Interest rates could be a big problem for Brown
Tuesday 08 October 1996
But, of course, the balance of probability is that this will be a Budget which never happens. If, as is the balance of probability, Labour wins a May general election, many of its features will be modified almost immediately after they have been put into effect.
On the tax side, any immediate changes in excise duties will go into effect straight away in November, but changes in income taxation will only start in April, so that only one pay-packet at the new rate will be in people's bank accounts when the election comes.
Then, on the assumption that Labour is able to form the next government, there will have to be a second budget modifying the first, probably in June. This will be the first taste of what it might be like under the new government - the extent to which fiscal policy really will be different. While it might seem a touch premature to be discussing Labour's first shot when we have not yet had the Tories' last one, anyone seeking to think though the influences on financial markets in the next few months ought to start building a Labour budget into their time-frame.
Some assumptions: the evidence of the past few weeks confirms that manufacturing is growing slower and the services industry is growing faster.
According to yesterday's figures, manufacturing has not grown at all during the past 12 months, which means all the growth in the economy is taking place elsewhere. Service output has risen 3.2 per cent in the past year.
It is very hard to see this growth slackening through the winter and spring, particularly given the one-off boosts to people's wealth that will come from the conversion of several building societies to quoted companies. So growth next summer will be running at somewhere between 3 and 4 per cent, unemployment will still be falling and though, as yet, there will be little immediate sign of a pick-up in inflation, people will start to worry about this.
The prospect therefore will be for higher interest rates, if the first upward nudge has not already taken place. Some estimates for the main features of the UK economy next year and in 1998, drawn from forecasts by NatWest Markets, are set out in the graph.
Forecasts are only forecasts but you can see the two obvious potential problems looming next year: that sharp rise in inflation which needs to be met by a rise in base rates; and a PSBR stuck at pounds 26bn, only slightly lower than this year's pounds 28bn. We do not yet know the base line that Mr Clarke will set, but you can see the strategic problem an incoming Labour chancellor will face. He will have to slow the economy, taking a decision of how to do so within a couple of weeks of taking office.
What might this mean in practice?
NatWest has made some assumptions: that Mr Clarke cuts taxes by pounds 3bn in November, a cut matched by cuts in spending, but enough to get 1p off income tax. He will not, they think, go for tax cuts over and above this - a view which would fit in with everything that Mr Clarke said in Washington at the IMF meeting last week.
But then what will Gordon Brown do? It would be very difficult to reverse the income tax cut, particularly since Labour will have had to give some pretty firm commitments in the election campaign. He will, however, be committed to some additional spending and while he will be able to call in the windfall tax on utilities, that is a one-off tax which will not (presumably) be repeated in later years. He will probably increase corporation profits tax, or at least the burden of company taxation in some other form, but that will not bring in revenue for another year. Meanwhile the privatisation programme will wind down, depriving him of another source of revenue. NatWest assumes a rise in spending of rather more than pounds 2bn, with taxation up a bit under pounds 2bn so that the PSBR rises by only pounds 500m.
It is an interesting exercise because it shows just how difficult it will be for the new government to do anything radical - to do more than fiddle a bit with numbers already handed to it. In public finance terms a couple of billion extra of taxation or spending is nothing, for it is well within the forecasting errors of recent years. Adding less than a billion to the PSBR is also a minimal change.
Even so, there is a problem, for any increase in the PSBR will be greeted adversely by the markets, which will already be expecting a rise in interest rates. The clear danger for Labour is that interest rates will have to be higher than they would under a Tory government, partly because of concern about a laxer fiscal stance, but also because of higher inflationary expectations.
Other policies of Labour, in particular the minimum wage, will have some effect in increasing inflation and though this will probably be small, Labour will have to lean harder against inflation: which means even higher interest rates. That seems to be what the professionals expect, to judge by surveys of business opinion.
I suspect that these considerations may encourage Mr Brown to try to run a tighter fiscal policy than Mr Clarke, not a looser one. If this is right, the June budget would be very interesting politically, for somehow spending would have to be cut below Tory plans, or there would have to be tax increases over and above those already planned.
It would be even more interesting in economic and financial terms, for if Labour can quickly establish the reputation that it wants, as fiscally responsible, then the prize of cheaper long-term borrowing could be grasped quite quickly. Remember that UK public finances have to stack up against those of other EU members whether or not Britain joins EMU - or perhaps one should say whether or not EMU happens, for despite the current mood that it will, the practical difficulties are far from resolved.
It should not be too difficult for the UK to establish a fiscal position which is at least as favourable as that of France or Germany, but to do so means coming down from that pounds 26bn PSBR to pounds 20bn or lower.
Is it credible that Labour might introduce something that feels like an austerity budget within a month of taking office? If you believe the answer is "yes", then all expectations of higher inflation, higher interest rates and higher spending would be wrong. If not... expect Labour to run up the learning curve and bring in the austerity Budget in 1998, not 1997.
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