Sunday, March 14, 2004
Chancellor prepares to face the terrible twins
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

I can't guarantee that the expression “the twin deficits” was never used before Ronald Reagan became American president, but that is certainly when it entered into popular usage.

The twin deficits — red ink on both the balance of payments and the federal budget — emerged during Reagan’s first term, 1981-84, and were a feature of the 1980s. They have come back with a vengeance under George W Bush.

They are also back in Britain. Last week brought bad news on trade. The Office for National Statistics, which released the figures, accompanied them with a grim list of records. January’s trade deficit in goods was a record 5.6 billion and the deficit in goods and services combined was a record 4.6 billion. And, if anybody thinks that exporters just had an off month, the goods deficit in the latest three months, 14 billion, was also a record, as was the deficit in goods and services, 11 billion.

When we say “record” in this context, this is not some Johnny-come-lately set of figures. The trade figures go all the way back to 1697, when William III, of William and Mary fame, was on the throne.

Many readers wonder why the trade gap, which used to lead the television news and pose all sorts of problems for governments, now no longer seems important.

This is because in an era of fixed exchange rates and capital controls, such as the 1950s and 1960s, a big trade deficit would put downward pressure on a currency and require a response in the form of higher interest rates. Now capital flows dominate and countries can let currencies float lower without necessarily responding. The game has changed.

That said, the record trade deficit still means that sterling is probably too high, particularly against the dollar, and that the economy is too reliant on consumers and government spending, and not enough on exports and investment. The markets have also taken notice of the figures for once, causing a mini-slide for sterling, particularly against the dollar. There may be more of that to come.

Britain’s other deficit problem, the budget deficit, gets its fair share of attention and has no trouble being the lead item on the news. This is because high levels of government borrowing do have a direct consequence in tax increases or public- spending cuts. Gordon Brown may not have committed himself to keeping the trade deficit under control, but he did set strict limits for the budget deficit. In the case of one of those limits, the “golden rule”, the risk of a breach is significant and growing. (The golden rule is to keep the budget deficit at least in balance over the cycle, in other words, borrow only to fund capital spending.)

That is not, of course, how the Treasury sees it. Brown will insist this week that the so-called black hole in government finances is a figment of independent forecasters’ imaginations, and that there is no question of putting up taxes, now or later.

Is he right? Amid the avalanche of figures to come out on Wednesday, when the budget is unveiled, two will determine the answers to that.

The first, which sounds more complicated than it is, is the ratio of taxes to gross domestic product. The chancellor can look back on 2003 with satisfaction because growth, at 2.3%, met his forecast. Despite this, tax revenues were much weaker than he expected. Geoffrey Dicks of Royal Bank of Scotland said the Treasury is left to argue that it was the “wrong kind of growth”, just as British Rail used to complain about the wrong kind of snow.

The Treasury expects a sharp bounceback in the tax-GDP ratio, from 38.1% in 2003-4 to 38.9% in 2004-5, 39.5% in 2005-6 and 40.4% in 2008-9. These may not sound like huge numbers, but every 1% of GDP is equivalent to 12 billion in today’s prices. If the revenue bounceback does not occur to the extent the Treasury expects, the black hole will be real.

This is where the big difference lies between Brown and independent analysts. He believes this year’s borrowing of about 37 billion will be as bad as it gets, and that the deficit will trundle down to below 30 billion in the coming years, comfortably meeting the golden rule.

Other forecasters think this will not happen, and that the rise in taxes relative to GDP will be much more muted. Borrowing will stay above 40 billion and the golden rule will be broken.

The second key number will be on public spending. Politicians normally steer clear of brown envelopes. But this particular Brown envelope is the jargon for the amount the Treasury intends to let spending rise in the coming years.

The clear message this week will be that shadow chancellor Oliver Letwin’s plan to cut the public-spending share of GDP from a projected 42% to 40% has not impressed the chancellor. Labour intends to fight the election on the argument that these are reckless spending cuts from the same men who gave you boom to bust, Black Wednesday and other disasters.

Even Brown’s numbers, however, will look tougher than of late. He is committed to 7.4% real growth in health spending until 2007-8. Education will also continue to do pretty well, perhaps 3% annual real growth in spending after 2005. But that will leave only 1.5% spending growth for other departments — below the economy’s growth rate, according to Price Waterhouse Coopers.

Geoff Hoon, the defence secretary, did not expect to be still in his job by now. While he is, he is kicking up at what the Treasury’s numbers could mean in terms of military cuts. Expect to hear squeals from other departments.

The Treasury’s record on controlling public spending has been rather better than it has done on predicting tax revenues. Even so, these numbers might be hard to achieve, particularly with health proving to be such a large, and untouchable, cuckoo’s egg in the spending nest.

Brown will confront his twin deficits this week and insist that everything in the garden is rosy. But like his Downing Street neighbour, the shortfalls are likely to hang around for longer than he would like.

PS: Alongside the budget we will get Kate Barker’s final report on housing supply. According to evidence submitted to her review, Britain needs 39,000 more houses to be built each year to meet population growth, and 240,000 extra to bring house-price inflation, now as high as 18%, in line with general inflation.

The report will direct some criticism at the housebuilders for being too slow to respond to demand. Mostly, though, it will recommend ways of securing more land for housebuilding. That does not just mean hitting local-authority planners and Nimby (not in my back yard) homeowners over the head.

The problem is that the incentives are all wrong. Landowners stand to make huge gains when, say, farming land is approved for housebuilding and increases its value 300-fold. A building boom around Ashford, Kent, is said to have turned many farmers into millionaires dozens of times over. But existing homeowners in these areas don’t see any such gains, and neither does the council.

Two types of tax thus suggest themselves. One, used in Denmark, taxes landowners on land approved for building, to discourage them holding it for further gains. The other would tax some of the windfall gains, known to economists as economic rent, that landowners make when selling. Some of those gains could then be channelled into improving local amenities and cutting council tax. Nimby resistance would fade.

From The Sunday Times, March 14 2004