Stephen King: Brown can gloat over Stability Pact, but he also faces difficult choices

Public sector net borrowing at £21.1bn means the Chancellor hasn't got a lot of wriggle-room left

This week, the Chancellor of the Exchequer, Gordon Brown, will unveil his pre-Budget report (PBR). The PBR will never be accompanied by the fanfare associated with the Budget proper - perhaps only one solitary bugle player rather than a complete marching band of trumpeters - but it nevertheless provides a useful update on the economy and the public finances.

So what will Mr Brown be saying? First of all, he will have an opportunity to gloat - at the expense of his fellow Europeans and those economic forecasters that exist beyond the boundaries of the Treasury. The big fiscal event in Europe in recent weeks has been the virtual collapse of the Stability Pact. This suits the Chancellor down to the ground - he has always claimed that his own fiscal rules were more sensible and more flexible than those contained within the Stability Pact, and he now looks increasingly justified in making that claim. Meanwhile, when everyone else was more sceptical, the Chancellor put his faith in a global recovery to help deliver the kind of UK economic growth he needs to balance the fiscal books. It's still early days, but consensus forecasts for UK economic growth in 2004 have started to edge up a bit. At 2.6 per cent, they're still some way short of the Chancellor's last projection of 3.25 per cent, but the gap has closed to Mr Brown's advantage.

Nevertheless, something still seems to have gone a little bit awry in the Chancellor's plans. So far in this fiscal year, public sector net borrowing has amounted to £21.1bn, and this is only up to the autumn. That compares with the Chancellor's projection for the year as a whole of £27bn, so he hasn't got a lot of wriggle-room left. Indeed, John Butler, my colleague at HSBC, reckons that the full-year amount is more likely to be up at over £33bn, and even then he's basing this estimate on some very conservative increases in public spending in the remaining months of the fiscal year.

So what explains the borrowing overshoot? If anything, events have been helpful for Mr Brown. For example, unemployment has continued to surprise on the downside, good for revenue growth and for limiting increases in public spending. Yet, as my left-hand chart suggests, although unemployment has been persistently lower than consensus expectations over the past seven years, the relationship with income tax receipts has turned out to be very poor indeed. In the late 1990s, there appeared to be quite a clear relationship - as unemployment surprised on the downside, income tax receipts surprised on the upside. More recently, though, income tax receipts have come in a lot lower than expected, despite continued good news on unemployment.

The Chancellor assumed that higher tax revenues in the late 1990s were here to stay, but it increasingly looks as though the higher revenues that came through back then were just another manifestation of the dot.com bubble. Back then, bonuses surged in a number of industries, leaving the Chancellor's coffers unexpectedly full. But with the boom times now over, suddenly Mr Brown looks to be a little bit short. The low unemployment rate has been a tremendous success for the Chancellor but it hasn't quite generated the revenues that he would have hoped for.

Will any of this make a great deal of difference to the Chancellor's longer-term fiscal plans? I very much doubt it. He has two fiscal rules that are his "guiding lights" for all budgetary decisions. The first of these is the co-called golden rule: that, over the economic cycle as a whole, Mr Brown will borrow only to invest and not to fund "current" spending. The second rule is the sustainable investment rule: public sector net debt as a proportion of GDP will be held over the economic cycle at a stable and prudent level. Other things being equal, net debt will be maintained below 40 per cent of GDP - at around 35 per cent - over the economic cycle.

On the Chancellor's own published numbers, he has no difficulties in meeting either of these rules. The right-hand chart shows Mr Brown's Budget projections, indicating the shift into surplus on a "cyclically-adjusted" basis over the next three years or so. Only if you adjust the numbers downwards on the basis of a lower trend growth estimate do you end up with a more worrying result - but it is unlikely that the Chancellor would want to consider going down that route at this stage.

Yet he may eventually have to. One of the problems with the Chancellor's approach to the fiscal arithmetic is that he adopts an asymmetric philosophy to good and bad times. If growth is stronger than expected in any one year - and revenues are also higher than expected - he assumes that this can be counted as a permanent improvement in economic conditions that will never be reversed. If growth is weaker than expected in any one year - and revenues are lower than expected - he assumes that this is only a temporary shortfall, and that economic conditions will eventually return to normal. This approach guarantees an upward bias to revenue projections that could eventually end in tears.

Perhaps, then, the Chancellor is not so prudent. The numbers may look fine for the time being but, come the next Parliament, he could face some much more difficult choices. For the time being, he doesn't have to do an awful lot but eventually he will have to contemplate either some embarrassing tax increases or reductions in public spending. Perhaps, though, he's hoping that he'll be Prime Minister by that stage, leaving someone else to carry out this rather thankless task.

The other area of interest in this PBR will be the new, harmonised, inflation target, known as the HICP. This target will simply bring the UK in line with countries in the eurozone and could be seen by some as a way of clearing the way towards eventual euro membership. In one sense, this is no more than a tactical shift that should have few implications for the long-term behaviour of the UK economy. However, there are a few tricky issues still to be resolved. Where will the target rate be set? The European Central Bank's current target is, in effect, a little less than 2 per cent. If we go for something similar, this would imply a less strict approach to inflation because a HICP target at this kind of rate would imply RPI-X inflation of about 2.8 per cent, above the current RPI-X target set for the Bank of England. How will wage negotiators behave? Will they focus on the harmonised measure or, instead, will they stick to RPI-X? If they choose the latter, does this imply either higher inflation or, at the very least, higher wages?

Tricky issues, perhaps, but at least there is discussion about this issue. If the Chancellor really wanted to harmonise Britain with the eurozone, he would simply tell the Bank of England to select its own inflation target. And pigs will fly.

The Chancellor might claim that Britain is moving closer to Europe but I suspect he would prefer to argue that, on most economic counts, Europe is moving closer to Britain. And on the fiscal rules, he would be absolutely right.

Stephen King is managing director of economics at HSBC

stephen.king@hsbcib.com