Hamish McRae: Pity the man who must inherit the red box...

In the first in a series of reports on the economy, our writer assesses the scale of Britain's financial predicament and wonders what, if anything, the would-be chancellors can do about it

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There are three areas of economic management that the next government has to tackle and on which its performance will ultimately be judged. The first is immediate: how it will cope with the present fiscal emergency and produce a medium-term plan for correcting the budget deficit. The second concerns the longer-term sustainability of public finances: how it will attempt to reconcile the disparity between what British voters are prepared to pay in tax and the level of services they demand from the government. The third is what it does to improve the competitiveness and competence of the British economy, coping with issues as different as banking regulation, competition law, consumer protection, infrastructure planning and so on.

The first has been widely, almost obsessively, debated – and with good reason. A budget deficit of 12 per cent of GDP is not just unsustainable; with the possible exception of Greece, it is the largest in the developed world. So far the Government has been able to finance this gap, helped by the Bank of England buying government securities under its "quantitative easing" programme. That was not the aim of QE, which was to boost the economy, but it has been one of the side effects. Even so, the British Government now has to pay almost one percentage point more for 10-year debt than Germany, whereas two years ago the countries could borrow at approximately the same rate.

Were the next government not to have a credible plan, that interest rate gap would rise further, pulling up not only the rate of interest the government pays but also the cost of longer-term credit to households and companies. Thus, fixed rate mortgages would rise too. This is why the next government will seek to retain the UK's present AAA credit rating, the highest rating given by the agencies, which have warned of a possible downgrade. It would not be a catastrophe to lose that rating and given where we are the downgrade may be inevitable. But it would push up longer-term interest rates, which would become more of a drag on economic growth.

Given the importance of this issue, expect the three main parties to seek to differentiate their approach. Insofar as there are distinctions, these will centre on three areas. The first, the date on which the squeeze (for it is this) will begin and in particular how much will be done this financial year. The second is how quickly the deficit should be cut: should, for example, the next government seek to eliminate the entire structural deficit (that is, allowing for the economic cycle) within the five years of the next parliament? And the third is the balance between tax increases and spending cuts.

All three main parties have made a commitment to cut the deficit and insofar as there are distinctions between them, Labour would seem to favour a later start than the Tories, a somewhat slower pace of correction and more emphasis on tax increases than spending cuts. The Liberal Democrats appear to be in between. But in assessing the response of the parties, and inevitably the personality of the three key individuals, Alistair Darling, George Osborne and Vince Cable, the electorate needs to be aware of two things. One is that the differences between the parties are much smaller than the similarities, for the differences are in the low billions whereas the gap to be plugged is something like £70bn a year, maybe more. The other is that this may not be in the hands of the next government anyway. Much of the deficit has to be financed by borrowing abroad. If the policy is not credible, changes will be forced on the UK by the global markets and possibly involving the International Monetary Fund as is happening in Greece.

The next great challenge facing the new government is longer term. Even if the budget hole is fixed, and it has to be, that does not tackle the growing imbalance between what the public wants from the government and what it is prepared to pay for in tax. This is harsh mathematics. Over the past 30 years no government of either party has been able to sustain tax revenues above 38 per cent of GDP. Right now it is much lower, around 35 per cent of GDP. Yet the level of services that voters appear to demand not only requires spending of higher than 40 per cent of GDP, say 42-43 per cent, but that will rise further as the population ages and health and pension costs climb.

The challenge is how to explain the scale of the gap and to reach a political consensus on how it should be bridged. One way in theory is to increase taxation. Another way is to make people pay for benefits they now receive free of charge. Labour made a start on that by introducing university fees, and a wider care system for those in old age, for which people would have to pay insurance, is being discussed. But to bridge the funding gap would require much wider charging, for example for some forms of healthcare. None of this will be easy – and cross-party agreement may be impossible – but not to do so puts government in the position where they cannot hope to meet the electorate's expectations. That would be a disaster for politics as well as for the country as a whole.

The third group of economic issues – how to improve the performance of the economy – is a wide one. There is the question of regulation of finance and the first issue there is what to do about banking. That covers how and when to sell the stakes in nationalised or part-nationalised banks back to the public. There is a conflict here between on the one hand encouraging these banks to be as profitable as possible, and so increase the price at which they can be sold, and on the other, getting them lend as widely and cheaply as possible to British companies.

There is also the larger issue of whether to stick with the present structure of bank regulation, brought in by Labour in 1997, or whether to scrap it and bring back control into the Bank of England as the Tories have proposed. If there is going to an additional tax on bank transactions, should that be brought in unilaterally or should the UK move in step with the rest of the world? In practice what the next government will do will be largely determined by events and the difference between having regulation in the Bank of England and having it outside it will be less than it might appear. But the tone will be important, for the economy needs a healthy financial sector, whoever is in charge in Westminster.

There is also the approach to infrastructure: should there be a third runway at Heathrow or new high-speed rail links to the north? What is to be done about nuclear power and electricity supply in general? Can a government make a significant difference to the size of our manufacturing sector?

And finally there is the approach to business in general. Labour has sought to be generally supportive of enterprise for most of its time on office, but that relationship recently has soured. No one doubts the country needs strong businesses but which outcome, including a Labour government with a strong Liberal Democrat element, would in practice have better relations with British commerce, large and small? Can a government be consumer-friendly at the same time as being business-friendly? Or does business simply want competence and nothing much more?

The big point here is that the next government will inherit an extremely difficult economic situation, more difficult than at any stage since 1979. The judgement facing the electorate is not so much one about the detail of the policies on offer but rather about the likely competence of the rival economic teams to cope with the stuff thrown at them. As we have learnt to our cost, the world economy can spring huge and unpleasant surprises. There will be more to come.

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