Thanks to Mr Nelson's remark that an interest rate cut is now unlikely, we know that the Chancellor has followed the advice of the Bank and the Treasury: the half-point cut in interest rates in November did indeed take 'full account' of the tax rises announced in the Budget, as was claimed at the time. The Halifax borrowers whose payments are fixed on the end-January rate will have to wait another year for more than a half-point cut. It is a half-measure Kenneth Clarke will live to regret.
Economic policy should be based on the best anticipation of what is likely to happen, rather than an appraisal of what has just happened. The economic data that have just been published are certainly strong, but that is no surprise. The real question is whether the recovery will continue to be robust when the largest-ever single set of tax increases takes effect in April, at a time when the pound is still going up.
There is enough momentum in the economy to ensure that it is not pushed into reverse, but the Chancellor is now running the risk that it will undergo a pause in the spring and summer. That will be bad news for the unemployed and for businesses. We are still at the stage of the recovery where many companies are rising strongly, but remain under water financially. A slowdown will also be bad news for a government that is certain to be buffeted by disastrous results in the local council and European Parliament elections.
True, there is a hot debate about the likely impact of the tax increases, the most noticeable of which will be the one percentage point rise in employees' National Insurance contributions. As far as economic theory is concerned, you pay your money and take your choice. The new classical economists tell us that tax increases will have no effect, because people will happily realise that future government borrowing will be lower and hence their future liabilities as taxpayers will be lower. They will therefore compensate by spending just as much now, if necessary by borrowing.
Personally, I have always found the idea that people react in quite such a sanguine or well-informed way hard to believe. Quite apart from natural uncertainties about the future, few people have easy access to borrowed money. There are plenty of schemes to borrow money at extortionate interest rates on credit cards or hire-purchase schemes, tied to particular purchases. But it is not easy to borrow at reasonable interest rates unless you have a sizeable amount of equity in a house or flat.
That tends to be the case only for people who have paid a mortgage for some time, who are arguably the people who need to borrow least. For those starting on the housing ladder, who are now more likely to be trapped with negative equity, the whole question is academic.
So let us look at the real world. Several City analysts have rightly consulted our recent history as a guide to the impact of tax increases. The graph, for example, shows the pattern of the recovery of output today compared with the pattern after the infamous March 1981 Budget, in which the then Sir Geoffrey Howe raised taxes by 1.75 per cent of national income. It is designed to reassure investors that even this year's bigger tax increases will not stall the recovery.
But this is not the whole story. The Government's propaganda attack on the 364 economists who signed a public protest about the excessive deflation of 1981 was extraordinarily successful, not least because ministers have repeated opportunities to get their message across on the media, whereas even Brian Redhead has never managed to interview 364 economists on the Today programme, at least not at the same time. Ministers chirpily claimed that the recovery had begun just as the 364 said that it would not.
The 364 certainly exaggerated the depressive effects of the Howe Budget, but they were not as wrong as is often painted. The 1981 recovery was weaker than any other post-war recovery, despite a sharp fall in interest rates and the pound. The normal pattern in any economy is that the strength of the recovery mirrors the ferocity of the downturn: the worse the recession, the sharper the subsequent bounce. The 1979-89 cycle was quite different. It began with the worst downturn since 1921, and it continued with the slowest post-war upturn.
Indeed, the gap between actual output and potential output (or full capacity) continued to increase throughout 1981 and 1982. The economy did not register growth above its 2.25 per cent a year trend until the year to the first quarter of 1983, fully two years after the March 1981 tax increase. Indeed, growth was not rapid enough to reduce unemployment until 1986. On the normal post-war definition of recession, the economy continued to be in deepening recession through 1981 and 1982.
There is simply no explanation for this feeble recovery unless we posit a serious impact from taxation: sterling weakened during 1981 and 1982, interest rates fell, and there was little corporate or consumer debt compared with today's position. So the 364 economists were more correct than their detractors. Indeed, the Government eventually panicked so much about the prospect of facing the electorate for a second time without a fall in unemployment that it encouraged the over-borrowing of the late 1980s and the unemployment count-fiddling that did so much to undermine public faith in state statistics.
One big difference between today's situation and 1981 is that unemployment is already falling. I do not believe that this is much to do with any fresh changes that the Government may have introduced in the administration of benefits, but nor is it much to do with new jobs. The growth of employment is still weak. The real explanation is the shrinkage of key groups entering the labour force. There are fewer young people, and more of them are, thankfully, staying on in school for longer.
But this means that even big falls in unemployment - and the drop announced last week was 47,000, to take the rate just below 10 per cent of the labour force - should not be taken as a sign of an overheating economy or of the need for a more restrictive economic policy. Unemployment can surely fall by at least 2-4 percentage points without a risk that wage demands will begin to accelerate. Growth needs to be unsustainably high if unemployment is to continue to fall: only when the economy has absorbed its spare capacity and unemployed should the brakes go on.
Yet a more restrictive economic policy is precisely what we are getting. There is a strong case for fiscal tightening because of the budget and trade deficits, but only if there is an easing in monetary policy. This is not the case. Monetary policy is also getting tighter. Interest rates in real terms - after allowing for inflation - have been edging upwards as the inflation rate has subsided: since the autumn, short rates are down by a half-point, whereas underlying inflation is down nearly one point. The real short-term interest rate, taking the underlying inflation rate excluding mortgages, is 3 per cent, against 0.7 per cent in the United States and 1.4 per cent in Japan, economies that have similar levels of household indebtedness.
The pound is also up, abetted by Mr Nelson's indiscretions. Sterling's trade-weighted index closed on Friday at 82.7, fully 1.6 per cent higher than the last time there was an interest rate cut and 7.7 per cent higher than its average level in February, the low point after our exit from the exchange rate mechanism.
The post-ERM devaluation, once a hefty 16 per cent, is now just 9 per cent. Given that the shot to competitiveness is one of the few things that have kept the recovery going, this is not helpful.
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