation is that newborn babies will pay nearly £70,000 more in lifetime taxes than they will get back in services. Add in interest on national debt and it gets worse.

The bottom line is that we need to pay another 6 per cent of GDP in taxes over and above measures designed to get a sustainable bud-get. That is not a political statement; it is a mathematical one. But there is a political consequence. If people feel they get a bad deal out of taxes – which inevitably they will – how will that change attitudes to government services more generally?

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