Stephen King: Brown the tinkerman risks fiscal own-goal

This time the Bank can't rely on its friends at the Treasury to lend a helping hand

Once upon a time, Budgets were really exciting. Shrouded in secrecy, they would be unveiled by Chancellors in the same way that magicians would conjure rabbits out of hats. Not any more. By the time of Wednesday's Big Event, we'll know quite a lot about its contents. A little giveaway here and a little giveaway there, perhaps. These days, the Treasury likes to reveal its tricks before the magic show commences.

More often than not, these tricks are rather modest. This Chancellor is the equivalent of Claudio Ranieri, Chelsea's manager and self-styled "tinkerman". Gordon Brown likes to fiddle around, a stickler for detail so long as the big picture is behaving itself. To be fair, the Chancellor can - and, no doubt, will - make exactly that claim. Growth in the UK economy is fine, inflation is low, the budget deficit obeys the Treasury's fiscal rules (at least for now) and, unlike the US and many countries in continental Europe, the old "boom-bust" cycle has seemingly been abolished.

I'm not sure, though, that this lets the Chancellor off the hook entirely. Mr Ranieri and his boys in blue have done very well to progress to the quarter finals of the European Champions League but will, unfortunately, now have to deal with their nemesis, otherwise known as Arsenal FC, a team that Chelsea have failed to beat in the past 16 attempts. Similarly, Mr Brown and his Treasury troop have done very well so far, despite all their tinkering, but cannot be sure that an economic nemesis, a financial equivalent of a close encounter with the Gunners, can always be avoided.

If there is a problem, it lies not so much with the Chancellor's fiscal framework per se but, rather, with the choreography between fiscal and monetary policy. The Chancellor's friends on the other side of town - namely the Monetary Policy Committee of the Bank of England - are in charge of monetary policy, but they always have to have one eye on what the Chancellor himself is up to, both because he sets the inflation target for them and because his decisions on fiscal policy will have some influence on how the inflation target is achieved.

The left-hand chart raises an important issue. The chart shows the Treasury's own estimates of the cyclically adjusted budget deficit in the UK between the 2002 and 2005 fiscal years. I've included the Chancellor's past four estimates, beginning with the 2002 Budget and finishing with the 2003 pre-Budget report. Over the past two years, there can be no doubt that fiscal policy has been looser than originally planned. The cyclically adjusted estimates of the budget deficits from 2002 through to 2005 are all a lot higher now than was the case a couple of years ago, implying that the Treasury has injected more demand into the economy than was originally intended.

I have no problem with this and, for that matter, neither does the Treasury. Over much of this period, the global economy was weak and there was a perceived economic threat to the UK. Far better, under these circumstances, to offer economic support, either through interest rate cuts or in the form of tax cuts or higher public spending. The Bank of England and the Treasury did exactly that, allowing the UK economy to avoid recession when all others suffered.

What happens, though, when the UK economy is looking a bit too strong, rather than a bit too weak? The Bank of England already thinks this is a problem: after all, it's already raised interest rates and, if the financial markets are right, there are a few more rate increases to be delivered over the next few months. If the choreography between the Treasury and the Bank of England is to be maintained, would it not be reasonable to think that any increases in interest rates should be matched by a tightening of fiscal policy?

Economic logic is on my side. But I don't think that political logic necessarily is. I would be very surprised were the Chancellor to announce changes designed to reduce the scale of cyclically adjusted budget borrowing from the numbers seen in the pre-Budget report. In other words, this time, the Bank of England is on its own: it cannot rely on its friends at the Treasury to provide a helping hand in its desire for a moderation in the pace of economic expansion.

This conclusion immediately sets alarm bells ringing in my head. In the absence of any fiscal help, the Bank is caught in a tricky situation, a classic problem whereby only one policy instrument is available to deliver more than one goal. To demonstrate this, imagine two worlds of strong consumer spending growth, driven by rising house prices. In the first world, the Bank and the Treasury both tighten policy. In the second world, only the Bank tightens policy. The objective in both worlds is the same, namely the achievement of the inflation target.

But the two worlds differ markedly from one another. The main initial difference lies with the path for interest rates. Interest rates in the second world will be higher than in the first world, because monetary policy in the second world is having to do all the work required to slow the economy down in order to hit the inflation target.

That, in turn, means that the exchange rate is likely to be higher in the second world than in the first world, because of the higher level of interest rates. And, if this is true, the inflation target will be hit not just by the impact of higher interest rates on consumer demand, but also through the impact of a higher exchange rate on UK exporters, who will see their profits squeezed and, in turn, will be forced to reduce their domestic costs.

More broadly, the second world produces a much more unbalanced outcome. Consumer spending doesn't slow down far enough, the exporting sector gets hit too hard, industrial production growth remains too weak and the trade position starts to deteriorate.

And we're seeing exactly these patterns at the moment. Manufacturing production is stagnant, January's trade deficit was the biggest on record in nominal terms, yet house prices continue to rise strongly and consumers still haven't lost their appetite to spend. And, as the right-hand chart suggests, these developments could get worse: sterling's recent climb has been closely associated with the Bank of England's interest rate increases at a time when interest rates remain very low indeed both in the US and the eurozone.

The Bank of England would ideally like to see the Treasury tighten fiscal policy. It would make the Bank's job a lot easier, and would enable policymakers to focus on the bits of the economy that are too buoyant - consumer spending, the housing market - leaving alone those areas that are already looking rather vulnerable, such as industrial activity and trade. But this is unlikely to happen. Instead, the Bank will be faced with a difficult choice. Raise rates too quickly in the short term, and consumer confidence could collapse. Raise interest rates too slowly - thereby keeping consumer spending going - and foreign exchange traders would have a persistent one-way bet on sterling that would serve only to make the imbalances in the economy that much worse. In the end, the danger is that the asymmetries of the Chancellor's fiscal approach could be leaving us with an asymmetric - and potentially unstable - economy.

Stephen King is managing director of economics at HSBC

stephen.king@hsbcib.com

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