Hamish McRae: This public-spending squeeze will be much tighter than people expect

Economic view

Sunday 11 October 2009 00:00

People still don't get it. And we don't get it because we aren't being given it. The "it" is the scale of the squeeze on public spending that is about to happen, whosoever wins the coming election.

George Osborne's warning at the Tory conference of cuts to come was portrayed as being risky, for he did at least acknowledge that public spending would have to come down sharply. But the scale of the cuts suggested was tiny compared with what will actually occur. True, he acknowledged this was just a start, and it would be ridiculous to expect an opposition to spell out what it will do in any detail, since no one knows quite how bad things will be come next spring. What we do know, though, is that the inclination of the Tories will be to get on with the task of correcting the deficit, rather than hang around and wait for something to turn up.

I suspect we will get an indication within the next six weeks from Labour that it too plans to get on with cutting public spending, for it has to produce a pre-Budget report. Alistair Darling's reaction to the Osborne line was that it would be unwise to start reducing the fiscal deficit before the recovery was assured, and I can see the intellectual case for that. David Blanchflower, a former member of the Bank of England's Monetary Policy Committee, used stronger language. But there are two powerful arguments against permitting the deficit to continue at present levels. One is that beyond a certain point a fiscal deficit stops boosting the economy and actually has the reverse effect. The other is that you cannot go beyond a certain deficit because the markets won't let you: you simply cannot borrow the money at an acceptable rate.

This financial year the deficit is already heading for well above the £175bn announced in the Budget, as revenues fall short and spending runs above target. The end number looks like being something around £200bn or even more. That is dreadful both because the additional borrowing has to be financed and because the credibility of Treasury revenue forecasting and financial control is undermined.

It also raises the argument about the effectiveness of fiscal policy. The Government is borrowing between 12 and 14 per cent of GDP and yet the economy has only just about stopped declining. Many other countries, including Germany, France, Canada and Australia, seem to have resumed growth with deficits at half our level. The US, on the other hand, has a deficit broadly similar to our own and it too is struggling to get growth moving. Why?

Once a government is seen to be going beyond a certain point in its fiscal deficit, people become frightened and take actions that undermine the fiscal boost. They become aware that policy is unsustainable. So they do everything they can to make themselves bullet-proof. Companies cut back on investment and pay back debt; individuals try to build up savings. Only when they are confident that the government is being responsible do they resume their normal activities.

History gives some support to this. Japan in the 1990s ran up huge deficits to try to combat the recession. The result was a decade of lost growth and a debt burden now approaching 200 per cent of GDP. By contrast, Britain famously cut its deficit in the 1981 Budget in the bottom of a recession and was attacked for it. It is still controversial but that Budget is now credited by many people with creating the circumstances for turning round UK economic performance.

As for the argument that the deficit cannot be financed, the position at the moment is that it can. But that depends on the Bank's quantitative easing programme continuing, and at some stage that has to end. You can have a debate about when that should be but no one, not even Professor Blanchflower, would argue that it should continue forever. I suspect, too, that we are able to finance the deficit at the moment in part because the markets are working on the assumption that the new government will get a grip on things after the election next year. My worry is that the markets could suddenly reach a tipping point and confidence flood away. These things do happen.

If neither the Government nor the Opposition is explaining quite how dire the immediate outlook for public spending over the next couple of years is likely to be, I don't think anyone is beginning to explain the longer-term consequences for the public sector here, or indeed anywhere else, of what has happened.

In round numbers, Western governments will double their national debts, going from 50 per cent of GDP to 100 per cent of GDP, before the deficits are brought under control. Their interest payments on that debt will accordingly double too. So an additional 2 per cent of GDP will have to be set aside for debt interest. There will have to be some sort of programme for paying down the debt, so let's say another 2 per cent has to go to that. The size of the workforce paying taxes is already shrinking in several developed countries, including Japan and Germany. That will cut tax revenues. The burden of pensions and health care for the elderly will continue to rise, even with a higher retirement age.

So there will be less money coming in, but more needed for services and debt payments. It cannot add up.

Yet hardly anyone is thinking through the long-term consequences. Everyone is assuming that once the recession is over it will be business as usual. I happen to think growth will be resumed next year and that there will be a reasonable, if bumpy, economic recovery, so in that sense it will. But it won't be business as usual for government. Here in Britain it is perfectly possible that we will not get back to pre-recession tax revenues for a decade, however much rates are increased. The Government will be like a pensioner on a fixed income, having to meet necessary outgoings without any prospect of more money coming in.

This is going to change politics. You can catch a tiny bit of this in the party conferences. In the case of Labour, it was a string of promises that government could fix this, that and the other by spending more. That was old-style politics. In the case of the Tories it was more of a focus on people taking responsibility for themselves and that the Government was part of the problem rather than part of the solution. That was a tilt towards new-style politics. But I don't think that any of us are prepared for a world where governments do not do a whole raft of things they are expected to do at the moment because they simply will not have the revenues to do so.

This is not just a British or a European problem. It will be one for the entire developed world. However, the countries that are best at rethinking what new government means will prosper relative to those that stumble. Small, nimble, effective government – that is easy to say but, gosh, it is going to be hard to deliver.

The price of gold reflects investors' fear that inflation will return

Gold is back. It hit a new high last week at more than $1,060 an ounce, and when gold soars it tells us something about the morale of investors. Rationally, an investment that gives some income is better, but gold gives you none. So anyone investing in it is, in effect, saying they don't mind about the return on their money; they only want to protect the capital value.

The phenomenon's previous peak was early in 1980, when gold reached $850 an ounce, equivalent to about $2,300 today. But then inflation was in double digits and there were the gravest doubts about the authorities' ability to get it back under control.

Now inflation hardly exists. But fear of it does and it was notable on Friday that the price fell back after the statement by the chairman of the Federal Reserve, Ben Bernanke, that as the recovery took hold, monetary policy would be tightened. But will the world's exceptionally loose monetary policies be tightened sufficiently quickly to head off a serious bout of inflation?

Behind this is a sharp divergence of view between professional investors and private individuals. The first see government bonds priced as they are to yield 4 per cent or less as perfectly good investments. In buying them they are making the assumption that inflation over the next decade will be below 2 per cent – allowing a real return of 2 per cent or more. In the short-term deflation is their biggest threat.

The second group, those investing their own money, are suspicious that governments will create inflation to reduce the real value of their debts. So they want assets that give them some protection. Result: equities have soared and alternative investments, particularly gold, have shot up too.

So who is right, the professionals or the amateurs? The obvious response is to say both, depending on timescale: deflation now, and maybe for the next few years, but inflation later. What is clear is that these abnormally low interest rates will not last forever and the path back to normality will be bumpy.

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