Tax-cutting policies will lose the markets' vote
Monday 15 July 1996
His Summer Economic Forecast last week was presented to the European Union's finance ministers the day before. It showed that the UK, though not doing as well as predicted, was hoping to scrape through most of the criteria, but with virtually no margin of error.
As the finance ministers warned, this means no tax cuts or spending increases in the Budget. Yet if the Government gets through to November, there will be enormous pressure on the Chancellor to cut taxes. He has endorsed the EU warning, but he will be accused of botching the election if he refuses to cut taxes under what looks like pressure from Brussels.
The table shows the UK barely meeting the criteria. Inflation is the easy one, and most members of the EU are expected to pass it. Even so, the Treasury's 2.25 per cent forecast looks optimistic with a consumer boom. Other forecasters go for 2.5 per cent, which is only 0.6 per cent below the likely limit of 3.1 per cent.
The long-term interest rate test is easy too, because it allows for a limit of 2 per cent above the three best countries. If the present gap of 1.5 per cent between UK gilts at 8 per cent, and French and German bonds at 6.5 per cent continues, it will not be so wide as to keep the UK out. The best that can be said for the UK's government debt is that it is expected to stay within the 60 per cent of GDP limit, if only for the next year or so. But it has been rising rapidly towards it.
The crucial criterion is the general government deficit limit of 3 per cent of GDP in 1997. As Treasury forecasts deteriorate, the achievement of this target has been postponed by a year. It will now need good luck with the forecast and a fudge of the calendar.
The Treasury predicts that the financial deficit will be 3 per cent of GDP in 1997/98. It will be higher in calendar 1997, the year to which the criterion applies; outside forecasters put it at 3.7 per cent, and the Treasury's implicit forecast is 3.25 per cent. Such figures might just be acceptable. As France and Germany may need some fractional flexibility themselves, they can hardly deny it to the UK.
This leaves the exchange rate stability criterion. Most other countries say that the UK has to be in the exchange rate mechanism for 1997 and 1998 to qualify. With the present 15 per cent bands, this would not be economically difficult, but it would still be politically impossible. If the UK case that there are other ways of measuring stability is accepted, the pound/ mark rate may not behave too badly.
The Eurosceptics have so far supported the Chancellor's Maastricht policy, because it fits in with their own views about the need to curb the public sector. But principles vanish when political survival is at stake. The Chancellor gave in to political pressure unnecessarily in last November's Budget by cutting taxes by 0.5 per cent of GDP. This made it harder to reduce the deficit, came too long before the election to have any political pay-off, and whetted the backbenchers' appetite for more of the same.
If Mr Clarke believes his own growth forecast of 3.25 per cent in 1997 it will be irresponsible to cut taxes. He will probably try to get away with just cutting short-term interest rates, which may look low to us, with 5.75 per cent base rates, but are still a full 2 percentage points above French and German rates.
If the Chancellor ends up with looser monetary policy, and then looser fiscal policy as well, the financial markets, if not the electorate, will vote against him. We will be seen to have opted out of the single currency, long-term interest rates will go up, and the exchange rate will go down.
The British economy may run out of luck after a brief interlude of success outside the European monetary club. As Mr Clarke, if not his colleagues, has understood, joining the euro, far from ending the recovery, will help to prolong it.
Cutting government deficits can, in some cases, stimulate economic growth by means of lower interest rates, contrary to the Keynesian conventional wisdom. The OECD and the IMF have recently published studies of fiscal consolidation demonstrating this point. To take an example near home, Ireland currently has an economic growth rate averaging 6 per cent, after reducing its budget deficit from over 10 per cent to 2.5 per cent of GDP.
If the UK can get its government deficit and debt moving downwards convincingly, it will get the same benefit of lower long-term interest rates that countries expected to join the single currency are already getting. If long-term interest rates fell by 2 per cent, there would be a saving of pounds 17bn on servicing the national debt, and the government deficit would fall by 1 per cent of GDP. Sluggish business investment would at last pick up.
If the UK fails the convergence tests, its treatment at the hands of the financial markets will be more severe than if it passes but still decides not to join the euro. If it passes the tests, it would be perverse to have gone through the short-term pain of adjustment, and then abstain from reaping the full benefits offered by the single currency.
The markets would assume that, if we were so attached to our freedom to devalue that we stayed out of the euro, we would be more likely than not to use it. They would not wait to find out, but mark the pound down. This time, devaluation would be more likely to bring inflation in its wake than during the recession in 1992, and the UK might cease to meet even the inflation criterion.
In theory, going it alone on the path of financial virtue is an option for the UK. But the present uneasy cat-and-dog menage of Chancellor and Governor is unstable. If the Chancellor again overrules the Governor, and cuts interest rates, it will be seen as political interference in monetary policy such as an independent central bank is designed to avoid. Politicians do not want an independent Bank of England, but they may get better monetary policy from an independent European Central Bank.
Joining the single currency is a historic decision. It is a triumph of hope over experience to suggest that we have succeeded in reversing the post-War decline in the pound in any permanent way. The plaudits heaped on Alan Greenspan's wise management of the US Federal Reserve indicate that we would do better to take the pound out of party politics and pool it in the euro under a European Central Bank accountable to national and European parliaments.
Christopher Johnson, a former chief economist of Lloyds Bank,is author of 'In with the Euro, out with the Pound: the Single Currency for Britain', published by Penguin on 19 July
Convergence forecasts for 1997
Treasury OECD Commission Limit % % % %
Inflation(1) 2 .25 2.5 2.5 3.1
Long-term interest rate(2) 8.0 8.0 8.4
Gross government debts(3) 56 59 56 60
Government deficit(4) 3.25 3.7 3.7 3.0
Limits: Inflation 1.5 per cent above three best forecasts, long-term interest rates 2 per cent above three best forecasts.
Notes: I. Treasury RPI less mortgage interest, others consumer price deflator. 2. Yield on 10-year government bonds; Treasury takes recent levels as forecast. 3. As per cent of GDP. 4. As per cent of GDP; Treasury derived from 1996-97 and 1997-98 forecasts.
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