Brown bets the house on slowdown being nothing more than part of economic cycle

Public Finances

Gordon Brown put his reputation as the Iron Chancellor on the line yesterday as he cut his growth forecasts and raised his borrowing plans.

In the largest political gamble of his five-year career, he has in effect bet the house that a return to boom times will eventually pay for his massive public spending plans without the need for further tax hikes.

He admitted the public finances would plunge £10bn a year further into the red in both the current fiscal year and in the following period.

But he insisted that an economic recovery beginning in 2004 would help him meet his "golden rule" that he must balance the budget over the cycle. In other words, he is gambling that the current slowdown is a cyclical phase rather than a structural shock.

The report won a mixed reception in the City, with some experts saying he was too pessimistic in the short term but too optimistic in the years leading up to the next election.

With the economy flirting with recession, the Chancellor only ever had three choices – cut spending, raise taxes or allow borrowing to let rip.

Having used this week's Confederation of British Industry conference to rule out spending cuts and tax hikes, yesterday's decision was inevitable. Yet Mr Brown's critics leapt on the revisions, dubbing him the "rusty Brown" or "aluminium Chancellor".

No sleight of hand could disguise the drastic downward revisions to the public finances and economic growth unveiled by the Chancellor yesterday.

In fact the public finances are set to plunge £30bn deeper into the red than forecast in the Budget – much more than the City had expected and greater even than Treasury leaks on Tuesday hinted.

But Mr Brown insisted he would not breach his own fiscal rules, and gave an ebullient speech that delighted the Labour back benches with the return of his 1990s catchphrase of "the old boom-and-bust approach".

He was swift to blame the global economic slowdown for his trouble, pointing out repeatedly that it was the worst slump for three decades.

"Twenty of the world's biggest economies, accounting for 60 per cent of the world's output – the United States, Japan, much of Europe and Latin America – have been in or are in recession after the sharpest slowdown in global economic activity for almost 30 years," he said.

Yesterday's report ends months of speculation that the Government would be forced to abandon the optimistic forecasts it set out in the Budget six months ago.

For the first time in his five years as Chancellor, Mr Brown had to explain a ballooning deficit rather than celebrate another unexpected public finance surplus.

Crucially the Government claims it will avoid breaching its "golden rule" – borrow only to invest and not to fund current spending.

The test is met when, over the economic cycle, the current budget is in balance or surplus. The pre-Budget report showed that it remained in surplus – just – throughout the forecast period.

Adam Law, UK economist at Barclays Capital, said the Chancellor was taking out some insurance by adding an extra £10bn of borrowing over the coming two years.

Simon Rubinsohn, chief economist at Gerrards in the City, said there were hints he was considering more help for the poorest families: "He thrives on these little changes and that would allow him to fund them."

But other analysts were more worried about the long-term outlook. The accountants PricewaterhouseCoopers said his longer-term forecasts might be too optimistic. John Hawksworth, head of macro-economics, said: "The crunch time will come in the 2004 Budget and spending review, when he will have to make a choice between turning off the spending taps or announcing further tax increases. These decisions cannot be put off for ever."

Some economists, such as those at HSBC and the National Institute of Economic and Social Research, believe the Treasury is implicitly assuming stock market boom conditions will return.

John Butler, UK economist at HSBC, said as much as a third of the £50bn surplus built up in the 1990s was linked to the share-price bubble.

"If so this is temporary. This is a structural factor that will become very clear by the end of the parliament and he will have to keep increasing his borrowing estimates," he said.

The report shows that the current financial year will leave a public sector net borrowing (PSNB) of £20bn rather than the £11bn forecast in April.

Going forward, the PSNB, with Budget forecasts in brackets, rises to £24bn (£13bn), £19bn (£13bn), £19bn (£17bn) in 2005-06 and £20bn (£18bn) for 2007-08.

The key factor behind the massive increases in borrowing was the economic slowdown. Mr Brown's forecasts in April that the economy would grow by 2.25 per cent this year and 3.25 per cent in 2003 always looked unrealistic. He has now cut those to 1.6 and 2.75 per cent respectively.

As share prices surged, the Treasury benefited from burgeoning banking profits, stamp duty on share trades and tax income on exorbitant City salaries.

Last year's pre-Budget report cut the revenues target by £9bn for 2002-03, mainly due to an expected City effect, with another £0.5bn shaved off in April.

But at the time the FTSE All-Share stood at 2,542 and was forecast to grow in line with GDP. In fact the index is now languishing at 1,975 – a fall of about a quarter.

The report acknowledged the largest impact was from the stock market. Because of the "cautious" assumption that the stock market will only grow in line with nominal GDP, this costs £4bn a year in revenues over the forecast period.

On top of this, tumbling profits in the City of London will slash another £5bn from revenues in the coming year before the recovery kicks in.

A Treasury source insisted there was no structural tax crisis. "We believe the impact on financial company profits will be temporary," he said. "We believe this is a cyclical effect."