Stephen King: And, lo, Gordon came upon the stable and found a cyclical revenue shortfall

It's not the amount of public spending that's problematic: it's the lack of improvement in public services
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The Independent Online

For those of you opening your Advent calendars, this is a rather unusual year. In earlier festive seasons, you might have associated each date with a unique celestial scene or, in my children's case, a miniature Mars Bar or Twix. This year, though, you're likely to be a little surprised by some of the pre-Christmas entries: the meeting of G7 finance ministers that took place over the weekend, for example, or today's UK pre-Budget report, or maybe the Doha trade discussions that are due to carry on in Hong Kong in the middle of the month. So, be careful. You might be expecting another chocolate treat every day but you could, instead, come across images of Gordon Brown, Peter Mandelson and Rob Portman, the US Trade Representative, gazing at each other beatifically.

Of course, you might regard this as a flight of fancy, either because you seriously doubt that our finance and trade leaders would ever turn up in your advent calendar or because, if they were to, their mutual gazes would be a little less than beatific.

December's financial and economic events will, nevertheless, deliver countless headlines - tomorrow's newspapers, no doubt, will be full of Gordon's fiscal arithmetic. But what should we make of Mr Brown's efforts? How should we judge the progress - if any - made at the weekend's G7 talks? And what of the Doha round? Is a deal possible? And, if there is no deal, what will the world economy look like over the next few years?

The Chancellor of the Exchequer has his own, UK-specific, problems that are not dependent on events taking place overseas. It's reasonable to divide up his problems with the public finances into three separate categories.

First, he's got a problem with the pace of economic growth. At the time of the Budget, he expected the UK economy to expand at a rate of 3 - 3.5 per cent this year. The number now looks more like 2 per cent. As a result, he's suffering a cyclical shortfall in revenues. To be fair, though, his forecasts have, on average, been a lot better than those of the forecasting community as a whole, so a one-year aberration doesn't seem too bad.

Second, and more seriously, revenues have been weaker than expected for a given rate of economic growth. This looks to have been a structural miscalculation that has its roots in the late-1990s technology boom: then, revenues were unusually robust, yet the Treasury was happy to assume that those years of plenty would continue. They haven't. As a result, budget deficits have been persistently bigger than the Treasury had expected.

Third, the Chancellor has fundamental difficulties with public expenditure. It's not the amount of public spending that's problematic: instead, it's the improvement - or lack of it - within public services. There are two issues. There's a measurement problem. The official statistics suggest that, to date, public sector productivity has been in decline. Of course, it's difficult to know precisely how to measure public sector services: a hospital with fewer patients might mean more success with preventative medicine but might, equally, mean greater bureaucracy and, therefore, less money for beds. Nevertheless, the results so far have not been encouraging. Then there's an incentive problem. The setting of targets is all very well but people adjust their behaviour to those targets, making the targets increasingly meaningless: a good example of this is contained in Freakonomics (Levitt and Dubner), where some Chicago-based teachers fiddled the exam results to ensure that their own classroom efforts were not below par. I'm not suggesting that the UK public sector is full of cheats and frauds but, rather, that the setting of targets is likely to distort people's behaviour, thereby undermining the Government's original ambitions.

As for the big international issues, the good news is that most policymakers recognise what those issues are. For finance ministers, it's global imbalances. For trade representatives, it's the need to avoid the return of protectionism.

These two topics are closely related. Both of them are, of course, linked to the challenges associated with globalisation. But, because globalisation is both difficult to understand and politically controversial, it's never easy for our leaders to reach agreement on the appropriate "next steps", even if they agree on the underlying structural challenges.

Oddly, the US is in an unusually strong position to force its view of the external imbalance story onto the rest of the world. I use the word "oddly" not so much because of America's size but rather because of the degree to which it has built up liabilities to the rest of the world. Typically, it's the debtors who are vulnerable when it comes to international finance. But in America's case, the tables are turned. The US, uniquely, has borrowed from the rest of the world in its own currency. If, therefore, the dollar subsequently falls in response to growing external imbalances, it's the foreign creditors who initially have to pick up the bill: getting their money back in devalued dollars isn't that attractive an option.

The threat of persistent dollar decline has amounted to very little over the last 12 months: the dollar has been nicely supported by the Federal Reserve's constant nudging-up of interest rates. But US policymakers know very well that, should other countries fail to expand, and should the US current account deficit get ever-bigger, the dollar will eventually have to fall a long way. They also know that a dollar decline would be probably more damaging outside the US. A big rise in the euro, for example, could easily undermine a Continental recovery that, so far, has been driven primarily by export success.

There's no doubt that the US will emphasise this point of view. It's a way of stressing that external imbalances are not just a problem for the United States and its budget deficit, but for the world as a whole and, hence, that any solution must involve co-operative efforts on all sides. And it's here that disagreements are likely to be brewing away. The US would like to see greater currency adjustment from the Chinese and from other Asian economies. The adjustment we're likely to see will probably be rather small. The US would like to see greater microeconomic reform in continental Europe but, despite favourable noises, the political will to deliver such reform still seems to be lacking. And the US would like to see more progress on European agricultural reform: indeed, without that reform, the Doha trade round could end up in serious trouble.

So what happens if the US doesn't get its way? Rather than playing the global finance and trade policeman, the US could then find itself adopting a more domestically-driven role, reflecting the growing protectionist sentiments of a nation that's still ambivalent about globalisation. That would not be good news at all. All the progress made to reduce trade barriers and capital controls over the last 50 years would begin to go into reverse. As Alan Greenspan put it on Friday: "If ... the pernicious drift toward fiscal instability in the United States and elsewhere is not arrested and is compounded by a protectionist reversal of globalisation, the adjustment process could be quite painful for the world economy."

Stephen King is managing director of economics at HSBC