Peter Jones: America's taxing past may fit the bill for Britain

AS GORDON Brown and Alistair Darling contemplate the shattering of New Labour's much-trumpeted golden fiscal rules, could they be looking across the Atlantic for their way out of the looming crisis now about to grip the nation's public finances? Does the way Bill Clinton handled the American economy in his first term as US President offer a model for getting out of the hole they're in?

The problem Brown and Darling face is intimidating. Thanks to the banks bailout, Government borrowing this year looks set to soar to 64bn, says the Institute of Fiscal Studies, way ahead of the 43bn forecast by Darling in March. In 2009-10, many economists think it could hit 100bn, or 6% of GDP. At the same time, as recession freezes the economy, tax revenues are falling. As unemployment rises, so does welfare spending. And as the national debt climbs higher, public spending has to be diverted from paying doctors and teachers to debt repayments.

It means Brown and Darling face the worst nightmare of any government – having to raise taxes or cut public spending, or both.

Much the same problem faced Clinton when he won the US presidency in 1992. Famously, he and his team had single-mindedly focused on one theme – "it's the economy, stupid". The American economy had slowed and then fallen into recession in 1990-91, causing unemployment to rise. The incumbent Republican president, George Bush Snr, equally famous for his campaign soundbite "read my lips, no new taxes", had been forced into tax increases.

A major cause of the recession was a credit crunch. The culprits were America's savings and loans institutions. These were not unlike Britain's building societies. People deposited money in them to earn, say, 3% interest, and the money was lent in mortgages costing 6% interest. By 1987, there were more than 3,600 of them with $1,500bn in assets. But rising interest rates put a terrible squeeze on them and, by 1989, many were going bust. As with the banks bailout, taxpayers' money was needed to sort out the mess at an eventual cost of $87bn, putting more pressure on the federal budget.

By the time Clinton came into office, economic recovery had begun, but the public finances were in a mess. US national debt had risen to $3,000bn and the annual federal budget deficit had soared to $290bn. Interest payments were the third biggest item in federal spending after welfare and defence. The deficit was forecast to hit $560bn by the time Clinton faced re-election. And yet Clinton had won by promising tax cuts for the middle classes, more spending on national infrastructure and more jobs. And he said he would halve the federal deficit. He had few tools to promote faster economic growth; the Federal Reserve had cut short-term interest rates to 3%. The task looked impossible.

At their first meeting, the Federal Reserve chairman Alan Greenspan told Clinton how it could be done. The key was to cut the federal deficit, he said. In his autobiography The Age Of Turbulence, Greenspan says: "Improve investors' expectations, I told Clinton, and long-term interest rates could fall, galvanising the demand for new homes and the appliances, furnishings, and the gamut of consumer items associated with home ownership. Stock values too would rise as bonds became less attractive and investors shifted into equities. Businesses would expand, creating jobs."

The Greenspan advice reinforced Clinton's deficit-cutting instinct. Clinton focused on cutting it by $500bn over five years, but it meant his first budget brought tax increases, not cuts, and few spending increases beyond a $20bn package economic stimulants. Clinton later wrote in My Life: "I hated to give up the middle class tax cut, but with the deficit numbers worse, there was no choice. If our strategy worked, the middle class would see direct benefits worth far more than a tax cut – in the form of lower home mortgages and lower interest rates on things like car payments, home mortgages, and student loans."

Getting the budget through Congress was an exhausting struggle – it passed in each house only by a single vote. But it worked. By 1997, the annual budget deficit was down to $22bn and by 2000, the year Clinton left office, the budget was in surplus, the extra cash being used to reduce America's national debt.

So, it can be done. But Brown and Darling have less than two years to get the economy back on track before they face the voters. And the lesson from Clinton's experience is that they will have to raise taxes and cut spending, which will look like electoral suicide. Nevertheless, if they are to rebuild investment confidence, it is the way they will have to go.