Hamish McRae: We need new means to control deficits

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We cannot go on like this. The new Government has to cut back spending and the only issue is how far and how fast it should go along that path. That is the broad message from the report of the new Office for Budget Responsibility, which has set out the background to next week's Budget.

But it is – and this is no fault of the OBR, which has been widely praised for its effort – a puzzling message. That is partly because the numbers are so huge that they defy comprehension. This is a world where a billion or two either way means nothing. Only when you get into the tens of billions do figures matter. But it is also because the concepts are confusing. What is the difference between the structural deficit and the actual one? Why is it that though the deficit seems likely to come down a little faster than the previous Government projected, we apparently have to have £34bn this year in tax increases and/or spending cuts – with much more to come, year after year, for the rest of this parliament?

So let's stand back from the figures and look at the process. For what is happening here is an attempt to re-cast the way in which our Government reaches decisions about fiscal policy. In effect we are trying to remove the freedom of the Government of the day to spend money that it is not able or prepared to raise in taxation. This is a global thing. A similar process is starting to take place in other countries, in response to a similar crisis. Our new constitutional arrangement, the OBR, is just an early attempt to impose fiscal discipline, just as a generation ago this country, along with others, had to impose monetary discipline.

The easiest way to get a proper perspective on what is happening is to think back to the great inflation of the 1970s. Gradually, with each successive swing of the economic cycle, inflation had risen throughout the developed world. But it had been held to some extent in check by the discipline of the fixed exchange rate system. Then, with the move to floating rates and the quadrupling of the price of oil in 1973/4, inflation suddenly shot upwards, running into double figures in just about every developed country and with the UK suffering more than most.

This led to huge social stress, as anyone who remembers the 1970s will recall. There was a second peak of inflation at the end of the 1970s, in some countries even higher than the first. Then, gradually and painfully, monetary policy came back under control and inflation was brought down. But to start with the world did not have the institutional tools to do the job. In Britain we experimented with money supply targets, then pegging sterling in the ERM, then inflation targets and finally in 1997, the independent Bank of England. The whole process, from getting in the IMF in 1976 to the monetary committee of the Bank, took 21 years. Other countries followed much the same course, making like us some false starts on the way.

Now look at the parallel with fiscal policy. During each successive economic cycle, government deficits around the world have tended to climb. If you allow for the impact of ageing populations the underlying trends have been completely unsustainable. But it took a really serious recession to tip an already deteriorating situation into an absolutely desperate one.

So now, around the world, we are going to see different countries trying to find different constitutional ways of controlling fiscal policy. Our OBR is one. The plan for the prior vetting by the European Union for the sustainability of government budgets is another. Individual continental governments are considering new constitutional measures to restrict deficits. The US will have to do something if it is to continue to attract funds from abroad to cover its deficit.

But – and this is the key point – we are at the very early stage of this process. It is going to take a decade, maybe two, before we find a new stability. There will, I fear, be casualties on the way. It is pretty clear that some countries cannot repay their debts. Greece is the obvious example but there will be others that will have to renegotiate their terms. There is the further issue of the euro, which of course has been stress-tested and will be tested again. The support efforts so far are a patch, not a cure.

There will, too, be another economic downturn. We have not abolished boom and bust. It would be wonderful to be able to be confident that the expansion that has just begun will carry on strongly for several years but it may not. Even if it does, the world will go into the next downturn with debts at least as large as they have gone into this one with. If the parallel with monetary policy is right it will take two full economic cycles to get fiscal policy back on track.

All this seems to be a challenge to democracy. We regard it as normal that governments should have authority over fiscal policy. It is difficult to envisage an elected government being told by some other non-elected body that it does not have the right to borrow more money. But think back. It is unthinkable now that the Chancellor should set interest rates. Yet that was the situation only 13 years ago. So what is seen as the proper role of government does change. As we become more aware that governments have loaded debt onto children and the unborn, we will accept that there should be an extra-democratic body taking a long view of fiscal responsibility. But there will be more bumps along the path to that destination.


For further reading

'The Pinch: How the Baby Boomers Stole Their Children's Future – And Why They Should Give It Back' by David Willetts (2010)

Tomorrow: International Studies by Adrian Hamilton