Wednesday, November 05, 2003
Whatever happened to fiscal prudence?
Posted by David Smith at 09:40 PM
Category: David Smith' s magazine articles

In Britain Gordon Brown is preparing to deliver his pre-budget report, in which he will acknowledge that government borrowing is coming in significantly higher than he predicted. In America, George Bush is heading for a $500 billion budget deficit – nearly 5% of gross domestic product – and has asked Congress for another $87 billion to fight terrorism and make Iraq safe. He may need more for both purposes.

Europe may have had its differences with America on Iraq but it is at one when it comes to government borrowing. Both France and Germany have signalled that they will break the 3% limit for government borrowing in 2004, thus cocking a snook at the euro stability and growth pact. The only difference between the two countries is that German is breaking the borrowing limit with regret, while France appears almost gleeful about doing so.

Across the world in Japan, the government has been borrowing heavily for years, to finance a series of fiscal packages aimed – without much success – at boosting the economy. The result has been rising government debt and a big budget deficit.

Big borrowing by governments, it seems, is back in fashion. Not so long ago politicians stressed the importance of fiscal prudence. Now they are wallowing in ever-increasing amounts of borrowing. No wonder bond markets have been displaying nerves.

To be fair, the decision to borrow more was not a collective decision by G7 (Group of Seven) finance ministers. In the case of Japan it goes back years. Once the bubble economy had burst in the early 1990s, the classic Keynesian solution of introducing public works programmes to generate jobs and growth seemed the obvious one.

What the Japanese authorities had not reckoned on was the response of their own consumers. Japanese households, rather than warming to their government’s fiscal boosts, instead were alarmed by what it might mean for their future tax bills and so saved rather than spent, nullifying the effect.

Economists call this effect Ricardian equivalence, after the great English economist David Ricardo. It took successive Japanese finance ministers several years to work this out, by which time deficits and debt were sky-high.

For France and Germany, borrowing is more recent. Both countries entered the euro with their public finances in good shape. The Maastricht treaty required budget deficits to be below 3% of gross domestic product to qualify for euro membership and most European economies over-achieved on that. Their expectation, however, was that once the euro was up and running they could relax a bit. The single currency would generate economic growth, and this would help the public finances.

Instead “euroland” has found itself stuck in slow growth and high unemployment, and we know from past British experience that government borrowing soars in such circumstances. Even such a determined deficit-cutter as Margaret Thatcher found herself borrowing huge amounts when the UK economy was so affected.

When it comes to George Bush and America, he took the decision early on that budget surpluses were for wimps. Having inherited a situation from Bill Clinton in which surpluses were stretching out into the indefinite future, the president immediately embarked on a programme of aggressive tax cuts. America’s 2001 recession came when the stock market bubble burst, with predictable consequences for the public finances.

The unpredictable event, of course, was September 11 2001. After that nobody questioned Bush’s strategy of spending public money to rebuild the damaged parts of New York and Washington and to beef up homeland security. Few questioned the war with Afghanistan, or for that matter Iraq (although many more do so now).

In the 1980s, under Ronald Reagan, America had the famous twin deficits – on the budget and current account of about $200 billion each – and under the second George Bush they are back with a vengeance. Except that, in both cases, the deficits are a lot bigger. With the budget deficit heading for $500 billion, the current account will be more than $600 billion in the red. Actually, America has a triple deficit problem. Household and corporate borrowing means America’s private sector, as well as its public sector, is in deficit. More than ever, it relies on the rest of the world as a source of funds.

There is no prospect of this changing, at least this side of next year’s presidential election. Indeed, if securing a Bush re-election means a government borrowing binge, the attitude seems to be that this will be a price worth paying. The mess can be cleaned up later.

Which brings us to Britain. Gordon Brown did not want to be a borrowing chancellor but he is. This year, according to independent forecasters, borrowing will be 31 billion, next year 34 billion - 4 billion and 10 billion above the Treasury’s forecasts. Over the next few years, forecasters say, the chancellor will have to face up to the fact that his fiscal rules are not going to be met. That will mean higher taxes or, as we are seeing from the noises coming from the Treasury, a determined effort to rein back public spending.

There was always something inevitable about the position Brown would find himself in. For his first two or three years at the Treasury he kept the tightest of grips on public spending – coming in even below the Conservative targets he inherited – and stealthily raised taxes.

Then, on the assumption that the public finances had been restored to health, he announced a big relaxation of spending, led by record increases for the National Health Service. Under Labour NHS spending was to double in real terms. Nor was the extra spending a flash in the pan. In the case of health, commitments were made to raise it by 7% annually right through to 2007-8. That was a huge pledge.

Once the taps were turned on, however, the revenues needed to pay for it started to fade. This was partly for cyclical reasons but also probably for structural reasons. The chancellor based his spending increases on a false promise as far as revenues were concerned.

And now he is left having to justify large budget deficits and promising that they will come down as the economy recovers. His reputation for fiscal prudence is tarnished. But at least he’s in good company.

From Professional Investor, November 2003