29 February 2008
An economic downturn is coming, that much almost everyone is agreed on. But its depth, width and length are still uncertain. As the Budget looms, Priyen Patel looks at the options
With growing financial turbulence, high levels of consumer indebtedness and weaker global economic prospects, the management of the UK economy and the public finances is the subject of ever-greater scrutiny.
There is an increasingly prevalent view that a 'correction' is needed for both the economy and the public finances, but there is considerable debate over its speed and severity: is this a full-scale downturn or a plateau for growth? This will be brought into sharper focus on March 12 when the chancellor makes his 2008 Budget announcement.
Consensus among commentators on the economic outlook has moved into negative territory very rapidly. At the end of January, Deloitte's economic adviser, Roger Bootle, wrote in his quarterly Economic review that growth would slow sharply from 3.2% last year to around 2% this year and to below 2% in 2009. This would mean the UK economy entering its weakest period of growth since the Exchange Rate Mechanism crisis of 15 years ago.
Any deterioration in economic performance could have a dramatic impact on the public finances.
Monetary policy is the available tool for ensuring macroeconomic stability, and critical to that is the Bank of England's requirement to keep inflation under control. Although annual inflation has been near the Bank's 2% target, it has nudged upwards since the end of last year to 2.2% in January. Looking ahead, the salient message from the Bank's February Inflation report has been that the economy faces two sharpening risks in both directions.
First, tighter credit conditions for households and businesses will bear down on demand both in the UK and abroad. There are signs that consumer spending has already moderated and that investment intentions have eased back since the last quarter of 2007.
Second, and conversely, rising energy, food and import prices will increase inflationary pressure.
Both developments have become more acute and the near-term outlook is one of inflation rising sharply alongside a marked slowing in growth for the UK. This is set within a context of much poorer prospects in the advanced economies, particularly in the US.
But it is the continued stress in financial markets that is really causing concern among policy makers. The Financial Stability Forum, an international institution set up to promote financial stability and prevent crises, presented a gloomy report to the Group of Seven finance ministers and central bank governors less than three weeks ago. It concluded that the impact of declining asset prices and the lack of available credit could trigger a vicious circle of tightening credit markets, which would slow growth, which would in turn affect financial institutions' lending capacity, which would slow growth further and so on.
A major issue, however, is how quickly tightening credit will transmit into wider aggregate demand. The impact is already apparent in property markets, and is particularly likely to affect investment in commercial and residential property, and business investment more generally. The household saving rate is likely to rise, slowing the growth rate of consumer spending, signs of which are already evident in official data of retail sales.
Reacting to similar conditions in the US last month the Federal Reserve made the biggest interest rate cut for more than two decades. In just over a week, it announced a cumulative 125-basis point reduction through two announcements. The merits of the decision have divided economists over whether it can bring calm to credit and equity markets, or indeed, whether a further cut is needed.
There is an argument, of course, that the credit crunch is in fact reality catching up with us. Following a period of easy credit, the problems in financial markets reflect an era of unsustainable economic growth that is now coming to an end through an adjustment in asset prices, credit, demand and, ultimately, output.
The general expectation for the UK is for an economic slowdown, not a recession, but the jury is still out on the pace of it. Carefully considered monetary policy will be needed to manage demand and steer the economy along a stable path. The Bank's job, as its Monetary Policy Committee will deliberate in early March, is complicated at a time when stagnating growth is coupled with heightened inflationary expectations.
While the Bank faces a delicate balancing act in managing conflicting risks, the Treasury has to ensure that the 'fiscal arithmetic' (to use the prime minister's terminology) adds up when the chancellor makes his Budget statement.
The government claims that the public finances are still within its twin fiscal rules for borrowing: the 'golden rule' requiring the budget to be kept in balance or surplus over the economic cycle; and the sustainable investment rule, a 40% ceiling on the ratio of public sector net debt to national income.
On the first rule, the state of the current budget balance is in a reasonable position. It might have been 'too soon to assess' at the 2007 Pre-Budget Report, but at Budget 2008 the Treasury is expected to make a formal judgement about when the 1997/98 economic cycle ended and confirm its provisional judgement that the 'golden rule' has been met.
No doubt the chancellor will point out that Labour inherited a large budget deficit of 2.8% of national income in 1996/97 and a debt burden above 40% of national income – ten years later both have been cut.
However, as the Institute for Fiscal Studies points out, of 21 comparable industrial nations, 19 have done more to improve their structural budget balances and 16 have done more to reduce their debt burdens. This difference largely reflects Labour's ambitious plans for public sector reform driven by spending, increasing the public sector share of national income since 2000.
But the government can boast a strong track record of 62 consecutive quarters of economic expansion, inflation not far from its 2% target and stronger expected growth in 2007 than any other G7 economy.
Critics will point out that there are many 'known unknowns' that the government will have to grapple with – a volatile financial services market, consequent variability and likely weakness in business tax receipts, two wars, the impact of Northern Rock on the credit market and a range of other issues with unknown outcomes. This has been reflected in the 2007 Comprehensive Spending Review, under which public spending in the next three-year period will rise at only half the rate as in previous Spending Reviews, with the local government settlement being particularly tight.
The question is whether this is enough to deliver the correct 'fiscal arithmetic'. It is not clear. Successive Treasury forecasts for the public finances since 2001 have been consistently over-optimistic and have been revised down repeatedly in Budget and Pre-Budget Reports. The IFS's Green Budget 2008 voiced fears that tax revenues would not grow as strongly as the Treasury hoped. This is due to factors such as the credit crunch, a weak outlook for profits growth that will depress corporation tax receipts and lower stamp duty revenues.
Another big question is whether the chancellor's second fiscal rule is 'fit for purpose'. At the start of the Labour term, public sector debt had peaked at 43.8% of GDP in 1997, its highest since the mid-1980s. Since then, the debt ratio has fallen below 40%, currently standing at 37.6% of national income. With the nationalisation of Northern Rock, the rule will be breached. Bringing the bank's assets and liabilities on to the government's balance sheet will add £100bn to public sector net debt, bringing the debt ratio to around 45%.
Furthermore, when new international financial reporting standards come into force in April, the best part of £30bn from existing Private Finance Initiative deals will also come on to the government's books.
It is by no means damaging to the underlying position of the public finances that net debt rises just above 40% of national income, as long as the likely forecast is stable and controlled. But, breaching a self-imposed and widely vaunted public finance rule is politically damaging for the government.
The IFS forecasts that to maintain the sustainable investment rule over the medium term, an £8bn tax increase will be required. In the longer term, it maintains, Labour is planning to allow the tax burden to increase by 1% of national income (£14bn) and to cut public spending by 0.5% of national income (£7bn). Were this to happen it would take the tax burden to a 24-year high and public spending to an eight-year low as proportions of national income.
Thus, in the next months and years, both the ability of the Bank to control inflation as well as the value of the Treasury's borrowing rules will be put to the test. The chancellor will have a number of difficult decisions to face: manage the prospect of breaching his fiscal rules or consider increasing taxes; as well as deliver public service improvements with less spending. None sit easily in the run-up to a general election.
Priyen Patel is a senior consultant in the public sector strategy team in Deloitte's consulting practice
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