Budget 2009 - Darling's Dilemma

All talk of green shoots is verboten right now on the government benches - it’s all hair shirts and austerity on the eve of Chancellor Darling’s second budget next Wednesday. But outside government there’s no shortage of people who do claim to be seeing signs of recovery in the economy. Most of them are the usual suspects - like the estate agents, who were forecasting a recovery in the housing market almost before prices started to fall. But with stock exchanges rebounding by 22% and the banking sector apparently stabilising, there is bound to be a period of modest recovery at least in the financial markets. British exports are up and some economists, like the Centre for Economic and Business Research, say house prices have only another 10% to fall.

The trouble is that this may be good news outside the Treasury, but bad news within it. For, if there is any sign of recovery, the first thing the government and the Bank of England ought to do is increase taxes and interest rates to sort out the deficit. This would halt the apparent recovery in its tracks, which will make people very annoyed. “Why is the government blocking recovery”the British Chambers of Commerce and the TUC will complain, just when people need to be helped back to work? Indeed, unemployment will be rising just at the moment the government puts its foot on the brake.

Which probably guarantees that it won’t. This is where the interests of economics and politics collide. There is no doubt that the British finances are dire: the Institute For Fiscal Studies says that the government is going to have raise taxes or cut spending by £20bn a year over the next five years to fix the holes caused by collapsing tax revenues and increases in welfare payment to the unemployed. The final figure will almost certainly be more than this because the IFS is not taking fully into account the cost of the various bank rescues and toxic asset buyouts which the government has embarked upon. £1.3 trillion has been put on the table and while that won’t all disappear into the banking black hole, a lot of it surely will.

Taking all this money out of the economy now would reduce demand and provoke a further downturn on the eve of the next general election. Increased taxes would make people even more reluctant to spend in the shops than they are now. Increased interest rates would kill the expected recovery in the housing market. The value of sterling might rise, which would damage exports, and of course there would have to be big cuts in the public sector, which would add to unemployment. This is very difficult medicine for an unpopular government. From a narrow political point of view, doing nothing to impede economic revival is not so much a no-brainer as a full frontal lobotomy.

However, there had been indications that the Chancellor, Alistair Darling, was minded to start increasing taxes sooner rather than later. He has of course already made clear there is to be a new 45% tax rate on people earning over £150,000. He has been warning that the economy is in a bad way and that difficult choices will have to be made. Alistair Darling has made a virtue out of being the ‘feel-bad’ chancellor, never knowingly optimistic, and he does not want to go down in history as the second Labour chancellor to have to call in the IMF to rescue a bankrupt Britain. The first having been Denis Healey in 1976.

But equally, Gordon Brown does not want to be a prime minister who has never won a general election. It is inconceivable that he would allow Darling to take any actions that would jeopardise Labour’s prospects in the general election that must be fought before May of next year. Electoral success desperately needs a recovery, or the appearance of one. So, on the eve of this week’s budget, we can expect much happy talk of stimulus, electric cars house building, help for home buyers. There will be promises to do “whatever it takes” to get the economy moving again and to hang with the public finances.

The Chancellor has been receiving deputation's from businessmen, trades unionist and Labour backbenchers all urging him, with the PM’s implicit backing, to stoke the economy with more borrowed cash. It all sounds very plausible: invest now for the upturn; don’t allow skills to wither on the dole; boost confidence and house prices. It’s only money, after all, and it can all be paid back later when the economy recovers...

But the ugly reality is that Britain’s financial predicament is much worse than it appears. Fiscal stimulus implies that there is something to stimulate, not a flat-lining corpse. There needs to be huge structural change in the UK economy to address the ageing population and our over-dependence on debt and finance. The unfunded public sector pensions bill alone amounts to £1trillion. Meanwhile, private debt of £1.5 trillion will have to be paid back. The cost of 3.3 million unemployed will also be eye watering. The liabilities of the nationalised banks are huge: RBS alone has liabilities equivalent to 150% of GDP. Add all this together it’s not hard to get a very big number indeed, which is why many international financiers have taken to calling London “Reykjavik on Thames”.

Of course, this doesn’t all have to be paid at once, and much of it may never have to be paid at all. We have to assume that even financial toxic wasted dumps like RBS will eventually recover. But let’s be absolutely clear, whether on the right of the political spectrum or the left, the inescapable priority of British politics for the next decade will be winning the war against debt. With these huge financial overhangs, the merest hint that the government is not taking steps to repair the finances of he state would lead to a loss of confidence in the UK economy followed by a letter to the IMF. Already, the cost of insuring against a UK default on the derivatives market has been increasing alarmingly. Welcome to New Britain.