The British Budget Deficit

In my Money Week column this week, I've been writing about the terrible state of British public finances. Here's a taster.

The battle lines for the next general election are already being drawn. Gordon Brown plans to fight on a platform of protecting public services from savage Tory cuts. We’ve already heard plenty about the nurses and policemen who’ll be fired if the Conservatives win power next year, and we’ll hear plenty about the teachers and care-workers who’ll be joining them in the next ten months.
Brown’s rhetoric is dishonest, as plenty of independent experts have already pointed out. The last budget pencilled in cuts of 7% in real terms to public spending for the years after 2011. The truth is, as anyone who wants to take a look at the figures can quickly work out, that whoever forms the next government will have to push through painful cuts.
The rhetoric, however, is potentially very dangerous. It is crowding out a sensible debate on how the vast budget deficit can be bought back under control. At some point, it is going to spook the currency markets, making a cut in Britain’s credit rating almost inevitable. And it may well provoke the Bank of England into raising interest rates sooner than it otherwise would.
This is more than just harmless political knock-about. It risks provoking a serious economic crisis.
No one can have missed the way the arguments over spending cuts have been ramped up in the past two weeks. You might think a government presiding over a budget deficit now expected to hit a massive 12% of GDP, the highest in the developed world, and the biggest the UK has run since it was engaged in the small matter of fighting World War II, would at least be willing to concede that spending had to be tightened up a bit.
Not at all. The Government insists that spending will carry on rising. In the House of Commons, Brown argued that capital spending would increase up to and including the 2112 Olympics, whilst Ed Balls, the schools secretary, has insisted spending on education can continue rising in real terms. There has so far not been a single admission by a senior government figure that spending will have to be cut in real terms, and in many cases, very savagely.
That is nonsense. Real Madrid might be able to carry on spending money as if the credit crunch had never happened. The British government won’t be able to. “We must live within our means,” argued the Chancellor Alistair Darling in his speech to the Mansion House. “There are tough choices ahead.”
There isn’t any sign of those ‘choices’ being made yet. In reality, the only decision facing any British government is whether it wants to get serious about the black hole in its finances now or after the election. Deficit spending on this scale – one in every four pounds the UK Government spends this year will be borrowed money, and it will be taking on additional debts of £14,000 for every family in the UK – simply isn’t possible.
Right now, the yah-boo rhetoric is crowding out any kind of serious debate about how that deficit can be bought under control. Countries can significantly reduce state spending without slashing services or tearing up welfare programmes. In Canada, for example, government spending as a percentage of GDP peaked at 53% in 1992, which is roughly where the UK will get to next year. It has now come down to 38% of GDP. Outstanding debt was cut to 32% of GDP in 2008 compared with 71% in 1995. At the same time, corporate taxes were cut back all the way to 15%, and little damage was done to the country’s traditional welfare and healthcare systems. Most of it was achieved by reducing state payrolls, and at the same time cutting business taxes, so the people laid off in the public sector cold move into jobs created in the public sector. There is no great miracle about it. But so far the UK is resisting learning any lessons about how other countries have curbed their deficits.
Worse, the currency markets are going to take fright. Ignore the recent rise in sterling. That is going to be reversed soon, and probably savagely. Standard & Poor’s has already cut its rating on the UK, putting it on ‘negative’ outlook. That is just the start. The ratings agencies have cut Japanese and Irish debt, and those countries are in no worse fiscal shape than Britain. Probably better. So far the currency markets have remained fairly sanguine about the collapse of British government finances, largely because they assume a change of government is imminent. The Conservatives will restore discipline even if Gordon Brown won’t. And yet as the debate becomes ever more divorced from reality, that is unlikely to last. At some point, confidence will crack, and the sterling will face a collapse that will make funding the deficit much, much harder. In a world where most governments are borrowing on an unprecedented scale, there is not much incentive for investors to hand their money to a government which shows no inclination to even admit spending has to be reined back.
Most seriously, if the politicians won’t get a grip on spending, the Bank of England might have to do the job for them. “If, as seems likely, the necessary fiscal surgery is delayed, then the MPC is likely to judge that the responsibility for maintaining economic and market stability falls to them and cannot be ducked,” argued Citigroup economist Michael Saunders in an analysis of the deficit. He forecasts as many as three half point hikes in interest rates in 2010 as the inflationary consequences of massive deficit spending start to become clear. Couple that with the tax rises needed to cope with the deficit, and the inevitable slow down in public spending, and it is clear that the UK faces a very severe squeeze on spending. Forget about a rapid return to growth. Britain will be lucky if it avoids another recession in 2010 and 2011.
The UK needs to start a serious debate about bringing public spending under control now. The longer it postpones it, the worse the pain will be when it finally does get around to addressing the issue.