Decisive action – but here are the catches

Published on Monday 24 November 2008 21:20

ALISTAIR Darling's Pre-Budget Report (PBR) needs to be judged in two main parts. First: does it do enough by way of a fiscal boost to minimise the recession and restore long-term growth? Second: has the Chancellor done enough by way of tax rises in the medium term to steady market nerves shaken by the inevitable rise in public debt? In other words, how will the PBR play on the high street and in the City?

To begin in the high street, the stimulus is a big one – next year's increase in borrowing is the biggest annual percentage jump in peacetime. Early indications were that Mr Darling would pump extra spending to the equivalent of 15 per cent of gross national product into the economy. As it is, his fiscal boost is around 20 per cent, achieved through a VAT reduction plus a host of technical measures to help small businesses and families. In hard cash, this amounts to some 20 billion of extra spending between now and 2010.

Given the scale of the global financial crisis – which has destroyed confidence in the banking system, collapsed the housing market, driven down share prices and frightened consumers – Mr Darling has to be congratulated for his boldness.

Pointing the blame

George Osborne, the Conservative Shadow Chancellor, predictably attacked the package on the grounds that the Labour government was in part responsible for the original crisis. And there is no doubt that Gordon Brown must carry a good deal of the blame for the housing and credit bubbles in the UK, as well as for his naive pretence that the business cycle could be abolished.

However, none of these trenchant criticisms can avoid the fact that a bold stimulus package was needed and that Mr Darling has provided it, while the Tories have merely blustered.

But will the Darling fiscal package work? The Chancellor is gambling that the VAT cut will encourage consumers to open their wallets over Christmas. The risk is that Christmas shoppers, faced with massive discounting by worried retailers such as Marks & Spencer, will hardly notice VAT falling (temporarily) from 17.5 per cent to 15 per cent. Even if some consumers are persuaded by the cut to spend more than they might have, others may simply pocket any saving and use it to pay off those nasty, post-Christmas credit card bills.

The truth is that Mr Darling probably opted for a VAT cut because he can easily reverse it at the start of 2010. A cut in income tax, on the other hand, is tricky to go back on – as president-elect Barack Obama has just found out. Nevertheless, whatever the political difficulties, a cut in the basic rate of income tax might have been better understood on the high street.

On the other hand, the Chancellor has offered many useful fiscal concessions to the business community, including deferring the proposed rise in corporation tax for small firms. HM Revenue and Customs will also allow companies facing financial difficulties to spread the payment of all their business taxes over a timetable they can afford. These are reforms which Mr Darling should consider making permanent.

The Chancellor also made much of bringing forward capital spending. The pity is that he did not announce some iconic new project – such as a national high-speed rail network – that might have raised national morale at a difficult time. If Mr Darling's calculated risk pays off, the UK economy will start to recover from the middle of next year. But what if Mr Darling's economic growth forecast proves too rosy, which is not inconceivable? What if other nations do not emulate his fiscal courage and the global economy remains mired in recession until 2010? What if a major US car producer fails, triggering further turmoil in the already jittery markets? The Chancellor has shot his economic bolt. He has little left in his armoury, short of resorting to the printing press.

Even if the Darling mini-budget (for such it was) works in the short run, there remain questions that need to be asked about its long-term implications. Just how sustainable are the Chancellor's numbers? This is where the PBR will be judged by the City.

The most obvious worry is that the Chancellor foresees public debt ballooning until at least the year 2014 – well beyond the immediate crisis. This is because, aside from borrowing to fund yesterday's emergency fiscal stimulus, the government intends to continue increasing public spending by 1.1 per cent in real terms into the indefinite future. This includes spending more on the revenue account than is raised in taxes – what economists call a structural deficit.

The problem with this plan is that those who lend the government money – many of them foreign financial institutions – may conclude that Mr Darling is not ramping up borrowing merely to stave off global recession. They may decide he also is borrowing to buy Labour the next election.

As a result, they may not lend the cash the government is seeking, precipitating a further fall in the exchange rate of the pound. Or if they do lend, they may demand significantly higher interest rates, which could actually choke off any economic recovery.

Many in the City wanted Mr Darling either to cap longer-term spending for the duration, or even to promise to cut spending after the emergency was over.

As it is, the Chancellor has tried to make the books balance in the years to come by promising deferred tax rises, such as a hefty jump in National Insurance contributions paid both by individuals and by companies, effective from 2011.

Bigger tax worry

The worry must be that even greater tax rises are in train, if the forecast borrowing is to be paid back.

The government may reply that, if its optimistic growth forecasts hold, none of these problems will arise. And in the current state of market panic, there is a reasonable case to be made for the government sounding optimistic.

Yet there can be too much of any good thing – including optimism. It might have been better for the Chancellor to have kept his revenue budget in balance after 2010, even if he went on borrowing to fund investment. That at least would have shown a willingness to be prudent. As it is, he may have taken an unnecessary risk with City confidence at a time when unnecessary risks should be avoided.

Yesterday's PBR was one for the history books. If the stimulus works, then the Prime Minister and his Chancellor will deserve a pat on the back. Certainly, they deserve our respect for taking decisive action.

Taking no action at all would have been far, far worse.

THE PRE-BUDGET REPORT: FULL COVERAGE