Hamish McRae: In the end it's the deficit that counts

I am confident about the economic recovery but the fiscal position is dreadful
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There will, of course, be a sense of unreality about the pre-Budget report today. The function of the report is to set out the framework for the Budget in the spring, but we can reasonably assume that there will be an emergency Budget in June following the general election that will overthrow everything in it. So what can sensibly be said about this exercise?

I think the best preparation for it is to look at what Alistair Darling said in his pre-Budget report on 24 November last year. From the present perspective it is a remarkable document in that just about everything in it is, I'm afraid, so wrong as to be almost comical in its inaccuracy.

Thus, the economic forecast for this year was that Britain's economy would shrink by between 0.75 and 1.25 per cent. We don't have final figures but looks as though it will have declined by about 4.5 per cent. The Budget deficit for the present year was forecast to be £118bn. In the subsequent Budget this was increased to £175bn and current market estimates range between £180m and £200m. The pre-Budget report announced the cut in VAT to 15 per cent for 13 months but this was to be clawed back by an increase in the top rate of income tax to 45 per cent from April 2011; now it is 50 per cent from April 2010. Borrowing was supposed to peak at 57 per cent of GDP in 2013-14. It reached 59.2 per cent last month and it is hard to see the peak being much below 100 per cent of GDP.

We all make mistakes and the depth of the recession has been more serious than most of us expected late last year. But the UK economy has been in the middle of the pack as far as the depth of the recession is concerned: worse than the US and France, not quite as bad as Germany or Italy. Where we have been far worse than everyone else is in the scale of public borrowing. The Government cannot control the economy but it should have at least some control over its own finances.

Indeed, the tone of Mr Darling's pre-Budget report last year is remarkably similar to the statement a few months earlier of a fellow Scot, Sir Fred Goodwin, in the annual report of the Royal Bank of Scotland. "The diversity and quality of our business platform," wrote Sir Fred, "enabled us to deliver good financial results... Our earnings momentum remained powerful, notwithstanding the impact of challenging credit market conditions... Our results demonstrate the resilience of the group in the face of testing circumstances." As we now know, within a few months he was out on his ear and the bank was bust.

Now I am not saying Mr Darling is Sir Fred. Far from it; the closer parallel is with his predecessor, Gordon Brown, the principal architect of fiscal disaster. But it is worth contrasting the tone of last year's pre-Budget report with Sir Fred's because it highlights the way the world has utterly changed over the past 18 months and the difficulty that people in positions of power have in accepting that they were wrong. Today's pre-Budget report will have been endorsed by Mr Brown and we have to see it in that light.

There are two big issues. One is how well the UK is placed to sustain reasonable growth through the next period of global expansion; the other, how competently our fiscal deficit will be tackled. It is possible to be quite confident about the first but there must be grave worries about the second.

To be confident about the economy right now, with Britain supposedly the only major country still in recession and widespread expectations of another dip next year, might seem almost perverse. But there are some reasons for expecting decent growth by 2011 and beyond. Thus Goldman Sachs thinks the UK may be the fastest-growing large developed economy by then.

The positive case for us is partly that we have a very competitive exchange rate which will increase foreign demand for both manufacturing and service exports. The parallel is with the period after the ejection of sterling from the European exchange rate mechanism in 1992, which kick-started the long period of strong performance. Another reason is that financial services will recover.

It is a quite reasonable concern that the UK is over-dependent on one export industry, just as Germany is over-dependent on vehicle exports, and banking has had a difficult time. But it is important to remember that banking is only one part of financial services – there are securities markets, insurance, all the associated professional services and so on – and the world has to buy these. We are losing some of that business to other centres and are doing our best to lose even more, but the industry is so huge that quite a lot will be left and that business will be in better shape to compete.

I have to say I do find it strange that the Government should be so hostile to financial services. Given the proportion of tax revenues generated directly and indirectly by the industry, and given its own investment in it on our behalf, you would think it would want to get it back on its feet as soon as possible. I could not imagine Angela Merkel saying that the German motor industry had got too big and to be cut back in size – but politics is a rum business and these are rum times.

But even assuming this reasonably positive economic outlook is right, we still have this dreadful fiscal position. We have to assume our credit rating will be cut in the coming months, maybe more than once, and our borrowing costs will accordingly rise. It is the only safe assumption to make. But this government cannot fix things. It has no democratic mandate at home and no credibility abroad. The place it has to go to borrow these hundreds of billions is the City; there is nowhere else. Yet it bad-mouths anything and anyone connected with finance. How bright is that?

What worries me most is that the other lot do not understand it either. It is only partly a question of how radically to cut public spending and whether it is practicable to raise much more in taxation (this government has tried repeatedly to raise revenues and repeatedly failed to meet its targets). Yes, there will be an emergency Budget after the election but it has to be thoughtful and credible. If we learn anything today it will be the height of the mountain they will have to climb.