Public finances are a mess and will get worse, says ITEM club

Fresh research using the Treasury's own model of the economy suggests that the public finances will "deteriorate quite rapidly" in the wake of the credit crisis.

The Ernst & Young ITEM Club's latest forecast for the UK economy describes the public finances as a "mess" and states: "With the pros-pect of slower growth this year and hence slower tax revenues, ITEM forecasts a grim outlook".

The current deficit for the first eight months of this financial year has come in at £23.1bn, £8.6bn worse than last year, while net borrowing was £36.2bn, £10.2bn worse than the equivalent in 2006-07.

Peter Spencer, chief economic adviser to the ITEM Club, issued a stern warning that things will get worse. "Now that the economy is slowing sharply, the public finances will deteriorate equally rapidly," he said. "The first effects will be seen in February when the January tax receipts estimates will be published. These will be down on last January's figure, which was, of course, swollen by huge City bonuses and profits. We have revised our forecast of this year's current deficit up to £14bn, compared with the Treasury's pre-Budget report forecast of £8bn."

As to the Government's ability to stick to its own financial framework, Mr Spencer added that "the prospects of meeting the golden rule in the upcoming economic cycle without further fiscal tightening look very slim". However, the ITEM Club rejects that idea as well. "Policy should have been tightened during the upswing and it would be compounding the error to tighten it up now," the report said.

Unlike in the downturn of 2002, the Government's lack of manoeuvre on tax and public spending means that monetary policy will have to take most of the strain in managing the economy, at a tricky time when output is slowing and yet inflation – because of world prices – is stubbornly rising. The club predicts the Bank of England will cut interest rates by another 75 basis points, to 4.75 per cent, over the course of the year.

Mr Spencer said he believes households' finances will be much more focused on savings in 2008, with consumption growth slowing. However, he expects the effects of this to be offset by a strong labour market, and loosening monetary policy. "As we warned this time last year, we have been living beyond our means, lured by the offers of cheap no-questions-asked credit and tempted by the high prices that the family silver will fetch in international markets," he said.

"In the future, most families have no option but to tighten their belts. They can no longer afford to dip into housing equity to keep up the growth in spending."

However, on the wider economic horizon, the ITEM Club is more cheery. Forecasting economic gro-wth for 2008 at 1.8 per cent, the economists say the year will see a "rebalancing rather than recession". "With the weakness in the high street holding down inflation, there is room for interest rates to be cut to prevent the abrupt reversal in the credit markets leading to a reversal in the economy," the report said.