Should we spend our money on rail or hospitals? We cannot have both

If we were to spend £5bn on rail, that would use up a quarter of all additional resources the economy will generate over the year

Mervyn King, the new governor of the Bank of England, says the consumer boom is over. Over the next few years growth of consumption will have to be held back to fund increased spending on public services.

He is right, of course. But the Great British Consumer is only just waking up to the scale of the change he or she is about to face. This is not just a question of the extent to which taxes will need to be raised to fund the Government's spending ambitions, though obviously that is a contentious aspect of the coming squeeze. It is also a simple matter of there not being enough total resources, public or private, to fund the programme the Government has in mind.

As it happens there is a very good example of the squeeze this week, with the £54bn of investment that Network Rail claims will be needed over the next 10 years to get the trains running on time. Part of that is supposed to come from higher fares, part from the Government, that is to say higher taxes. But in one sense it does not matter how the bill is met. The fact that it has to be met at all means a squeeze on consumption. Some back-of-an-envelope numbers make this clear. The economy last year generated £1,044bn in Gross Domestic Product. This year we will get 1.8 per cent growth - that is the consensus of the forecasters - or in real terms another £19bn or so. If we were to spend £5bn on investment in the railways, the figure that would be needed if the £54bn were spread evenly over the 10 years, this one project would use up a quarter of all the additional resources that the economy will generate over the year.

It gets worse. Consumption is going to go up a bit, even if it does not rise at the heady 4 per cent a year that it has been rising for most of the past decade. Consumption by households last year was £662bn - yes, we consume two-thirds of our GDP and the proportion has been rising as people have supplemented the rise in their incomes by borrowing. Let's assume that we consume half of the additional resources available, say £10bn, which would be equivalent to a rise in consumption of some 1.6 per cent, a far cry from the additional £30bn or so of spending each year to which we have become accustomed. If consumers take £10bn that leaves just £10bn, of which the railways want to use up £5bn. So there would be just £5bn for additional spending on all other things, including house building, private investment in plant and machinery, the health service, education, roads, a new outbreak of foot-and-mouth, an unexpected war, whatever.

The eventual figures won't look quite like that for a host of reasons. These include the distortions of inflation, the Government increasing its deficit, the impact of net investment from abroad, a change in our terms of trade enabling us to charge more for our exports and buy cheaper imports. We can, for a while, continue to spend money we haven't got. We cannot, however, do that for very long. Sooner or later everything has to be paid for. Sure, we have a big economy, nearly 5 per cent of total world output, and it has been growing reasonably fast. As the size of the base grows, so too will the annual percentage increments.

But it is not infinite in size. For the immediate future we can only count on it growing by an additional £20-30bn each year. Even that would be much faster growth than that being experienced by most of Continental Europe at the moment.

This has profound implications that intuitively we consumers (and taxpayers) are beginning to grasp. There has been a sudden shading off of the rate of growth of consumption, perhaps because people feel less confident about borrowing against the value of their homes. Mr King, who, before he went to the Bank, was one of our top academic economists, sees what will happen very clearly. But I don't think the Government has any perception of the jam it has got itself into.

There are two main reasons for that. The first is that during its first term of office both public finances and consumption patterns were unusually favourable.

It was very lucky inheriting the second half of the longest boom Britain has enjoyed since the Second World War. This both generated a feel-good factor and boosted tax revenues. As people spent they increased VAT takings, while bonuses for high-earners boosted income tax. More spending meant more jobs, which in turn brought in more tax. Add the "stealth taxes" and the auction of the mobile telephone spectrum, and each year revenues came in at the top end of the scale. Debt was repaid, making the numbers even better.

The second factor was low spending. The Government squeezed spending even harder than the Tories had done, blaming any short-fall in services on under-investment by the previous governments. With hindsight it probably squeezed too hard. You can do this for a while without obvious effect but the backlog of under-investment, particularly on the transport infrastructure, is now catching up on them. So the experience of this Government during its first term of office was that the economy would boom and the financial numbers would turn out better than expected. But it was stung by criticism of public services. So it felt confident during its second term to go on a spending binge to try to fix the problems it had (though it would not accept this) to some extent exacerbated during its first term.

It is now facing two huge difficulties. The first, which has received a lot of attention, is getting value for money. Here I have some sympathy with the Government. It is really quite hard to spend money wisely. This is partly because the main method of control is an audit after the event. So you are driving on a rear-view mirror. But it is also because your people are not very experienced in the sort of commercial contracts that increasingly govern public spending initiatives. To get better efficiency and market responsiveness you have to get the private sector in. But then you don't know how to specify the contract to make sure it is delivered.

It seems to me, however, that even if the Government were able to spend the money wisely it would still be in trouble. That is because people will not like the inevitable squeeze on consumption that is involved. It can no longer rely on the exceptionally favourable circumstances it enjoyed during its first term. Global growth will be slower, the housing boom will be over, consumers will be less willing to supplement their income by borrowing and there are unlikely to be any windfalls like the radio spectrum auction.

If we were rational we would, I suppose, accept this. All it means is consumption rising at 1-2 per cent a year, a little slower than the rise in GDP, not 4-5 per cent, which was rather faster. However we pay for it, either in higher access charges (for example for universities) or in higher taxation, there will have to be more money spent on health and education, even if spending on the railways could be brought under control again.

Trouble is, we have become used to rapid growth in consumption. It is nice to spend money - our money - on things we want to buy. I think we will be quite grumpy.