10 October 2008
Economists have warned that the government's £500bn banking sector rescue package will lead to a further squeeze on public spending in two to three years' time – and put public sector debt at its highest level since the 1970s.
The measures announced by Chancellor Alistair Darling – including part-nationalisation of major high-street banks and protection for UK customers caught out by the collapse of Iceland's financial sector – were followed by calls from town hall leaders for similar support for local authorities with money in Icelandic banks.
A number of local authorities are understood to have deposited sums with the stricken Icelandic bank Landsbanki, which was expected to default. Darling's announcement, made before the financial markets opened on October 8, was reiterated in the Commons later that day, with both Conservatives and Liberal Democrats offering support for his measures. But a planned evening lecture – in which the chancellor was expected to outline changes to the government's fiscal policy and borrowing constraints – was postponed.
The government had been under pressure to ditch or change its fiscal framework, amid speculation that its sustainable investment rule would be broken with debt hovering just below the ceiling of 40% of gross domestic product.
But Prime Minister Gordon Brown signalled that the programme to support the banking system marked a change of tack, declaring: 'This is not a time for conventional thinking or outdated dogma but for the fresh and innovative intervention that gets to the heart of the problem.'
Brown admitted that the rescue package would be funded by borrowing, but pledged: 'All these are investments being made by the government, which will earn a proper return for the taxpayer.'
The public purse would 'get the upside' from the £50bn recapitalisation scheme – a key part of the rescue package that means the government acquires preferential shares in the banks.
Economists calculated that Darling's move would allow debt figures to rocket through the ceiling set in the fiscal rules. Robert Chote, director of the Institute for Fiscal Studies, told Public Finance he was expecting the £50bn bank capitalisation to be added to public sector net debt. 'That would add 3% of national income to the net debt.'
He noted: 'That increase is on top of Northern Rock, Bradford & Bingley... and the probably modest costs of compensation [for customers of Iceland's banks].' If these elements were added to the debt figures, the PSND would reach 50% of national income 'which we haven't seen since the mid-1970s', Chote said. 'But the government will hope they will recoup some, possibly all, of the debt if the banks improve.'
The government's intervention into the banking sector would not hit public spending immediately, Chote said. 'The squeeze is likely to be a consequence of the increase in borrowing in the next couple of years when the economy returns to normal. It's going to be a question for after the next election.'
Charles Davis, senior economist at the Centre for Economic and Business Research, said borrowing for 2008/09 could now hit £100bn, up from the think-tank's £60bn September forecast.
He warned: 'Clearly it's going to cost us in the future. It has to influence policy down the line in terms of raising taxes or cutting spending.' Davis agreed that the effects would be felt in two to three years' time.
He warned: 'The economic slowdown is what will really hit government revenues. This [borrowing] could compound it, but we are not sure by how much.'
The International Monetary Fund this week predicted that the UK would be in recession during 2009 and the National Institute for Economic and Social Research estimated a 0.2% fall in GDP for the three months to September. The NIESR noted: 'Unless output growth resumes in the near future, it will be reasonable to say that a recession began in May.'
Local authorities were this week weighing the latest effects of the international financial turmoil, with Local Government Association chair Margaret Eaton writing to Darling urging action to protect town hall deposits with Landsbanki.
Welcoming the chancellor's move to freeze the bank's UK assets, she wrote: 'We would strongly urge you to take whatever further action is needed to safeguard and support the position of local authorities and the communities they serve.'
The LGA initially identified more than 20 councils affected by the Icelandic collapse, with deposits ranging from a few millions to 'the low tens of millions of pounds'. Deposits had been placed 'across a range of financial institutions to spread risk', Eaton wrote, adding: 'Any difficulties any council might face will be as a result of wholly exceptional circumstances.'
In response to questioning by the Liberal Democrat Treasury spokesman Vince Cable in the Commons, Darling stopped short of a commitment to support councils, describing their situation as 'slightly different' to ordinary consumers 'in that they're a more informed investor'.
The matter was 'evolving', the chancellor said. 'We are trying to sort it out with the Icelandic government.'
PFoct2008
