Stephen King: Luck may be running out for the prudent Chancellor

Pretending that we know exactly where we are within the economic cycle is dangerous, it's a straightforward gamble

Is Gordon Brown really prudent? Or is he a gambler? The Concise Oxford Dictionary says that someone who is prudent is "careful to avoid undesired consequences". A gambler is someone who "chooses to play games of chance for money, especially for high stakes".

We may get a better idea on 27 November, when Mr Brown presents his pre-Budget report. As always, the Chancellor will argue that he has always been careful to avoid undesired consequences. His fiscal framework is a case in point. Over the course of the economic cycle, he will only borrow for capital spending purposes. He has also placed limits on the total amount of debt that he is prepared to have on the Government's books.

So far, it's been relatively easy for the Chancellor to stick to these rules. However, it's increasingly looking as though some of this success is a matter of luck rather than pure good judgement.

The windfall gains stemming from the sale of 3G telecoms licences – correctly used to pay off part of the national debt – were big only because the auction took place at the peak of the telecoms mania.

The surge in income tax revenues over the past few years may have been partly the result of big bonuses and pay levels delivered as a result of the dot.com bubble, a process that has now come to a sticky end. The same argument also applies to corporate tax revenues (and, given that telecoms companies gave potential profits to the government by buying licences, corporate tax revenues will, in any case, be more depressed).

Output across the economy more broadly has held up a lot better than in countries elsewhere in Europe but there is a danger that this story is very much based on the "never-never", reflecting unsustainable household borrowing. Tax revenues may, therefore, not be sustained at current levels.

More generally, the Chancellor's reputation for prudence rests on assumptions that may turn out to be wrong and yet they are held with a conviction not justified on the basis of past experience. The Chancellor explicitly states that he knows, first, where we are within the economic cycle and, second, what the underlying long-term – or trend – rate of growth is.

Specifically, he says that the output gap – the difference between actual output and the level of output that can be sustained over the longer term while maintaining price stability – was zero in 1999. More precisely (thereby lending a spurious sense of accuracy to the whole process), he suggests that the output gap was at zero in the third quarter of 2001. He also claims that the trend rate of growth is 2.75 per cent a year (prudence tells him that he should use 2.5 per cent as the basis for his fiscal plans, but that is nevertheless an upward revision from his earlier prudent 2.25 per cent estimate).

These numbers may be right, but there is a good chance that they are not. A fine example of error comes from the OECD, an organisation that, in theory, should have a better chance of getting economic estimates right than politically motivated finance ministries. The left-hand chart shows estimates of the output gap for the UK economy made by the OECD back in 1996 compared with those made by the OECD today. In some cases, the differences are substantial. The point is obvious: pretending that we know exactly where we are within the economic cycle is dangerous. This is not prudence: it's a straightforward gamble.

Ultimately, prudence can only really be gauged with the benefit of hindsight. There are, however, a number of key questions that need to be raised now to gauge the likely success or otherwise of the Government's fiscal plans.

Question One: Is the fiscal process symmetrical in the light of surprises to economic growth?

The issue here is the sustainability of government revenues within the context of the Chancellor's fiscal framework. When growth has surprised on the upside, the Chancellor has typically assumed that the initial windfall gain raises the overall level of revenues on a permanent basis. This year, however, when growth surprised on the downside, the Chancellor built in an automatic recovery in economic growth, and hence revenues, for 2003. A symmetrical approach would have left him having to revise down his revenue assumptions for the future.

Question Two: Does the fiscal framework help to deliver a lasting improvement in productivity?

This is a key question. By allowing the Government to borrow for capital spending purposes, the Chancellor is hoping that there will, eventually, be an impact on productivity.

He needs this to happen for the simple reason that, in 10 years' time, the population of working age will be shrinking (see right-hand chart). In normal circumstances, a prospectively ageing population should now be saving for that eventuality. The Government can do its bit by running fiscal surpluses. If, instead, it chooses to borrow, it must have a clear idea of how output per head within the population of working age will be affected. From this perspective, the emphasis on education is very welcome but there is still a suspicion that the Government is more interested in measuring inputs (how much money is being spent) than outputs (the benefit that the additional expenditure should bring about).

Question Three: Can the Government ensure that public spending is directed at the right targets?

Theoretically, the answer to this one is "yes" because of the distinction between capital and current spending. However, if current spending overshoots because of large pay increases to public sector workers, the Chancellor is going to find it a lot more difficult to support his capital spending projects without the budget deficit rising to worryingly high levels. The underlying issue here is the extent to which public sector monopolies may demand too high a share of government resources.

Question Four: Is the low-inflation environment a true measure of economic stability and, if not, will the Government's fiscal framework simply come unstuck?

The key problem here is likely to be the housing market. Should it pop, consumer spending could weaken dramatically. Consumers have become increasingly fixated on their housing wealth in recent years. Using a back of the envelope calculation, it looks as though consumers may have increased their spending by between 2 and 3 per cent over the past year or so alone purely on the back of mortgage equity withdrawal. This must be a finite process: unless the world economy and the UK corporate sector recover, thereby raising household incomes, consumers may eventually play a much smaller role in boosting the Treasury's coffers. Under these circumstances, a low-inflation environment may not, in itself, be a guarantee of fiscal stability.

In many areas, the Chancellor has shown a revealed preference for prudent action when faced with an opportunity for big spending increases. Using the 3G licence fee revenues to reduce the national debt is a classic example. Mr Brown's new challenges, however, suggest that he is going to have to gamble some more. He may have proved that New Labour is no threat to inflation and, so far, to fiscal laxity. It is less than clear that the current fiscal framework deals with the four key questions set out above. It doesn't deal properly with growth undershoots. It doesn' t say a great deal about productivity performance. It is hostage to public sector pay demands. And, finally, it may prove to be the last geared play on the asset price bubbles of the past few years.

Stephen King is managing director of economics at HSBC.

stephen.king@hsbcib.com