Stephen King: The world changes while Gordon fiddles with his calculator

Mr Brown should simply stand up and declare that the era of big government borrowing is upon us

Tap, tap, tappity, tap. Unlike the economy, Gordon Brown's pocket calculator must be close to overheating. The Chancellor is facing a major problem. Since he put together his November 2002 pre-Budget report, the world has changed. So, too, has the UK economy. And, with these changes, his budgetary plans don't look quite so clever.

Back in November, Mr Brown hoped to see growth within the G7 area of 2.25 per cent in 2003 and a further 3 per cent in 2004. Mr Brown also hoped to see growth in the UK of between 2.5 and 3 per cent this year followed by a further 3 to 3.5 per cent next year. With this kind of growth, the Chancellor hoped to increase public spending without significant risk to his self-imposed rules on government borrowing.

Four months later and the Chancellor's earlier growth assumptions no longer look like a "central case". The international environment looks plain nasty. The consensus at the beginning of this year thought that the US would deliver growth of 2.7 per cent. Latest data on employment and consumer confidence, together with the impact of higher oil prices, suggest that this pace of expansion is no longer within reach. Germany is teetering on the brink of recession. France and Italy will struggle to grow by more than 1 per cent. And Japan gave up on growth a decade ago.

If the international environment is no longer looking so clever, there are some obvious implications for Mr Brown's UK growth expectations. Let's start with exports. In November, Mr Brown thought that exports this year would rise by between 3.25 and 4.25 per cent. Unless he is to rely on a sizeable decline in the value of sterling, he ought to be cutting that number on 9 April, when he presents his Budget. He should also be thinking about cutting his projections for capital spending. Back in November, he seemed to think that investment this year would rise by almost 7 per cent. Given the state of UK profitability and the ongoing weakness of financial markets, this seems way too optimistic.

One potential offset is the consumer. In November, Mr Brown thought that consumer spending might rise by a little under 2.5 per cent. Although the housing market is looking a bit softer and although consumers have yet to feel the impact of higher national insurance contributions, consumer spending in 2003 may still be a little bit stronger than that. Yet there is a sting in the tail: the outlook for consumer spending as we head towards 2004 is looking increasingly murky. The Chancellor was hoping to see consumers increase spending by about 3 per cent next year. HSBC forecasts suggest that the number is likely to be only 1.3 per cent.

This week's charts show the Chancellor's predicament fairly clearly. The left-hand chart shows how the consensus forecast for 2003 UK GDP growth has evolved since the beginning of last year and compares this evolving consensus with the Treasury's own projections. The gap that has opened up over the past few months suggests that the Treasury will find it increasingly difficult to resist cutting its own forecasts. The right-hand chart shows how expectations with regard to the international environment have changed. It's clear that earlier optimism over a recovery in global growth has simply faded away.

So what should the Chancellor do? Let's say that actual growth this year is in line with the consensus and growth in 2004 fades to about 1.5 per cent, in line with the latest HSBC forecast. The Chancellor would then end up with a budget deficit that would shoot through 3 per cent of GDP and be heading rather too rapidly towards 4 per cent of GDP. At a stretch, the Chancellor might still be able to argue that this would be consistent with his "golden rule" – which allows government borrowing for capital spending but not for the purposes of current spending – but this really would be stretching the rule so far that it would render it virtually meaningless.

I reckon that the Chancellor has four options:

Option 1: Blame it all on the war. The Chancellor could argue that activity has been artificially depressed as a result of uncertainties over Iraq. Assuming a short and, from a UK government point of view, successful war, the economic picture in the second half of the year would be clearer, leading to a rapid recovery in growth. Sounds straightforward but there are two obvious difficulties. First, no one really knows how much of the recent growth disappointment is the result of war uncertainties. Regular readers of this column will know that, personally, I think the difficulties facing both the global and the UK economy are more "post-bubble" in nature and, therefore, war or no war, times would still be tough. Second, the housing market may not collapse but any slowdown should reduce the pace of mortgage equity withdrawal, in turn leading to a slowdown in consumer spending.

Option 2: Cut back on public spending. A non-starter: the economy is weak, has become increasingly dependent on job creation and wage inflation in the public sector and the Chancellor is committed to raising the standard of public services. Throwing money at the problem may not guarantee success but the Chancellor will not give up yet.

Option 3: Raise taxes. No surprise that we're starting to see the usual speculation about stealth taxes on the middle classes. But, again, the Chancellor's hands are rather tied. Does he really want to push taxes up – do exactly the opposite of the Americans – at a time when economic growth is increasingly hard to come by? In the plans submitted in the November pre-Budget report, the ratio of tax payments to GDP was already rising to the highs recorded at the beginning of the 1980s. Can the Chancellor – and the Prime Minister – really claim not to be the "tax and spend" party of the past? At which point does New Labour transform itself back into Old Labour?

Option 4: Borrow and be damned. To my mind, this is the best in a series of unwelcome options. The UK private sector is in trouble. Companies are suffering from weak demand abroad and pension deficits at home. Profits are low and there are few signs of any immediate recovery. Households have already been persuaded to borrow – via the interest rate cuts delivered by the Bank of England – but are increasingly coming to the end of the road, hit by high debts, housing fears and concerns in some sectors of the economy about mounting job losses. Under these circumstances, higher government borrowing should not threaten higher inflation, should not threaten higher interest rates and should not, therefore, provide any significant threat to economic stability.

This is the time to come clean. There's little point in fiddling around with growth assumptions because, by doing so, the Chancellor is engaging in the economics of hope rather than of likelihood. He is simply in danger of deferring, rather than dealing, with economic problems. Instead, he should argue that, in a world of high private sector debts and low inflation, the Government should be setting the conditions for private sector debt consolidation in a relatively pain-free fashion. That means bigger planned government deficits even if they break his existing rules. Rather than relying on unstable and unpredictable consumer indebtedness, Mr Brown should simply stand up on 9 April and declare that the era of big government borrowing is upon us. He should then challenge his rivals to tell us why, under current circumstances, the policy is flawed.

Stephen King is managing director of economics at HSBC.

stephen.king@hsbcib.com