Stephen King: All Budget bets are off if UK growth falters

The underlying assumption all political parties use is that the economy will chug along merrily
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The Independent Online

The obvious thing to write about this week is Wednesday's Budget. But as I'm not a politician, nor a political analyst, there's not a lot that I can say. Gordon Brown will offer a few pre-election sweeteners and, doubtless, will lay into the Conservatives' plans to cut public spending. Michael Howard, in response, will presumably argue that there's nothing to show for all these years of public spending increases. And the rest of us will probably yawn, dreaming of years gone by when national political debate reflected deep philosophical divisions rather than the now all-too-frequent doubts about individual character and integrity.

The obvious thing to write about this week is Wednesday's Budget. But as I'm not a politician, nor a political analyst, there's not a lot that I can say. Gordon Brown will offer a few pre-election sweeteners and, doubtless, will lay into the Conservatives' plans to cut public spending. Michael Howard, in response, will presumably argue that there's nothing to show for all these years of public spending increases. And the rest of us will probably yawn, dreaming of years gone by when national political debate reflected deep philosophical divisions rather than the now all-too-frequent doubts about individual character and integrity.

You'll also find that much of the discussion in newspapers won't be very helpful. Polly Toynbee, writing in Friday's Guardian (A Mission to Destroy), slated the Tories' plans to slash public spending by £35bn over the next five years: with these "cuts", the Tories hope to lower public spending as a share of GDP from 42 per cent to 40 per cent. As Ms Toynbee put it, "£35bn is more than what every teacher, nurse and doctor costs".

This, though, is a highly misleading argument, designed to tug at your emotional heartstrings rather than your logical faculties. Whichever party wins the coming election, they'll assume that the economy will grow in real terms at about 2.5 per cent per year or thereabouts over the next five years. Add a little bit of inflation, in line with the Bank of England's target, and nominal GDP will rise at about 4.5 per cent per year.

Over a five-year parliamentary term, these numbers would translate into a compound 25 per cent total gain. If, for argument's sake, nominal GDP amounts to £1 trillion at the beginning of a new term in office, it would thus be reasonable to assume a figure of £1.25 trillion at the end of it. Based on these numbers - and these are only working assumptions for my argument, not precise forecasts, nor the assumptions that the political parties use - public spending under the Tories' plans would therefore shift from 42 per cent of £1 trillion (£420bn) to 40 per cent of £1.25 trillion (£500bn). Smaller as a share of GDP, perhaps, but most definitely larger in absolute terms.

The truth is that no one is planning, absolutely, to cut overall public spending. All parties assume that the economy will grow. The only issue is how much of that marginal increase in activity will go towards resources for the public sector and how much towards resources for the private sector. Of course, within the public sector, each party will have its priority areas - which may mean cuts in other areas - but voters won't really be able to find a mainstream party that plans, absolutely, to reduce the size of the state.

The underlying assumption that all political parties use in coming up with their spending and tax plans is that the economy will continue to chug along merrily, boosting tax revenues and, hence, making more funds available for future public spending or for cuts in taxation.

But no matter how well an economy is run, Chancellors will, from time to time, end up in hot water. Whatever Labour promises, whatever the Tories promise, those pledges are contingent on the economy expanding. If the economy fails to do so - if there's some kind of shock that causes the economy to deliver an unexpectedly weak performance - Labour's hopes for public spending increases would look increasingly forlorn, as would the Tories' hopes of renewed tax cuts.

Whoever ends up as Chancellor after the next election, they'll be casting a nervous eye over developments at home and abroad. On the home front, there are two obvious risks. The first danger, that old stalwart of dinner party conversations, is the housing market. Transactions appear to be very low, suggesting that house prices simply haven't come down far enough to allow the market to "clear". And, should house prices fall, consumer spending could begin to look a lot more vulnerable, undermining the promises from any government, whether Labour or Tory.

The second risk is wage inflation. In last week's column, I noted that wage increases were coming through thick and fast, in part a response to the ambitious spending plans of the current government. Three problems potentially stem from this process. First, higher wage increases may delay the point at which the Bank of England can reduce interest rates in response to a softening housing market or, even worse, force the Bank to raise interest rates even with falling house prices.

Second, paying higher wages to attract more recruits into the public sector may simply raise the public sector's wage bill without, necessarily, improving the quality of services. Third, higher public sector wages imply upward pressure on private sector wages as well: indeed, this process is already under way. In a world of mobile capital, that bodes less well for the UK's ability to attract the best foreign investment: strong sterling and high wages are hardly the best combination for a lasting improvement in competitiveness.

As for the threat from abroad, the past couple of weeks provide a timely reminder of the fragile foundations that underpin the world economy's continued recovery (see charts). Ask any policymaker in any part of the world about the major risks to continued economic expansion and the answer is likely to include external imbalances. Of course, one country's current account deficit is another country's current account surplus so, on a trivial level, the global balance of payments always balances. But the key issue is whether the net savers are prepared to continue funding the net borrowers.

The main borrower is, as everybody knows, the US. The main savers are the Japanese and the Germans, with their ageing populations, and the Asian economies whose central banks have to buy US assets to prevent their own currencies from rising against the dollar. If nothing else changes - in other words, the US economy continues to expand at a faster rate than economies elsewhere - the US current account deficit will get bigger and bigger and, hence, America's dependency on the world's savers will continue to rise.

What happens, though, if the world's savers begin to have doubts about US assets? Perhaps they'll start worrying about higher US inflation. Or maybe they'll begin to recognise that a falling dollar is an easy way out for US policymakers. Or possibly they'll fret about the domestic inflationary implications of their currency pegs against the dollar. Whatever the catalyst, the danger would be one of further dollar decline and, initially at least, significantly higher US interest rates. And that's why the last few weeks have been worrying: bonds have sold off, the dollar has softened and markets are becoming jittery once again about the structural health of the US external accounts.

Make no mistake: if the US finds that it cannot easily fund its current account positions, the UK will find it difficult to emerge from the fall-out unscathed. Global interest rates and risk premia on assets have been held at unusually low levels through the combination of remarkably low US interest rates and the actions of Asian central banks, recycling liquidity from their own economies back into the western world. Take those two factors away - or at least threaten to do so - and suddenly financial markets, including Britain's, begin to look a lot more vulnerable. And, in those circumstances, the promises made by any political party begin to look rather hollow. Whatever happens in this week's Budget, whatever political promises are made to woo voters, they're contingent on the UK economy doing well: throw in a few economic banana skins and all policy bets are off.

Stephen King is managing director of economics at HSBC

stephen.king@hsbcib.com

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