Labour looks favourite for the fiscal beauty contest

ECONOMIC VIEW

It is 20 years since a balance of payments and sterling crisis forced the then Chancellor, Denis Healey, to turn back from Heathrow Airport and call in an emergency team from the International Monetary Fund. The result of the IMF's visit was stringent cuts in public expenditure and higher interest rates in order to bring the balance of payments deficit, public sector borrowing and inflation under control. In other words, it is two decades since monetarism arrived on these shores.

According to the doyen of opinion pollsters, Bob Worcester of Mori, Lord Healey was the most trusted of British Chancellors - in contrast to Kenneth Clarke, who ranks only a little above Norman "ERM" Lamont. However, the mess he made of managing the economy played a big part in Labour's 1979 downfall, if only indirectly through the spending cuts prescribed by the IMF.

Mr Worcester points out that voters judge governments' economic competence according to the standards the politicians set themselves. For Harold Wilson it was the strength of the pound; he devalued. In the late 1970s it was the UK's manufacturing and export prowess; the balance of payments chasm yawned. The next election will reveal how clearly voters remember John Major's passionate defence of sterling's parity in the exchange rate mechanism, and whether "Black Wednesday" nearly four years ago will be his downfall.

However, the other peg on which this Government has hung its hat is control of the public finances. Above all, Tories are supposed to be good at keeping the books in order. They have not been as good as they would like us to believe. As the Independent made clear earlier this week, using official statistics, the Conservatives have been guilty of asset-stripping in order to finance current spending. One-offs such as privatisation revenues have helped pay for government spending and tax cuts.

The pre-1992 election binge led to a build-up in the Public Sector Borrowing Requirement, which peaked at 7 per cent of GDP or pounds 45.4bn in 1993-94, before the post-election tax increases had started to put the books into better order. Add back the privatisation revenues, the asset-stripping element, and it was 8 per cent of GDP.

This is not too far from the Healey peak of 9.5 per cent of GDP in 1975- 76 ("only" pounds 10.3bn in those days, before the fiscally challenged Conservatives gained office). Of course, the PSBR has shrunk markedly during the past three years, and Mr Clarke promises that it will be zero at the turn of the century.

However, the comparison of the two worst episodes in the public sector finances in recent history is instructive. It partly explains why the "tax and spend" option has vanished from politics. Voters now face a choice between the "no-tax and no-spend" promises of New Labour and "no-tax but carry on spending" record of the Government. Labour still needs to erase the memory of its last administration. The Tories simply have the habit, and are unlikely to break it before the election. Reducing expenditure is not a pre-election task.

Although Mr Clarke rightly points out that he has delivered public spending on target for three years in a row, that has been accomplished by reductions in capital spending and running costs. Further trimming here will be harder, especially if the Private Finance Initiative continues to limp along feebly.

The forthcoming Budget will offer Labour the chance to pull ahead in the fiscal beauty contest. For Mr Clarke's broad strategy is most likely to be the same as last year's. A billion or two off spending plans, the same off the contingency reserve, slightly higher corporate taxes - and there is the money for a "responsible" penny or two off the basic rate and an increase in allowances for the low paid.

The fact that the Treasury turned over-pessimistic about the likely growth in tax revenues in its mid-year forecast, after a couple of years of over- optimism, will make for some pleasant surprises on the monthly PSBR figures in the run-up to the Budget and the subsequent election.

The projections published in the Budget Red Book will take advantage of the cyclical improvement in order to continue to portray a steady decline in the borrowing requirement towards zero around2000.

This strategy will leave the way open for Labour to say where the arithmetic has been massaged and how bad a fiscal position they think they will inherit. Tony Blair has set out a long-term objective of a 10 pence tax rate for the low paid. The next step is to get the bad news out with a forecast of what public sector borrowing is really likely to be in 1997-98 and beyond.

The big issue for Labour will then be whether to take the final step and say precisely what short-term increase in tax revenues will be needed to make sure public sector borrowing is no greater than public sector investment - the "golden rule" for sustainability to which the party has committed itself - and how they would do it. There is a case for arguing that precision about the numbers is better than vague fears.

The longer-term issue for any government after the election is the fact that the tax-cutting habit means underlying growth in public expenditure is higher than growth in revenues. If the scale of the public sector is to shrink, it has to shrink on both sides of the accounts. This would mean rethinking the way the welfare state has been allowed to expand, and reversing two or three decades worth of entitlements.

As the French economist Daniel Cohen has argued persuasively in a recent book*, it was the "golden age" of post-war prosperity, the out of the ordinary growth rates experienced during the 1950s and 1960s, that allowed the industrialised economies to afford their welfare states. A high rate of economic growth delivers rapid increases in tax revenues. Provision of public services and benefits can increase in line with the economy.

The adjustment to the post-1973 growth slowdown has proved, so far, impossible. During the past two decades public sector borrowing has averaged 4.5 per cent of GDP, 7 per cent under Labour and 3.5 per cent under the Conservatives.

Mr Clarke's implicit strategy is to assume that the economy's potential growth has increased from its post-golden age average of 2 per cent. The long term does not worry him. He is relying on the return of golden growth rather than the discipline of the golden rule.

In New Labour there is a greater willingness to think the unthinkable, although not necessarily speak the unthinkable, about imposing genuine discipline on the public sector finances and rethinking the structure of the welfare state. Lord Healey's Chancellorship casts a long shadow over the party.

*'The Misfortunes of Prosperity', Daniel Cohen, MIT Press.