Think Tank

Who would be the UK Chancellor?

The yawning gap between government spending and deficit is the defining issue facing the next government.

By Andrew Haldenby, director of the independent think tank Reform

• Introduction
• Meaningful reform required
• Avoiding damaging tax rises
• Fiscal consolidation restores confidence

 Introduction

The 2009 Budget projected this year’s deficit to be £175 billion (12.4 per cent of GDP).* That would be nearly twice the level that forced the UK to seek the support of the IMF in the 1970s. The UK’s borrowing in October 2009 was a record for that month, leading some commentators to predict an eventual deficit of over £100 billion. The national debt is spiralling towards the benchmark of 80 per cent of GDP at which the UK’s AAA rating is put at risk. The extreme gravity of the situation is that most of the deficit – 9.8 per cent of GDP, or over £140 billion – is “structural” in the Treasury jargon. That means that it will not be solved by the natural return to economic growth as we move through the business cycle. It is the consequence of a long period of overspending in the UK government sector, which has left tax revenues far below the country’s spending commitments.

 Meaningful reform required

There is no question that the deficit has to be corrected in the long term. The political consensus, rightly, is that the situation should be salvaged by bearing down on public spending, not raising taxes (although we should not ignore the truly terrible proposal of a new 50p rate of income tax on incomes over £150,000, which is the worst kind of gesture politics, damaging the business environment in the hope of a fleeting sectional political advantage).

The UK is not an under-taxed economy, it is an over-spent one. Mervyn King, the Governor of the Bank of England, described the past decade’s public spending policies as “unsustainable” in evidence to the Treasury Select Committee in June.

My own organisation has monitored the rise in public spending since 2001 and found that the extra money has not been accompanied by any meaningful reform to achieve value for money. Addressing the structural problems of the UK government sector – its inflexible workforce, its lack of competition, its habit of looking to Ministers rather than customers for direction – is long overdue, and is the other minimum success requirement of the next government.

The question facing investors is when the course of tough medicine should begin. Many will be tempted by the idea that the medicine should be postponed. They will look at the rise of UK equities and asset prices in the last period and think that a continuation of government action, both monetary and fiscal, would not be a bad idea at all. They will accept that the deficit needs to be reduced but will hope for delay (reminding us of St Augustine’s words as he wrestled with temptation: “Give me chastity, O Lord, but not yet”).

I think the costs of this approach would greatly outweigh the benefits. The clearest cost is the danger to the UK’s credit rating. Moving to a lower credit rating would certainly drive up the cost of borrowing; more damaging would be the evidence that the UK has moved from a first rank to a second tier economy, with all of the implications of that for inward investment. International reputation matters more in a globalised world.

At the same time, if public spending and borrowing remain high, the cost of financing that requirement would rise sharply. The cost of servicing the national debt is already the fourth highest item of government expenditure. The rising financing requirement would inevitably crowd out private sector activity, most obviously capital investment. That would impinge heavily on the productive potential and wealth creating potential of the private sector.

 Avoiding damaging tax rises

The longer spending constraints are delayed, the more likely it is that taxes would have to be raised, which would do even more damage to demand. Furthermore, if the financial markets take on board that the public sector deficit is going to remain high for an extended period, then the risks are that longer-term yields move sharply higher and the currency depreciates. The former would tend to inhibit growth; the latter would be inflationary.

Here I am following Mike Turner, Aberdeen’s Head of Global Strategy and Asset Allocation. In the summer 2009 edition of The Bulletin, Mike Turner contrasted the stock market bounce in the western economies with the much better-founded outperformance in Asia.

For the West, he concluded: “The global crisis has called for policy to be improvised, and the extraordinary measures required to ensure liquidity within the financial system may have unforeseen outcomes. I am thinking here of an eventual return to inflation and the damage that may cause when credit excesses are still being unwound.”

What investors also need to know is that the programme of public spending reduction is also underway. Without any fanfare of any kind, public sector employment is falling, public sector pay is being pulled back and capital programmes are being cut (for example, the NHS capital budget has been reduced from £12 billion to £7.5 billion in the last two years). Public sector managers, to their great credit, are doing the immediate things that can be done to get costs under control.

 Fiscal consolidation restores confidence

As we look forward to a possible Conservative government, given the opinion polls, there are strong echoes of the economic debate at the beginning of the 1980s. The UK economy at that time joined the long list of economies that have returned to growth following a fiscal consolidation. What happens in these examples is that the fiscal consolidation restores confidence, and the resulting increase in activity outweighs any reduction in demand due to a smaller government budget. This would not be predicted by a Keynesian view of demand management which misses the role of expectations.

Mike Turner went on to say: “I have more confidence in the recent outperformance of Asia. At least here there is logic, based on the better fundamentals that we have described.” Like him, I don’t think there is any escape from the fundamentals, for investors or indeed for citizens. Investors should cheer on Richard Lambert, the CBI Director-General, who has called for much more urgent action to reduce the structural deficit.

The political challenge is obvious but the Westminster debate is moving in the right direction. Independent organisations such as my own are helping policy makers map out a way forward and would welcome the input of the investment community in this task. A future of sustainable public finances, reformed public services and – eventually – lower taxes would be a bright one for the UK.

* HM Treasury, Budget 2009