Hamish McRae: We must use the next five years of growth to prepare for a downturn

Economic view
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The Independent Online

Well, we are on the glide-path to the emergency Budget in nine days' time and upon my word, what a bumpy ride it has been.

We hit an air-pocket with the plight of the euro, as the events on the Continent have greatly increased pressure on us to get our national finances under control more swiftly. Whereas six weeks ago, it was possible to have a debate about the wisdom of starting public spending cuts now, rather than waiting a bit, that option has closed. All Europe is cutting spending. We have to get on with it too. Then tomorrow we will get the final signal from the control tower of our present course and the corrections we need to make to achieve a credible landing.

In previous Budgets we got the forecasts and the response to them bundled up together. Now the Treasury will do things differently. First, we get the forecast of where the economy is heading and what that might mean for fiscal policy. That comes from the new Office for Budget Responsibility (OBR) on Monday. Then, on Tuesday week, we get the response to it from the Chancellor, or to put it more precisely, we get a Budget that is based on the OBR numbers. Then the OBR will assess how credible the response of the Chancellor is, going back over the numbers and coming up with some new forecasts.

The OBR is part of the Treasury, and rightly so. But the idea that Treasury forecasts of both the economy and of the fiscal deficit should be developed by a separate unit, reporting to this independent committee chaired by Sir Alan Budd, should correct two weaknesses of the previous system. One was that the Chancellor was able to massage the forecasts – and Gordon Brown did and Alistair Darling didn't (or at least not in his final year in the job). The other was that there was the sequence of decision-taking was unclear – you could not work out to what extent any policy move was really a rational response to a change in the underlying economic circumstances and to what extent it was a politically motivated decision. In theory, you were supposed to be able to do so, but in practice you couldn't.

We will have to see how the new structure works in action and I suspect it will take some time to bed down. We will get a lot more information than we have in the past and that is great. But the more subtle change will be that we get a genuine feel for the uncertainties of macro-economics. Here will be a central forecast for the economy, but also a range of possibilities outside of that, and the confidence that should be attached to these alternative projections. Meanwhile, there are two obvious things to look for: what is likely to happen to the economy and what is likely to happen to the deficit.

On the first, we'll have a look at the graph. As you can see on the left, the "normal" rate of growth during the run-up to the recession was 2 to 3 per cent. Arguably, that was a bit puffed up by the borrowing spree we went on, with rather too high a public deficit and a monetary policy that was, we can now see, too loose for it and permitted a housing bubble to develop.

Now look on the right-hand side. The purple and red bars show the central point of the growth forecasts of the Treasury and the Bank of England, the former of course under the previous management. The green bars show the consensus forecasts of the economic community. Just looking at that, don't the green bars look more plausible than the purple and red ones? I would be pretty confident that the OBR forecasts will be closer to the green bars than the others. Expect, too, for the OBR to throw forward the forecasts further into the future and let's see if it thinks the long-term trend growth rate for the UK is 2.25 per cent, 2.5 per cent or 2.75 per cent. That might seem small, but it matters a lot when looking at the sustainability of public finances.

On the deficit, there are some obvious issues and some less obvious ones. The headline budget deficit is obvious. Less obvious is how it has been reached. Last year, the Treasury was utterly determined not to be bullied by Gordon Brown into publishing fake forecasts. Alistair Darling won that battle. The result was the deficit turned out to be appreciably lower than the original number, but – big but – we will not know for a while if there has been some nudging of the numbers and that this improved figure for the last financial year implies a worse one for this year and beyond.

There is some evidence that repayments of tax owed was delayed under the previous regime to make the numbers for last financial year look better. It may also be that other government payments were delayed, too, perhaps only a few days, to shift them into the new financial year. Let's wait and see how much has been discovered, but don't be surprised if future projections are less favourable than the numbers previously published.

That leads to the biggest thing of all. We cannot really have much control over the pace at which we cut the deficit. I have previously argued in these columns that it would take more than one parliament to bring the deficit down to something close to balance. Now it looks as though it will have to be done in this one. Germany is setting a gold standard for fiscal prudence and the rest of us will have to do pretty much the same.

There are two reasons for this. One is that the costs of not being seen to be fiscally responsible have risen. Greece, which incidentally will not be able to pay its debts in full, started a global reassessment of sovereign debts and Japan, now warning that it too was threatened by its debt levels, cements that change.

The other is a growing awareness of the dynamics of the global economy. The world is heading into a growth phase that will last several years, despite the fact that a double-dip is likely (I think almost inevitable) in the next few months. We have therefore to use these next five years of growth, more if we are lucky, to fix public finances so that they are strong enough to withstand the next downturn. There is such a thing as the economic cycle. It would be lovely if there wasn't, but there is. So we really need to be running a surplus, paying down debt, by 2015, not just having debt that is rising more slowly than GDP.

This will be very difficult. It will be all the more difficult given the fact that the rest of Europe will be heading along the same track. But the prize – a government that can be relied upon to be honest about its finances – is worth chasing. The more we are honest, the lower the rate at which the country can borrow. And the lower the rate at which the government can borrow, the lower the rate at which companies and mortgage holders can borrow. The vicious circle becomes a virtuous one. The first step to the latter starts Monday.

A united Korea would be a force the world has to take seriously

You always learn more if you go to a place rather than read about it, and a short visit to Korea last week was an eye-opener. I had not appreciated that Korea is, with Australia, likely to be the fastest-growing developed economy in the world this year. Nor had I realised that it would become, later this year, the first country that had not been a member of the G7 to host a G20 economic summit. But the thing I came away with most notably was the way in which the country was starting to think about competitiveness in the future.

China will always be able to make things more cheaply than Korea, so Korea's lead in shipbuilding, steel, motorcars, flat-screen displays, and so on, is under threat. Yes, it can continue to push up-market; and yes, it can continue to automate and cut costs. But as quality in China improves, the trick becomes harder. It has the spectre of Japan, with nearly two decades of little growth, as a warning.

There was no obvious plan to move to a new growth platform, but there were several areas where Korean ideas are different. One is borrowing. Japan has a public sector debt of 200 per cent of GDP. In Korea, it is nearer 30 per cent. Another is the attitude to smaller businesses. The Prime Minister, no less, told us about the need for the country to build more medium-sized companies. He mentioned, too, how Korea needed more competitive service exporters, which Japan has broadly failed to achieve.

There was also talk of birthrates. Korea has fertility rates of about 1.6: why are rates rising in the UK and France, I was asked, and not in Germany? At least Korea does not find itself in Japan's trap, where entire communities are in decline because of the lack of young people.

But of course the most striking feature is the possibility, at some stage, that the two Koreas may be united. It would be a country with a population of 80 million, the same as Germany, and with technology that in some areas is the world leader. Getting from here to there, though, is fraught indeed.