UK: TIME TO BE TOUGH AND FOR A TOUCH OF THAT IMF MUSCLE. - It may be that we need an outside agency to stiffen our resolve.

by David Smith, economics editor of The Sunday Times.
Last Updated: 31 Aug 2010

It may be that we need an outside agency to stiffen our resolve.

Think of a big number. Double it, treble it and multiply it by itself. Even then, it is unlikely that you will come anywhere near £50 billion, the Treasury's estimate for the public sector borrowing requirement (PSBR) for this year. Fifty billion pounds, five with 10 noughts after it, is an enormous number - no less than 8% of gross domestic product (GDP). The task of dealing with it is enough to dampen even the ebullience of Kenneth Clarke, the Chancellor of the Exchequer.

The chart (below) puts the problem of Britain's budget deficit into perspective. It shows the general government financial deficit (which excludes privatisation proceeds and some other transactions) as well as the 'primary' budget deficit, that is, the deficit excluding debt interest. The general government financial deficit for this year, at more than 10% of GDP, is almost twice as large as that which forced the 1974-79 Labour government to call in the International Monetary Fund (IMF). The primary deficit, as Chief Secretary to the Treasury Michael Portillo was brave enough to admit recently, is easily worse than in any other EC country - yes, even Italy.

The painless solution to the PSBR problem is economic growth, and plenty of it. The argument here is straight-forward enough. Growth boosts tax revenues and eats into cyclical elements of public spending, notably those on unemployment-related social security spending. If we could be sure that the economy was set for growth of 4% a year for the next four years, then Clarke could sit back and watch his budget deficit problem disappear. Relying on a four-year boom, particularly one that would begin its life during a deep European recession, is, however, rather like betting the nation's finances on picking an outsider to win the Grand National four years in succession. It could happen but it would be unwise to rely on it.

The Treasury, in its medium-term projections, assumes average growth of 2.75% a year from now until 1997-8. On this basis, and after the deferred increases in VAT on fuel and power and National Insurance contributions announced by the former chancellor, Norman Lamont, in the March Budget, this year's £50 billion is the peak for the PSBR. But even at the end of the period, it would still be a hefty £30 billion. If growth is a stronger 3.25% a year, the PSBR comes down to £18 billion by l997-8. If it is a weaker 2.25% annually, the borrowing requirement hardly comes down at all, and would still be £42 billion at the end of 1998.

It could be that these projections are much too cautious, and that growth will bring down the PSBR much more rapidly than the Treasury thinks. After all, government borrowing proved highly sensitive to the recession. Before the economy began to contract in l990, many of our leading forecasters were projecting a repayment of public sector debt - budget surpluses - into the indefinite future.

The sheer size of the deficit now stacks up problems for the future. The debt interest paid by the Government in the l991-2 financial year was just over £16 billion. This year it will be £19.5 billion, next year £23.5 billion and, on current plans, it will rise to £29.5 billion by 1997-8. A third of the planned rise in government spending over the next three years will go on higher debt interest. This is the road to ruin - the old aim of achieving a balanced budget would require that the rest of the public finances head for a surplus of nearly £30 billion, when they are currently in deficit by £30 billion.

There is also an important structural element to the deficit, on both tax and spending. In the mid-1980s, North Sea oil revenues accounted for some 10% of all tax revenues and more than 0.5% of GDP. Now they have dropped to just 1% of all taxes and less than 0.5% of GDP. Lamont's announcement of deferred tax increases in the March Budget will eventually claw back about half of the tax gap left by the disappearance of the North Sea golden goose. But that still leaves a sizeable hole, of £10 billion or more.

On the public spending side, the boom of the late 1980s, coupled with the Government's largesse ahead of the April l992 election, has also produced a serious structural problem. Social security spending, excluding the effects of the recession, has been rising by 3% a year in real terms. Spending on the NHS, which has been increasing by a real 5% a year, has gone one better. When John Major replaced Margaret Thatcher, the new approach to public spending was a softer one. The Treasury had fought to freeze child benefit and was dismayed when he re-established its automatic annual uprating in line with prices.

Public spending this year is 45.5% of GDP. Growth will eventually bring it down to around 43% of GDP. But that is still around 3% of GDP, or between £15 billion and £20 billion at current prices, and too high. The stark position, therefore, is that the Government needs to cut up to £20 billion from its public spending plans, as well as raising taxes by a further £10 billion.

The Treasury has, of course, embarked on a 'fundamental' review of public spending, with Portillo in charge of it. And the headlines have been full of squeals of outrage as this or that benefit appears to be headed for a squeeze, or the Government aims to claw back spending by widespread charging for public services. My reading of the review, however, is that it is not quite as fundamental as the Treasury would have us believe. Most of the decisions that it will throw up will produce cuts at the margin but the end result will be the achievement of slower growth in public spending, and not the deep reductions required to put the public finances back on an even keel.

The reason for this is plain. The Government has a small House of Commons majority. Even a small rebellion could result in its defeat.

Denis Healey, who was chancellor in the mid-'70s, later made it clear that, while he was glad to get the IMF off his hands, its presence was useful in allowing him to force through unpopular tax and spending decisions. It may be that, in the current situation, the only way that appropriately tough action can be taken is if there is an outside agency insisting on it. Nearly 20 years on, it may be time to call in the IMF.

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