Jeremy Warner's Outlook: As the economy wilts, prudence on public borrowing is exposed as a sham

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The Independent Online

Gordon Brown may not yet have noticed the latest GDP figures. What with yesterday's crushing by-election defeat, he's got more immediate things to worry about, as in how much longer he'll keep his job. Yet for a politician who has staked his reputation on the abolition of boom and bust, yesterday's numbers on the economy were in some respects even more humiliating than coming second to the SNP in what was meant to be a Labour heartland.

We are not yet in the bust, but seem fast to be getting there. If there were any remaining doubt about it, yesterday's miserable 0.2 per cent growth rate for the second quarter confirms that the rules put in place 11 years ago to underpin market confidence in the Government's management of the public finances are being swept away by the gathering economic downturn.

The inflation target is already toast and it now seems clear that so, too, are the Government's forecasts for growth this year and next. After yesterday's numbers, it would require nothing short of the miraculous for the economy to come in at even the bottom end of the Government's range of 1.75 per cent to 2.25 per cent.

As for the forecast of a return to trend growth next year, that too is plainly for the birds.

Annual growth would equal no more than 1.1 per cent even if the economy managed to maintain the run rate seen in the second quarter. As it is, many analysts are expecting the second half to record a mild recession, so a fall to less than 1 per cent already looks possible, with little improvement next year. The upshot of all this is that the Government is going to miss its targets on public borrowing by a country mile, putting it in breach not only of its own rules but also of those dictated by the European Stability and Growth Pact.

From being one of the best performers in Europe on inflation, growth, public borrowing and employment, Britain may soon find itself one of the worst.

Much mocked by Mr Brown in his early years as Chancellor, the European Stability and Growth Pact rules now look like a rather better framework for governing public borrowing than his own, which, far from constraining behaviour in periods when there should have been surpluses, encouraged a backward-looking approach to tax and spend that relied on past surpluses to ensure borrowing balanced over a cycle of unknown length.

As it is, the Chancellor is now certain to bust the "sustainable investment rule", which sets a ceiling of 40 per cent on public borrowing as a proportion of GDP. Even the National Institute for Economic and Social Research, which is actually a bit more optimistic than most outside forecasters on growth, reckons that, on unchanged spending policy, debt would rise to 44.4 per cent of GDP by 2012/13. That number would be reduced a bit by plans to include bank interest payments as part of the national accounts, the effect of which would be to increase the total size of the economy somewhat.

Even so, the ceiling would still be breached, and that's before taking any account of off-balance-sheet spending through public-private partnerships or massive public-sector pension liabilities, again treated for accounting purposes as off balance sheet.

In apparent recognition of the inescapable, the Government this week admitted that it was examining ways to reform the fiscal rules. As I say, all this may seem the least of Mr Brown's concerns right now, but given the personal capital he's invested in prudential management of the public finances, it may come to be seen as even more powerfully symbolic of the collapse of the regime than yesterday's by-election result.

Calling the bottom on the credit crunch

While the economic downturn deepens, the banking crisis, which started us all off down the slippery slope, shows a few signs of easing.

This might not seem obvious, looking at the collapse in the United States of IndyMac, the Federal bailouts of Fannie Mae and Freddie Mac, and the panic around Washington Mutual, one of the US's biggest banks. If anything, conditions seem to be getting worse, not better. Yet almost exactly a year after the credit crunch began, there may be a few green shoots poking their way through the frozen tundra.

It couldn't yet be called spring; there's still a huge overhang of unwanted debt to shift from banks and hedge funds for which there are no obvious buyers.

The natural buyers of old are today the very same institutions trying to shift the stuff. In any case, the credit crunch couldn't be declared over until the securitisation markets reopen, and, until the overhang is cleared, there is no prospect of that. Even so, there are one or two encouraging signs.

Since the Bank of England's Special Liquidity Scheme (SLS) came into being last April, spreads between bank base rate, overnight and three-month rates have noticeably eased. The SLS and similar liquidity arrangements operated by other central banks mean there shouldn't be any further problem of funding.

The presumed "run" on Washington Mutual is in these circumstances quite hard to understand. In theory, at least, WaMu should be able to borrow all it needs from the Federal Reserve. Opening the discount window to investment banks alongside commercial and retail banks has almost certainly saved Lehman Brothers from a similar fate to that of Bear Stearns. Again in theory, there shouldn't be any repeat showing of banks going to the wall because of funding difficulties.

As the economy turns sour, virtually all banks will see a rise in conventional bad-debt experience, further impairing profits and capital already damaged by write-downs on tradable credit.

Even so, there is no reason to believe these charges will reach levels anywhere near those of the early 1990s, when, at the nadir of the downturn, some banks were forced to write off as much as 2 per cent of their loan books.

The fact that there are some deals getting done in the banking sector, albeit at very low prices – Santander's bid for Alliance & Leicester is one example – is another sign that the bottom may have been reached. Markets saw news this week of Bradford & Bingley packaging £2.9bn of mortgage loans for securitisation as further evidence of things getting better.

Sadly, there is a world of a difference between packaging and actually selling to investors.

For the time being, the only buyer of these securities would be the SLS. There may also be more shocks to come in the forthcoming season of banking results, which gets under way next week.

Nonetheless, for bankers the worst is probably over. Would that the same thing could be said about the wider economy.

Another profits warning from Rentokil Initial

Investors thought that salvation had arrived when it was announced last March that the hugely well-regarded former management team of ICI was being parachuted in to run the bombed-out services company Rentokil Initial.

Yet as if to prove the old truism that when good management is united with a fundamentally bad company, it's always the bad company which ends up winning, the dream team was yesterday forced to issue another profits warning, the fourth since December and the second since Mssrs McAdam and Brown arrived.

It seems that even they underestimated the scale of the challenge faced. Alan Brown, the chief executive, blames the problems mainly on the last attempt to set the company to rights, a reorganisation which so poleaxed customer service that contracts were cancelled wholesale. On top of trying to reverse this act of vandalism, the new team now has the economic downturn to contend with.

All in all, it's going to be a long haul back to the FTSE 100, and you begin to wonder whether Rentokil will ever get back there at all.

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