It is always the economy, stupid

By Martin Wolf

I am living in New York at the moment. I find that Americans who are aware other economies exist have one source of comfort: the US is in bad shape, but the UK is worse. Reading the Green Budget from the Institute for Fiscal Studies forces one to agree: the UK is in a mess. Yet it should still be a manageable mess.

The Green Budget demolishes Gordon Brown’s fiscal reputation: the UK entered the current crisis with one of the largest structural budget deficits in the industrial world and a bigger public debt than most; it had also done less to reduce debt and borrowing than most since 1997; public sector borrowing is set to reach a postwar high next year; rising debt and cuts in investment will reduce the estimated net worth of the public sector to less than half the level Labour inherited; the government’s fiscal rules are ancient history; and, in the unkindest comment of all, “the evolution of the public finances since 1997 mirrors the first 12 years of Conservative governments after 1979: three years of impressive fiscal consolidation, eight years of drift (masked by economic overconfidence) and then a big jump in borrowing thanks to recession and newly discovered structural weaknesses.”

So has this, as a result, become an unmanageable crisis? The answer is “no”, provided confidence in the solvency of the government, the solidity of the currency and the soundness of the economy can be sustained. Subject to these provisos, what lies ahead is not the end of the world. The UK has survived far worse.

The Treasury assumes that the crisis has reduced potential output by 4 per cent. An alternative view, to which I adhere, is that it confused the cycle – in this case, an exceptional boom in the financial sector – with the trend. It was in good company. Inevitably, such a reduction in expectations has drastic implications for the fiscal position: in 2009-10, the structural current budget is now forecast to run a deficit of 4.4 per cent of gross domestic product.

To get the budget under control, the government is committed to a squeeze on spending. As the IFS notes, total managed expenditure is set to grow at just 1.1 per cent a year in real terms between 2010-11 and 2013-14. The share of economic growth taken by public spending would be 14 per cent – far below the 44 per cent between 1997-98 and 2007-08. If Labour were to win the election, it would offer all its public-sector addicted supporters, not blood, but “sweat, toil and tears”.

Even so, public debt will jump. The Treasury forecasts that public sector net debt will stabilise at 57.4 per cent of national income in 2013-14. Yet, for a country that emerged from the second world war with public debt of 250 per cent of GDP, this is almost a bagatelle. At reasonable real interest rates (say, 3 per cent), the annual cost to the taxpayer would be less than 2 per cent of GDP. This is affordable.

The government is surely correct to borrow its way through the crisis, rather than add fiscal insult to financial injury. The Conservatives are right to criticise the government’s record as manager of the public sector, the financial system and even household borrowing. But they are wrong to take so pre-Keynesian a view of public finances in a crisis.

So what are the big risks? The biggest, by far, lies in the economy. The IFS itself predicts that public sector net debt will peak at 62 per cent of national income. If the cost of rescuing the financial sector were to be 8 per cent of GDP, as Goldman Sachs has argued, this would rise to 70 per cent of GDP. If the world economy is about to fall into a depression, losses in the financial sector could be far higher. If the economy were also to follow the path of Morgan Stanley’s “pessimistic case” – under which GDP in 2012-13 would be only marginally higher than in 2007-08 – the current budget deficit would remain close to 8 per cent of GDP, despite the squeeze on public spending. Net public debt would then be on its way to more than 100 per cent of GDP. It is hard to believe the government of an open economy could get away with this in peacetime.

Soaring real interest rates on public debt would be a consequence of such a scenario, as confidence was lost. But soaring real rates would also cause such a crisis. A vicious spiral would then ensue. In short, the UK would suffer the sort of crisis so many emerging economies have experienced. The trigger would be a flight from UK liabilities and so a currency collapse, a public debt crisis or, probably, both.

Fortunately, that is precisely what has not happened, as yet. The fall in the external value of sterling, combined with low rates of interest on government debt, despite the huge fiscal deficits, and the continued ability of the central bank to cut short-term rates is exactly what one would wish to see. I would far rather have to manage the UK through this crisis, despite the challenges, than Spain or Ireland. Gordon Brown does have one achievement to his credit: he kept sterling out of the clutches of the eurozone. That has given the UK the chance to rebalance its economy and return to growth, once the rest of the world economy at last recovers.

“Buck up,” as my colleague Samuel Brittan says. Life is going to be much harder for longer than almost anybody imagined two years ago. But the UK can, with tough discipline and some luck, manage even these shocks.