Andreas Whittam Smith: Our economy needs firm government

How could we handle a hung Parliament so that investors retained confidence in Britain?
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The first question to ask about a hung Parliament is whether or not it would cause a financial crisis. It is one thing to fret about the imprecision of the Chancellor of the Exchequer's current plans for bringing the huge deficit in the Government's accounts under control, as financial markets do now, or to note with dismay the holes in the Conservative Party's plans. But it would be quite another thing to confront the political instability of a Parliament in which no party had an overall majority.

For, in a hung Parliament, the party with the most seats, fearing a return to the polls after a few months, might lack the resolve for making necessary spending cuts. Or if the new Government were bold, it would be a reasonable to question whether its plans might be reversed soon afterwards. With current opinion polls suggesting a Conservative majority of just 20 seats, the possibility of a hung Parliament looms large.

As it is, the managers of pension funds and life assurance funds are already warning of the danger of a sell-off in the UK government bond market. On Tuesday, Pimco, which controls the largest bond fund in the world, said there was an 80 per cent chance of a downgrade in the credit rating of British Government debt if the Chancellor's plans remained as they were.

Earlier this week, the Financial Times asked 79 economists what they thought was the biggest risk to the economy. Nearly half of them said it was the threat of a fiscal crisis that could derail the recovery. Howard Davies, director of the London School of Economics, commented: "The major risk is the loss of confidence in the government's ability to get the public finances under control."

Sir John Gieve, former deputy governor of the Bank of England, remarked that inadequate plans to address record public borrowing could result in sharp rate rises and a fall in the pound.

Sir John was describing the sort of chain reaction that could develop if financial markets lost faith. The process is worth spelling out in a bit of detail. Step One: domestic and overseas investors start selling gilt-edged securities, particularly those whose repayment dates are far off. Step Two: the consequence is that the yields on these securities rise – say from the current 4 per cent to 5 per cent. Step Three: at the same time the foreign selling of gilts weakens the value of the pound on foreign exchange markets. Step Four: to defend the pound from a destabilising run, short-term interest rates would have to be jacked up sharply. Conclusion: we should have arrived at a situation where both short-term and long-term borrowing costs would have risen significantly. Mortgage rates would rise. Companies would pay more for their funding. Credit card debt would be expensive. The recovery, such as it was, would have been killed stone dead.

Remember, too, that we have been here before, albeit nearly 18 years ago. On the morning of 16 September 1992 when the then Chancellor, Norman Lamont, arrived in his room at the Treasury, the Bank rate stood at 10 per cent. That day, an avalanche of selling overwhelmed the pound. Raising the rate to 12 per cent didn't halt the slide, nor later that afternoon did a further increase to 15 per cent. As a result, Britain was forced out of the European Exchange Rate Mechanism (a precursor of the Euro) in humiliating circumstances. George Soros, the hedge fund king, made a billion-pound profit.

This brings us to the second question. How could the situation of a hung Parliament be handled so that the confidence of overseas investors in British government securities could be maintained? No doubt the instinct of a newly appointed chancellor of the exchequer, Conservative or Labour, would be to bash on with what he or she would have done anyway, regardless of the need to rely on third party votes to pass the necessary legislation. Indeed this approach could work, depending upon the exact circumstances at the time.

The risk of everything unravelling in the foreign exchange and bond markets would, however, be high. A prudent legislature would not want to go down that road. Nor would it have to do so, provided that the new government was prepared to make deals with the Opposition as well as with the minor parties. The aim would be to arrive at a Budget settlement that would attract a big, cross-party majority when put to the final vote. Regardless of the details, that outcome alone would be vastly reassuring to financial markets.

Let us consider a possible way of reaching this ideal sate of affairs. There used to be something called the "budget judgement". What combination of tax and spending changes would be consonant with both the state of the economy and people's aspirations? On this occasion the judgement would be somewhat different: what course for public borrowing over the following five years would both satisfy overseas buyers of government debt and yet not undermine the economy? Speculative though the exercise might be, such a track could be identified. Once plotted, it would have to be accepted across the political spectrum as the starting point for constructing the budget.

From this could be deduced the likely totals for welfare expenditure, debt interest and tax revenues on unchanged policies which, in the circumstances I am describing, would probably be best accepted as they turned out.

Then would come the two interesting stages. To establish to what extent spending on education, health, law and order and defence could be protected. As a matter of fact, I am not sure that the parties are very much apart on these issues, contrary to the impressions of profound differences that they like to give. Finally would come probably the most difficult part of the whole exercise – the imposition of swinging cuts on the rest of government spending.

Of course I have described a high level of rationality, concern with the public interest and co-operative working in conducting the nation's business of which there has been no example since 1945. We are adversarial in Parliament or we are nothing. Except that after the scandalous behaviour of the present Parliament in the matter of expenses, might not a new Parliament wish to make amends and start to earn the electorate's trust?