Economic Commentary: Comparisons can be odiously wrong

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The Independent Online
The Chancellor's new plans for public spending, announced last week, have been greeted widely as extremely tough.

Most commentators have swallowed hook, line and sinker their briefing from the Treasury and have portrayed the 'cuts' as a serious attempt to rein in public borrowing as the economy has headed into deeper recession.

'The Major's not for turning' is the message coming out of Whitehall, and there is even reverential talk of how the Government is attempting to relive the Thatcherite triumph of 1981, when Geoffrey Howe decisively broke with the post- war Keynesian consensus and introduced a massive package of fiscal retrenchment in the depths of recession.

Most of this talk is, in fact, nonsense. Last week's public spending figures were not half as tough as they looked - even if the new targets are achieved, which is far from certain. And anyway, parallels with 1981 are grossly misleading.

In the mythology of the Thatcherites the 1981 Budget was the moment when the private sector in Britain realised that there would be no more soft options. Instead of reflating out of recession, and in the process ensuring that inflation would inevitably rise later, Geoffrey Howe put fiscal and monetary discipline first.

He was told at the time by Britain's economic establishment - remember the 364 economists? - that this would make recovery impossible. Yet from that moment onwards the economy started to expand, and for many years inflation stayed low.

Unprecedented

It is certainly true that the 1981-85 economic recovery was not fuelled by budgetary expansion and was therefore different from some of its post-war predecessors. But to suggest that it was a self-induced recovery, triggered automatically by a private sector benefiting from low inflation, is equally wrong.

In fact, overall economic policy was eased massively after 1980, not through a change in the budgetary stance but by a significant reduction in interest rates and the largest devaluation in the exchange rate since the war.

Over the main period of monetary easing, from October 1981 to March 1984, base rates fell from 16 to 8.5 per cent and the currency was devalued, over a slightly longer period, by 27 per cent.

There was nothing automatic, unusual or inexplicable in the initial triggering of the Thatcher boom. All that happened was that a tightening in budgetary policy was swamped by a historically unprecedented monetary easing.

And the important message for the Major administration is that the Thatcher recovery proved neither that toughing it out necessarily works, nor that low inflation automatically leads to economic recovery.

This time the Government is adamant that there will be no sterling devaluation and (by implication) that monetary policy can only be eased at the pace permitted by the Germans. A budgetary retrenchment in these circumstances could not work as it did in 1981.

Then, it helped get interest rates down and thus led to a sterling devaluation. Now, if there were to be a fiscal retrenchment it would have no effect on either interest rates or sterling, since both are effectively fixed by ERM membership.

Economic policy would remain tight on every front, and we would have a genuine test of the thesis that low inflation is a sufficient condition for a recovery in activity without any easing in any element of policy.

On this the omens so far do not look at all encouraging, but fortunately the Government's budgetary stance is much less tough than it might appear.

Last week the Treasury trumpeted that next year's government spending plans had been left exactly unchanged in nominal terms compared with the 1992 Budget projection, and that nominal spending had been cut by about pounds 7bn a year in both of the following two years.

This is the case for saying that the plans are 'tough'. But in fact all that has happened is that the Treasury has partially allowed for the reduction in its inflation forecast since the Budget to feed through into its spending plans.

Table 1 shows the planned path for the real level of government spending after adjusting nominal plans for the Treasury's inflation projections. The real level of spending this year has risen by pounds 3bn compared with the Budget plan, and next year it will rise by pounds 4bn.

The growth rate in real spending in these two years will be extremely high, at 5.3 and 3.9 per cent respectively, and the share of government spending in GDP is likely to rise from 42 to 45 per cent.

Even in the final two years of the new plan the real level of spending is no lower than before - though the rate of growth is scheduled to slow sharply - and the share of spending in GDP is likely to remain at or above present levels.

This means that there is no need for the overall provision of public services to be any less than was planned prior to the election, though some rise in recession- induced spending, on social security and the like, might squeeze out the provision of real services elsewhere. However, what will have to change very considerably is the forecast path for the PSBR over the short and medium term.

In the election campaign the Government insisted, somewhat disingenuously, that its expenditure plans would be consistent both with further tax cuts and with the achievement of budget balance over the medium term. This now looks even less likely than it did in the heat of the campaign.

Table 2 combines the new government expenditure plans with the latest Goldman Sachs forecasts for government revenue over the next four years. It is possible that these revenue forecasts are based on a path for real GDP that is more subdued than the Treasury would consider central, but the differences are unlikely to be too large.

The Goldman Sachs projections show that, as a result of the deepening recession and the lower level of inflation now expected, government revenue next year is likely to be pounds 12bn to pounds 13bn lower than expected at Budget time.

Since the Treasury has left its spending plans exactly unchanged in that year, the whole of the revenue shortfall is added to government borrowing, so the PSBR in 1993-94 jumps from a Budget forecast of pounds 32bn to a new projection of about pounds 45bn. In the following two years revenue continues to fall short of the Treasury's Budget predictions, by pounds 26bn and pounds 28bn respectively.

In response to this the Treasury is looking for public spending cuts of only pounds 7bn a year so, instead of falling back, the PSBR remains stubbornly fixed at more than pounds 40bn a year.

Loss of control

And all this assumes that the Government's new planning mechanism will enable it, for the first time in many years, actually to hit its medium-term spending objectives. Since it is obvious that the ability to hit spending plans is more about the politics of the real world than about the committee structure in Whitehall, this should certainly not be taken for granted.

It is, of course, understandable that the Chancellor should want to appear as tough as possible in the next two or three years, since that is the only real chance he has of preventing a total loss of spending control in today's trying circumstances. But the idea that he is imposing a tight fiscal regime on the economy is completely wrong - and so it should be.

(Tables omitted)

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