Hamish McRae: Our recovery is a race against time

For the moment, all is calm. But the thunderclouds are about to burst
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When politics and economics clash, economics eventually wins. And so it was yesterday when the Prime Minister acknowledged that public spending would have to be curbed in the years ahead.

We have been living in a strange dreamland, a phoney war, where we all know that things will change utterly in a few months' time when the government, whatever government, will have both to raise taxes and cut spending. Those of us who banged on about the unsustainable nature of public finances will see ourselves vindicated, though we should take no pleasure in that. But for the moment all is calm; the Government is still "investing"; the thunderclouds have yet to break.

Next year the economic realities will dominate everything. It makes very little difference who wins this coming election, or indeed the one after. The next government will have to set out a 10-year programme to cut back what has become the largest deficit, relative to the size of the economy, of any major developed nation anywhere in the world. Really? Well, I am afraid so. We are not yet halfway through this financial year but, so far, the deficit is running above even the dire projections in the Budget, and looks like being at least 13 per cent of GDP.

This cannot be fixed in the life of one Parliament and the vital thing to do is to get the deficit under control as growth resumes, so that we are in reasonable shape to cope with the strains of the next global downturn as and when that comes. It might seem a bit premature to be worrying about that as growth has only just resumed, but it would be reasonable on past performance to expect another downturn in eight or 10 years' time.

So correcting the deficit is a race against time. We got through the downturn in the early 2000s in very good shape because our public finances were exceptionally strong when we went into it and public spending could, to some extent, offset slower private spending. We are doing badly this time because our finances were relatively weak. We don't want to face an even bigger catastrophe next time round.

Stated thus, the proposition is very clear. But the detail is quite the reverse, partly because it is not in the perceived self-interest of most politicians to clarify the different elements of the argument, partly because there are very big uncertainties anyway, and partly because the numbers are so big it is hard to get one's head around them.

The issue does however fall into three main parts. First, there is a debate about how quickly to correct the deficit. Should one make a start next year, as the Opposition suggests, or might one wait until growth is more secure? Second, there is a debate about the scale of the correction needed. As growth resumes the deficit will shrink and the question is how much more needs to be done. Third, there is a debate about the balance between spending cuts and tax increases. So, timing first.

No government has complete freedom about the timing of a correction. It has to satisfy the financial markets – which, in practice, means savers here and abroad – or the terms under which it can borrow will become more expensive. Provided there is some path towards correcting the deficit it should remain creditworthy, but the slower the path the greater the possibility of a sharp rise in interest rates. We still have a relatively low stock of debt, and the average maturity is relatively long, so the concern is not the size of the national debt but rather the rate at which it is increasing. The sooner we start, the more freedom we are likely to have to slow the pace of correction in the years ahead.

On the other hand, it makes no sense to clobber the recovery by attempting to correct the deficit too soon. Japan made that mistake in the mid-Nineties and pushed the country back into recession. My instinct, for what it is worth, is that some sort of start could and should be made next year, as the Tories suggest, but they need to be extremely careful not to push too hard and hence undermine the recovery.

To what extent will the deficit fix itself, and how much more needs to be done? We don't have to do the full 13 per cent of GDP and the present government proposed in the Budget that it should cut about half, 6.4 per cent of GDP, of that over an eight-year period. Vince Cable, who seems to have become the nation's favourite financial GP, suggests an eight per cent correction over five years. Writing in a new pamphlet published by the think tank Reform, he suggests that the situation is more serious than the Government acknowledges and that some £110bn a year has to be saved. He sets out some ideas as to how this might be done. The main burden is on the spending side, with an overall freeze on public-sector pay with cuts at the top end, cuts in public-sector pensions, more efficiency in the NHS, scrapping Trident, and so on.

In terms of the broad magnitudes, that £110bn may be about right. But it is huge. To put it in context, we spent £35bn on defence last year. So suppose we were to have not just no Trident but no army, no navy, no air force. That would save only one-third of the money we have to cut. In truth, everything has to be questioned.

That leads to the third issue, the extent to which the balance will have to fall on increased taxes rather than lower spending. That is a genuine political choice: how far are we prepared to pay higher taxes to buy public services? You might imagine that the Tories would want to put more emphasis on spending cuts and less on tax increases and Labour the reverse. I am not sure, though, that this would necessarily be true. Tax plans in the last budget show taxation at 35 per cent of GDP in 2013/14. That is about the same level as it was in 1997 when Labour took over. Labour has not been able to increase the tax take very much, hence a lot of its problems. It is perfectly plausible that the Tories might, initially at least, increase taxation by more than these Labour plans, but it will struggle to do so. It can put up tax rates but it may, like Labour, find the revenues continue to fall short.

One thing is for sure, however, as I think anyone listening to Gordon Brown yesterday will appreciate. The public sector will be desperately short of funds and will have to make very tough choices. The storm is about to break and when it does the nature of politics will be different for a generation.