Hamish McRae: It's the end of an error, but it may take some time to get back on track

Economic view

The politics are about to move and the economics will not be far behind.

The wall of comment about the scale of the fiscal adjustment that must be made after the election has started to change perceptions. But as has been widely observed, none of the leading politicians have really acknowledged what will happen. We, and indeed the electorates of the developed world, are going to have a different sort of government 10 years from now. How we get from here to there is less evident.

If you step back from the UK for a moment, the most important pointer to the way governments everywhere will develop has come from the band of southern European nations from Portugal to Greece. The plight of Greece started to spill over to Portugal and Spain, and the fear must be that it will spread to Italy, too. As it happened, I was in Spain when the downgrade of its debts came through and the news of the dreadful 20 per cent unemployment figure broke. Though it is hard to generalise from a handful of conversations, I certainly caught the fear among the business people I spoke to that demand for their products would not recover for some time. Exports were the only way forward; locals didn't have any spare funds to spend.

But the pressure to cut fiscal deficits goes far beyond these southern European nations. It has become a central issue, arguably the central issue, in our election. President Obama has acknowledged the need for change in the US, while Ben Bernanke at the Federal Reserve has spoken forcibly on the unsustainable nature of US deficits. The most sensible point that I have heard, however, was in Sweden earlier this year, when leading politicians from government and opposition agreed that public finances had to be made strong enough to meet the pressures of the next recession, whenever it came, as there surely would be one. That was forward thinking on a scale that is sadly absent elsewhere.

This thinking, though, will colour the next few years. One of the lasting effects of the Greek crisis is that countries will have to move much more quickly to cut deficits than they are, at present, contemplating. The reason is that politicians lose control. It is too dangerous politically to allow others to dictate policy for you. So you have to get ahead of market expectations or get external validation for your plans. That is why I think the next British government would be wise to seek some sort of seal of approval from the International Monetary Fund for its deficit-cutting plan.

If this is right, a number of questions follow. One obvious one is whether the pace of the recovery will be checked by faster-than-expected deficit cuts. It is extremely hard to know. Basic economic theory pulls in two directions. One theory holds that public spending, financed by borrowing, boosts the overall demand in the economy. The other holds that, beyond a certain point, more borrowing may undermine confidence, and push up interest rates, and accordingly cut private-sector demand.

What we can say is that some countries have experienced a much more serious downturn that others and large deficits do not seem to have had much effect either way. As you can see in the graph, the most serious recession among the major economies was in Japan, which has a deficit of more than 10 per cent of GDP and has had large deficits since the mid-1990s. At the other end of the scale, Australia has done very well, barely having any recession at all, with a deficit of around 4.5 per cent of GDP. But then it is a raw-material producer and is in the Asian time-zone. Germany, by contrast, also has a relatively low deficit, but has had a recession on a par with that of the UK. I had not, by the way, noticed until I looked at this graph quite how badly the UK was doing during this cycle relative to other G7 economies. A few months ago we were middle of the pack. Now we are competing for the wooden spoon with Germany and Japan.

There is a further complication. What is cause and what is effect? Is the UK doing badly because the size of the deficit has undermined confidence? Or is it because we are, for other various reasons, having a serious downturn that the deficit is so large? It will be a bit of both. My own instinct is that the former argument carried more weight, but at this stage it is a judgement that cannot be supported by evidence.

It matters, though, because if the deficit is the problem rather than the solution, faster cutting may not be so damaging as it otherwise might seem. That goes for us, but it also might go for the rest of the world, too. So I don't think the world should be too frightened of fiscal consolidation, provided it is done in an orderly and sensible way and a way that carries political support. The alternative is worse.

The final question flows from this. What can we really say about this next growth phase of the economy?

The conventional view that this will see solid growth in the developing and emerging nations, and lack-lustre growth in the developed world, is probably going to prove right. But I wish I had more of a feeling for the timescale. How many years of reasonable growth are we likely to get? If the normal 7 to 10-year cycle that has persisted since the 1970s continues we should have growth through to, say, 2017, and maybe a bit longer. That gives some years for governments not just to cut deficits but to start to run surpluses, as they will have to do. If on the other hand, this will be a truncated cycle, with growth faltering in three or four years' time, then things will be rather bleaker.

It is a bit of a relief that this will be the last of these columns before the election because it does seem to me that the electoral debate has drawn the focus away from these longer-term and much more important issues. We in the UK will only do well if the rest of the developed world does well. But the shape of the coming growth phase is still utterly unclear. We need – indeed, all countries need – a decent recovery to give us time to recover from our mistakes. We will get a recovery, for that is looking rather more secure as the months go by. But it may not be a strong one, even with optimal policies in the major developed nations, which of course on past experience we will not get.

Think of it this way. In the 1970s, the developed world made a huge error, an error of monetary policy, which gave us double-digit inflation and threatened the whole fabric of society. It took two cycles, the 1980s and the 1990s, to get that under control. In the 2000s the world made a similar error, but of fiscal policy, which gave several countries double-digit deficits and threatens the whole fabric of society. Expect it to take two cycles to get that under control, too. These are problems that will persist to the 2020s.

Incentives change our behaviour, but what about tax rises?

A small sign of the way society adapts to incentives: the March car sales have come in higher than expected. According to the Society of Motor Manufacturers and Traders, 397,383 new cars were registered – 26.6 per cent up year-on-year. Sales were helped by the tail end of the scrappage scheme and the SMMT expects them to shade off. Within the sales there were apparently big rises for small diesels and hybrids, as well as for other cars in low tax bands.

There are several things that are interesting here. One is that very simple schemes, such as the scrappage, do work. Another is that one-off incentives can have a material impact on timing decisions. Still another is that firms are acutely influenced by tax, for it seems fleet sales have been affected not only by the need to hold down fuel consumption but also the tax write-off provisions on the most efficient vehicles.

So it has been a success, in contrast to many other incentives brought in to boost demand. Now fast-forward to future tax changes. It would be astounding if VAT were not increased to 20 per cent, so some major purchases are bound to be brought forward. There are the known other tax increases that will go ahead, with the presumption of more to come. Many people have started to adjust behaviour for these, bringing forward income into the previous tax year, say, and cashing in capital gains. There will presumably have to be some new incentives, but the next government should be aware of the need for simplicity. It should learn from the successes and mistakes of its predecessor.

What it cannot know is what would have happened to revenues had the present set of tax measures not been brought in. Nor can it know the long-tail impact of present changes. To what extent will the tax rises result in changes in behaviour that will take a decade or more to feed through? My instinct is that tax revenues will be very soft for several years, partly as a result of slower growth but also because of a lagged response to changes in taxation more generally. But we will see.