Hamish McRae: In the face of a downturn, Darling will only make matters worse if he pushes up taxes

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The Independent Online

It's that day again. Alistair Darling's first Budget may not have quite the theatrical impact that the event had a decade or more ago, and not just because the present chancellor is, with the possible exception of John Major, less charismatic than any of his recent predecessors. The latter presentations of Gordon Brown had become pretty low-key affairs too.

The change is for two reasons. One is that the broad direction of British budgets has increasingly been revealed the previous autumn in what is now called the pre-Budget report. This year the main stories are going to be not what is new but to what extent the Chancellor has been forced to row back on what is old, from what he said last October. The two contentious issues are, of course, treatment of capital gains and of the "non-doms".

But there is another reason why budgets ain't what they used to be. We have all become aware that the big things that affect our lifestyles are not footling changes to the tax system but the seismic shifts taking place in the world economy. A US recession or a crash in our house prices would have much more effect on us than a couple of pennies off the standard rate of income tax, particularly since we know that any significant tax changes will be offset somewhere else. That global outlook is what gives the Budget spice this year, though not particularly agreeable spice I am afraid.

We were reminded yesterday of just how the turmoil in global financial markets rages on, when the Federal Reserve announced plans to pump another $200bn of cash into the markets, taking mortgage-backed securities in return. This move was co-ordinated with other central banks, including the Bank of England and the European Central Bank. When central banks co-operate you know they are worried, but you also know they are on the case. That was why the markets responded so positively yesterday to the news.

Such is the nature of central banking that they can pile money into the markets virtually without limit and thereby cope with short-term liquidity crises. What they can't do is solve the longer-term problems of the US economy, and to some extent that of other developed economies, including our own, of indebtedness and falling asset prices. The mountain of US debt is so bigand their housing market so weak that it does now seem likely that the US will dip into recession this year, indeed it may already be in it. Central banks can pump things up for a bit but they cannot solve the world economy's underlying problems.

This leads to two questions. How bad is the downward chunk of this economic cycle likely to be? And what, if anything, might British economic policy do to shield us from its worst effects?

There can be only the most tentative of answers to either question, but there are some things we can say. The projections for the American economy have got worse almost by the day, but I have not seen any mainstream forecasts that suggest that this downturn will be worse than the early 1990s recession, though it could be worse than the early 2000s downturn, which was hardly a recession at all.

World growth will be buoyed by demand from China, India, Russia and the Middle East, though this is a bit of a double-edged sword as that keeps commodity and oil prices high for the rest of us and hence contributes to global inflation.

As far as the UK is concerned, I have not yet seen a serious forecast of recession. I may have missed one and the mood may deteriorate through the summer but as of now the prospect is of slowdown, not recession. There is a debate, which I find very interesting, as to whether 2009 will be better than 2008. The majority view is that it will: so slowdown this year, recovery next. The minority view, which I side with, is that this year will not be too bad for the economy as a whole, but next year will be tougher. The very latest figures show only a slight slowdown, with growth running at a 2 per cent annual rate over the past three months and consumers still buying stuff, albeit at discounted prices. So far, at least, we are not experiencing the pretty catastrophic housing market conditions of much of the US.

But accept the working assumption that the downward bit of this global cycle will be worse than the early 2000s but not as bad as the early 1990s – and that this broad judgement will apply to the UK too. What can the Chancellor do to improve our relative position?

Go back to his inheritance. Gordon Brown made three really big decisions as chancellor: he gave the Bank of England independence to set interest rates; he kept Britain out of the euro; and he sharply increased public spending. The first two are very helpful right now. The Bank may have been too lax on its policy but it managed to halt the housing boom without the sort of crash that seems to be taking place in the US, or for that matter Spain and Ireland.

If the economy does slump, the Bank of England will be able to cut interest rates further. We also are able, since we still have sterling, to depreciate our currency against the euro and thereby help export demand. That has already started to happen. By contrast Italy, which cannot devalue its currency, is probably in recession at the moment.

The third decision is the problem. Whatever you think about the effectiveness of spending so much more on public services – that is a separate debate – we go into this downturn with public finances in much worse shape than in the late 1990s. The deficit this year is stuck at around £40bn or more than 3 per cent of GDP.

As growth slows, tax revenues will drop and spending will be pushed up. It makes no sense to push taxes up in the face of a downturn, for that would make matters worse. But it is possible the deficit will balloon in the next couple of years. I have seen a suggestion that it could reach £100bn if things go wrong. Even under the Government's own plans, taxation will rise by another percentage point of GDP over the next five years. That, according to the Institute for Fiscal Studies, would be to the highest level for 24 years.

So, in a sentence, we have flexibility in monetary policy but not in fiscal policy.

That is a real worry. It is a worry not just for this chancellor but for his successor, and in all probability – for this will take a decade to fix – his successor's successor. It is a puzzle that we can have allowed ourselves to get into such a mess and I am afraid the blame does lie with Gordon Brown, as he must realise. We are not in terrible shape for the global downturn, but we are not in good shape, and not nearly as good as we might have been with a bit more common sense and flexibility.

Expect all this to be muddled over today. It always takes three or four days to figure out what is really happening and the headlines will in any case be grabbed by the extent of the climb-down over non-doms and capital gains tax, plus the silly little tax tweaks that chancellors always seem to do. But don't be fooled: the big numbers are not good and they will get worse. Sorry.