Even a small rise in interest rates could tear asunder the Chancellor’s latest Spending Review, writes Bill Jamieson
Barely mentioned in Chancellor George Osborne’s 50-minute Spending Review speech yesterday was a figure that has embedded itself in the national accounts like a primed torpedo. It has the explosive capacity to blast all of yesterday’s figures to smithereens.
Against this, other problems with the Chancellor’s statement yesterday are secondary. Many will have succumbed early to a strange sensation of déjà vu. Have we not been through all this before? Were we not agonising over public spending cuts three years ago? Have we not heard time after time about efficiency savings, civil service reduction, local government cuts, pay rise curbs and resource reduction?
And are we not already well familiar with the predictable reaction and the protestations – “services at risk”, “savage cuts”, “ruinous austerity”? We hear – again – of impressive-sounding increases in infrastructure capital projects - £100 billion of projects to be announced today, swelling the total to £300bn. Heard it before? We almost certainly have. That figure covers ten years – stretching to the end of the decade – and the latest projects are unlikely to be started much before 2015.
For Scotland, where the activity of government is so often mistaken for the economy overall – it seems we are doomed to even harder times. You may have heard that the Scottish budget is only to be modestly reduced and we will have more money for capital spending and that we will have more borrowing power. Well, we heard wrong, apparently. Cabinet secretary for finance John Swinney was having none of this. It’s all a trick of numbers. The loans will have to be paid back. It’s yet more pain and austerity for Scotland.
So, it seems that we are locked in a continuous loop. All that seems to change are the numbers on spending and debt. Only they’re not getting smaller, they are getting bigger.
For the Chancellor himself is trapped on a treadmill: the more determinedly he peddles on public spending reduction, the greater the spending total seems to grow. Yesterday, the Chancellor told us that annual managed expenditure (AME) growth will continue to greatly outstrip the growth of spending by departments: on the government’s plans, total current public spending will rise from £657bn in 2012-13 to £694bn in 2015-16, a rise of £37bn, or 5.6 per cent. This splits into growth of £41.7bn (13.1 per cent) in AME and a drop of £4.6bn (1.4 per cent) in departmental spending. So much for “savage cuts”. And the public debt total continues to climb.
So why is it all taking so long? And why do we seem to be going backwards, not forward, even after cuts of between 8 and 10 per cent in many government departments?
Here’s one reason. One of the central problems for the Chancellor is that major areas of public spending continue to be protected – and spending in these areas continues to rise. Spending on health (£137bn) is up from 17.9 per cent of total spending in 2004-5 to 19.4 per cent. Education spending at £97bn and international aid (£11bn) are also ring-fenced.
Add to these “social protection” (£220bn) and debt interest, and £516bn of the Chancellor’s total outlay is effectively sealed off, leaving other government functions to take the hit.
But there is another and altogether more worrying reason. It relates to the one number in the spending review that was missing. And it is here we find the ticking torpedo.
It is the annual charge for debt interest. It is the fastest growing item of all government expenditure and ranks first for payment in the government accounts. This year it is set to hit £51bn. Back in 2004-5 this item accounted for 5.1 per cent of all spending. By 2017-18, it is forecast to hit £67.8bn and account for 9.5 per cent of all spending. By then, it will be absorbing more than a third of the government’s revenue from income tax.
Debt interest spending has increased rapidly in recent years as a result of the rise in borrowing. Some argue that there is no real problem – debt interest typically rises after a recession and debt interest payments in 2017-18 are only forecast to account for around the same proportion of total public spending as in 1997-98.
But back then the annual budget deficit was just 1.3 per cent of GDP compared with 7 per cent now, and economic growth was running at more than 3.5 per cent – more than double today’s level.
Moreover, the projections on debt interest assume interest rates will stay at their ultra-low levels and at international conditions will be stable. Neither assumption can be counted on.
Over the past few weeks, financial markets around the world have been falling sharply on hints by Ben Bernanke, the chairman of the US Federal Reserve, that the emergency policy of monetary easing known as quantitative easing may be coming to an end and that he plans to begin tapering off this support later this year. The immediate reaction to this has been to push interest rates higher.
There is no immediate prospect that interest rates here at their emergency low level of 0.5 per cent will rise soon. But the warning from the US is a reminder that such emergency support cannot continue indefinitely. Taking a two-year view, who would confidently count on UK interest rates remaining at 0.5 per cent?
Yesterday, as the Chancellor was delivering his Spending Review, the Bank of England slipped out a warning that “significant” numbers of people could face financial problems when interest rates start to rise. If rates rose by one percentage point to 1.5 per cent, the Bank said households accounting for 9 per cent of mortgage debt would need to take action.
If rates were to rise by two percentage points, to 2.5 per cent, that figure would rise to 20 per cent of mortgage debt. Paul Tucker, the Bank’s Deputy Governor, has asked regulators to investigate the issue immediately.
Not only would such a rise put a serious question mark over the speed and scale of our economic recovery, but it would also drive up the government’s debt interest bill. Nor would it be safe to count on a return to financial stability in the eurozone. Further turmoil would have knock-on effects on world debt markets, including our own.
George Osborne went as far as he reasonably could in his Spending Review yesterday. Indeed, it was reasonable as far as it went and it made sense. But much of this should have been dealt with three years ago when the coalition took office and the public was braced for austerity. Now, three years later, it is weary of the cuts. He is also constrained by his own ring-fencing policies, which have resulted in a hammering of non-protected departments.
Above all, he faces a debt interest explosion that could tear through the arithmetic of yesterday’s statement. There is more to worry about here than party politics and positioning ahead of the next election.