Despite the Budget dodges, base rates must rise

`The real nightmare for the next Chancellor is not that spending numbers have been artificially massaged down by Mr Clarke, but that there is no spare capacity left in the economy'

This year's Budget preparations saw the Treasury taking hold of its piggy bank, turning it upside down, and shaking it for all it was worth. On finding remarkably little inside, the Chancellor could (theoretically) have chosen to abandon his plans to reduce the basic rate of income tax by 1p, a measure which had clearly been pre-ordained ever since the ink dried on the 1995 Budget.

In any year other than this one, that is almost certainly what he would have done. But in this pre-election year, even Mr Clarke, who has bravely stood up to almost everything the Right of his party has thrown at him over several years, decided that discretion was the better part of valour. The penny cut in the basic rate almost assumed the status of a "pre-Budget" measure, with everything else having to be built around that fixed point. Treasury officials would almost certainly have preferred a more contractionary Budget, but view the outcome as about the best that could have been obtained, given the political circumstances of the Government.

Undoubtedly, they feel that the net tax cut would have been far larger under almost any Tory Chancellor other than Ken Clarke. Clearly so, but it is hard from the outside to avoid the suspicion that a large number of corners were cut in the preparation of the Red Book figures, all in the aid of presenting a tenable path for the PSBR while also "affording" that penny tax cut.

The baseline for public spending failed to decline conveniently this year because of a favourable surprise on inflation, as it had in the previous two years, and spending departments resolutely refused to give ground to the Treasury in the autumn spending round. So, instead of relying on genuine savings, this year's "cuts" in public spending have required a series of subterfuges of varying validity. Luckily, all of these have been spotted by the financial markets.

So why is the Budget less tough on domestic demand than it looks? The simplest reason is that the lion's share of the cut in the PSBR next year (pounds 6bn out of the pounds 7bn drop) is not caused by policy measures at all, but by the automatic effects of faster GDP growth on the budget deficit. This should not really count as a policy tightening.

Then there are more detailed matters. First, while the Red Book claims that privatisation receipts will fall from pounds 4.5bn this year to pounds 1.5bn in 1998/99, the truth is that other forms of additional asset sales are hidden away in the figures, of which the most important are the sale of defence married quarters, and the student loan book. For reasons that have never been clear to me, these are scored as negative public spending within the control total, an accounting device which flatters the overall figure by around pounds 2bn.

Second, the Treasury has for the first time ever this year decided to base its forecast for social security payments on a forecast of declining unemployment, instead of simply assuming an unchanged jobless total. Literally hundreds of times in recent years, ministers have piously stated that it has never been the practice of governments to forecast the level of unemployment. All of a sudden, it is - and what a happy coincidence that this change has been made in a year when it is possible to forecast a fall of 400,000 in the jobless total, thus lopping another pounds 2bn off the spending total.

Third, there is the closing of tax and spending loopholes, which is supposed to reduce the annual budget deficit by pounds 3bn in three years time. The Treasury is bound to come under a great deal of pressure to justify this figure at the Commons select committee this week, since there must be a suspicion that this programme was plucked out of the air to make the Budget add up.

Treasury officials are apt to get quite indignant about this suggestion, arguing that the "spend-to-save" estimates are as soundly based as any others in the Red Book. There are, apparently, local pilot studies which "prove" that for every pounds 1 spent on extra checking, the Government saves pounds 8 in reduced fraud. But why has this only become apparent this year, following several years in which the government was abusive towards Gordon Brown whenever he suggested that money could be saved by closing loopholes? And why stop at saving pounds 3bn, if this procedure has suddenly become so straightforward? The answer is presumably that there are diminishing returns to this type of effort, but then how can we possibly know where they will set in? All in all, it seems awfully convenient that these savings have popped up just before an election.

Probably this is all a mite too cynical. This Budget could have been a whole lot worse, since it is certainly true that around two-thirds of this year's income tax cut has been offset by genuine tax increases elsewhere.

Furthermore, in one important aspect of preparing a Budget, the Treasury has been much more forthcoming than ever before. This concerns the crucial matter of how far below capacity the economy is now working (answer: the Treasury reckons there is an output gap of 0-3 per cent, with the Budget based on a central estimate of 1.5 per cent), and how fast the economy can grow on trend (answer: 2.5 per cent per annum). Combining these two figures with the rest of the Treasury's forecast, we can deduce that it expects output to return to trend at the end of 1998/99, at which point the PSBR should be dropping below 1 per cent of GDP.

If this calculation proves to be wrong, it is much more likely to be because the estimate of the output gap is wrong, rather than because any of the details of the tax and spending programmes proves misleading.

The real nightmare for the next Chancellor is not that the spending numbers have been artificially massaged down by an outgoing Mr Clarke, but that there is no spare capacity left in the economy. If that turns out to be true, then everything is about to go wrong, not just the PSBR.

That is now a matter to be addressed by monetary policy. The Bank of England will certainly have spotted the Treasury dodges, which means that the Governor is unlikely to share the Chancellor's view that the Budget has substantially reduced the need for further base rate rises.

As the graph shows, overall monetary conditions have been tightened sharply in recent months, even though base rates have increased by only a quarter point. But the reason for this is the 10 per cent rise in the exchange rate, which is included in the monetary conditions index shown in the graph.

Since neither the Bank nor the Treasury believes that sterling should be counted as an independent monetary instrument, this will not deter officials on both sides of town from pressing for more base rate rises soon. The Chancellor may not agree, but it is doubtful that he can hold out until the election all on his own. Good economics now requires higher interest rates, whatever good politics may imply.

Gavyn Davies is chief economist at Goldman Sachs.

PROMOTED VIDEO
News
Teeth should be brushed twice a day to prevent tooth decay
education
News
Bryan Cranston as Walter White, in the acclaimed series 'Breaking Bad'
news
Sport
footballChelsea 6 Maribor 0: Blues warm up for Premier League showdown with stroll in Champions League - but Mourinho is short of strikers
News
Those who were encouraged to walk in a happy manner remembered less negative words
science
Arts and Entertainment
Princess Olga in 'You Can't Get the Staff'
tvReview: The anachronistic aristocrats, it seemed, were just happy to have some attention
News
Renee Zellweger as Bridget Jones
i100
News
ebooksAn unforgettable anthology of contemporary reportage
Life and Style
tech

Board creates magnetic field to achieve lift

News
There have been various incidents of social media users inadvertently flouting the law
news

Life and Style
Stack ‘em high?: quantity doesn’t always trump quality, as Friends of the Earth can testify
techThe proliferation of online petitions allows us to register our protests at the touch of a button. But do they change anything?
News
Bourgogne wine maker Laboure-Roi vice president Thibault Garin (L) offers the company's 2013 Beaujolais Nouveau wine to the guest in the wine spa at the Hakone Yunessun spa resort facilities in Hakone town, Kanagawa prefecture, some 100-kilometre west of Tokyo
i100
Sport
CSKA Moscow celebrate after equalising with a late penalty
footballCSKA Moscow 2 Manchester City 2: Premier League champions let two goal lead slip in Russia
Latest stories from i100
Have you tried new the Independent Digital Edition apps?
Independent Dating
and  

By clicking 'Search' you
are agreeing to our
Terms of Use.

iJobs Job Widget
iJobs Money & Business

Helpdesk Analyst

£23000 per annum + pension and 22 days holiday: Ashdown Group: An established ...

Senior Helpdesk Analyst / Service Desk Co-ordinator

£27000 per annum + pension, 22 days holiday: Ashdown Group: An established ind...

Senior Pensions Administrator

£23000 - £26000 Per Annum: Clearwater People Solutions Ltd: Our client is curr...

Corporate Actions Administrator / Operations Administrator

£25 - 30k: Guru Careers: A Corporate Actions Administrator / Operations Admini...

Day In a Page

Indiana serial killer? Man arrested for murdering teenage prostitute confesses to six other murders - and police fear there could be many more

A new American serial killer?

Police fear man arrested for murder of teen prostitute could be responsible for killing spree dating back 20 years
Sweetie, the fake 10-year-old girl designed to catch online predators, claims her first scalp

Sting to trap paedophiles may not carry weight in UK courts

Computer image of ‘Sweetie’ represented entrapment, experts say
Fukushima nuclear crisis: Evacuees still stuck in cramped emergency housing three years on - and may never return home

Return to Fukushima – a land they will never call home again

Evacuees still stuck in cramped emergency housing three years on from nuclear disaster
Wildlife Photographer of the Year: Intimate image of resting lions claims top prize

Wildlife Photographer of the Year

Intimate image of resting lions claims top prize
Online petitions: Sign here to change the world

Want to change the world? Just sign here

The proliferation of online petitions allows us to register our protests at the touch of a button. But do they change anything?
Ed Sheeran hits back after being labelled too boring to headline festivals

'You need me, I don’t need you'

Ed Sheeran hits back after being labelled too boring to headline festivals
How to Get Away with Murder: Shonda Rhimes reinvents the legal drama

How to Get Away with Murder

Shonda Rhimes reinvents the legal drama
A cup of tea is every worker's right

Hard to swallow

Three hospitals in Leicester have banned their staff from drinking tea and coffee in public areas. Christopher Hirst explains why he thinks that a cuppa is every worker's right
Which animals are nearly extinct?

Which animals are nearly extinct?

Conservationists in Kenya are in mourning after the death of a white northern rhino, which has left the species with a single male. These are the other species on the brink
12 best children's shoes

Perfect for leaf-kicking: 12 best children's shoes

Find footwear perfect to keep kids' feet protected this autumn
Anderlecht vs Arsenal: Gunners' ray of light Aaron Ramsey shines again

Arsenal’s ray of light ready to shine again

Aaron Ramsey’s injury record has prompted a club investigation. For now, the midfielder is just happy to be fit to face Anderlecht in the Champions League
Comment: David Moyes' show of sensitivity thrown back in his face by former Manchester United manager Sir Alex Ferguson

Moyes’ show of sensitivity thrown back in his face... by Ferguson

Manchester United legend tramples on successor who resisted criticising his inheritance
Two super-sized ships have cruised into British waters, but how big can these behemoths get?

Super-sized ships: How big can they get?

Two of the largest vessels in the world cruised into UK waters last week
British doctors on brink of 'cure' for paralysis with spinal cord treatment

British doctors on brink of cure for paralysis

Sufferers can now be offered the possibility of cure thanks to a revolutionary implant of regenerative cells
Ranked seventh in world’s best tourist cities - not London, or Edinburgh, but Salisbury

Lonely Planet’s Best in Travel 2015

UK city beats Vienna, Paris and New York to be ranked seventh in world’s best tourist destinations - but it's not London