Strong-pound Labour and weak-pound Tories
`Mr Clarke's plans for borrowing promise salvation. But they are based on a wholly implausible assumption of public spending control, a deus ex machina which drives a large wedge between projected spending growth and the assumed growth of GDP. Miracles of that sort do not happen'
Monday 23 September 1996
These topsy-turvy outcomes are not cast in stone. Never the less, the story of strong-pound Labour and weak-pound Tories is possessed of a compelling logic.
Consider, first, the likely economic legacy next spring, the most probable date of the election. The economy may well be suffering two forms of imbalance. The Conservatives' pre-election bid for growth may have left a monetary excess. Even more problematic, the government would be faced with an outsized structural budget deficit.
The extent of the monetary problem depends on several things: the growth of broad money supply, the pace of increase in house prices - a major influence on household thrift - and Mr Clarke's willingness to raise interest rates ahead of the election. On every count, there are reasons for concern.
Banks' balance sheets are strong, giving a natural uplift to money creation. The build-up of excess money deposits held by households is feeding a mini-boom in the housing market, with prices advances running ahead of mainstream forecasts. Windfall cash sums received from conversions and mergers of building societies might further support consumer demand. And while Mr Clarke might sanction a small rise in base rates, monetary policy is likely to stay permissive.
The risk, then, is of economic growth running to 4 per cent or more next year, with consumer demand rising by 5 or 6 per cent - well into overheating territory. Ironically, a boom of this sort, generative of lots of tax revenue, could create the impression that the budget deficit was coming under control. Mr Clarke might then be tempted to stoke the fire by granting bigger tax cuts this November.
But even without the pre-election relaxation, Britain's structural deficit is already too large. Two long-term developments are to blame: the Conservatives' failure to control public spending and, in the 1980s, their over-generous tax reductions. Since 1979, public spending in real terms has grown at an average rate of 1.75 per cent a year - only fractionally below the growth of the gross domestic product. So much for rolling back the state. Alas, this was compounded in the 1980s by excessive tax reductions. Despite the huge staged increases announced in 1993, tax measures taken since 1979 have directly enlarged the budget deficit by over 2 per cent of GDP.
Mr Clarke would like us to believe he hasstanched the haemorrhage. His plans for borrowing promise salvation. But they are based upon a wholly implausible assumption of public spending control, a deus ex machina which drives a large, sustained wedge between projected spending growth and the assumed growth of GDP. Miracles of that sort do not happen. The greater likelihood is that the structural budget deficit would run between 4 and 5 per cent of GDP without radical changes in spending programmes or hikes in taxation.
How would a Labour government respond to these challenges? Mr Blair plans to raise the country's rate of saving and investment in the hope of securing a higher trend rate of growth. But in office, the long-term vision would be severely challenged by the acute pressures of day-to-day government.
After so long in opposition, expectations would be running high. Yet the economy would be unbalanced and in need of tough treatment. A collision between Great Expectations and Hard Times would provide fertile ground for policy mistakes. Would Labour immediately seek to tackle the inherited budget imbalance?
It seems unlikely. A strong cyclical recovery or an over-optimistic assumption about trend growth may temporarily disguise the severity of the problem. But the choices facing the new chancellor would be unpalatable.
Take public spending. Labour wishes to raise the level of public sector investment, directly or in partnership with the private sector. That ambition would put even more onus on the control of current expenditure - a goal which has thoroughly eluded the present government. Meanwhile, public-sector workers, squeezed by the Conservatives and potential beneficiaries of a minimum wage, would be near the front of the queue demanding their New Deal.
Or take taxation. It seems improbable that Labour would immediately blight their chances of a second term by repeating the Conservative's tax-policy reversal of 1993. In so far as he has any explicit plans, the shadow chancellor, Gordon Brown's ambitions err towards lower taxes for the majority of taxpayers. He might consider raiding the corporate sector directly (by raising corporation tax) or indirectly (by reducing the imputation rate for dividend tax credits). But this would only raise the cost of capital, reducing business's incentive to invest.
A new Labour government's ability to tackle the budget deficit would therefore be highly constrained. A remaining Conservative administration, on the other hand, would be somewhat less shackled simply because much less would be expected of it.
The reverse tendencies apply in the case of monetary policy. Faced with potential overheating, any incumbent chancellor would have to raise base rates. But Mr Brown would be in a stronger position. Like Nigel Lawson in 1988 and 1989, Mr Clarke would be unwilling to admit the error of his ways and would probably tighten policy in a dilatory fashion.
Not so Mr Brown, who could happily blame 18 years of Tory misrule for the inconvenience of higher base rates. As important, Mr Blair and Mr Brown have convinced themselves that price stability would do wonders for Britain's trend rate of growth, for which Mr Brown would have an explicit target.
The scene could therefore be set during the early phase of a Labour government for a period of tight money combined with fundamentally slack fiscal policy. If so, sterling would probably appreciate. The government's need for finance would tend to drive up real interest rates and attract capital as inflationary pressures came under control. By contrast, Mr Clarke's greater reluctance to engage in timely monetary restraint and his concern for manufacturing would be likely to undermine the pound. Contrasting party attitudes to membership of EMU merely reinforce these conclusions.
Service-sector employees might therefore wish to vote Labour at the next election while job-challenged industrial workers vote Conservative. I think I shall avoid either temptation.
Bill Martin is chief economist at UBS
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