Sunday, February 07, 2010
Sharpening knives to avoid a Greek tragedy
Posted by David Smith at 09:00 AM
Category: David Smith's other articles


Imagine. The budget goes down badly in the markets, producing a big bond market sell-off and the threat of a downgrade from rating agencies.

A sombre prime minister broadcasts to the nation, explaining the need for austerity. Public-sector workers and students take to the streets. It does not reassure investors or head off a downgrade. The country is gripped by a fiscal crisis.

That is the kind of thing that has been happening in Greece in recent weeks and spreading to Portugal and Spain. Is it in store for the next British government?

The Greek question is important in its own right but also for other countries that have large deficits. "Nobody is suggesting we are going to follow Greece," Philip Hammond, the shadow Treasury chief secretary, said last week, only to be contradicted by George Osborne, the shadow chancellor, who said Britain was "facing a Greek-style crisis if we do not deal with this problem".

The Tories are having a bit of a wobble. Last week the Institute for Fiscal Studies (IFS), in its annual green budget, advocated more ambitious plans to cut the deficit but said it would be risky to start squeezing too soon. The Tories may have got wind of that, and got wind of voter concerns about the party's austerity message, with a narrowing poll lead. What looked like a firm commitment to begin cutting as soon as David Cameron was in Downing Street appears to have been softened. There would be no "swingeing cuts" in the first year, he said.

It looked like a u-turn, and that is how it will probably be seen, but to be fair to the Tory leadership, deep cuts in the first year were always a bit of a red herring.

Their Treasury team knew the difficulty of "in-year" cuts reductions after the fiscal year has started. Assuming a May 6 election, and a Tory budget within 50 days (if the party wins) we would be three months into the fiscal year before anything was announced, let alone implemented. Cameron and Osborne, particularly Osborne, always sounded more gung-ho about early cuts than these constraints implied, however. It is a change of tone.

This was always a bit of a phoney war. As the IFS pointed out, Labour is planning a fiscal tightening in 2010-11, 1.6% of gross domestic product, by reversing some temporary measures such as lower Vat, tax increases such as the 50% income-tax rate and reductions in public capital spending.

It was politically convenient for Labour to present itself as the guardian of recovery and the Tories to strike a pose as custodian of the public finances, even if the actual differences between them were small. The Tories have, however, blinked first.

Does this make Britain more likely to be the next Greece? This is a jumpy time, with markets nervous about a hung parliament as polls have narrowed. But the lack of market reaction to the Tory change of tone shows it is the need for a clear deficit plan, which has to be set out in the first few weeks, that matters. When the deficit is clearly on the way down, pressure will ease.

The IFS and National Institute of Economic and Social Research think more will be needed to halve the deficit (which may undershoot the Treasury's 178 billion projection this year) than we yet know about.

The IFS reckons the Treasury has detailed 57 billion of the 70 billion of spending cuts and tax increases needed, leaving 13 billion to announce. That sounds fairly small beer, like the "black holes" we used to worry about in pre-crisis days. Don't forget, however, that the 13 billion is on top of a yet-to-be-implemented 57 billion of spending cuts and tax hikes.

Though it would be desirable to achieve this 13 billion on spending, that may be hard even for a determined government. Treasury figures imply real cuts in spending on services of 2.9% a year from 2011 to 2015. Protect areas like schools, and real cuts elsewhere rise to 6.7% for at least two years. Even the Treasury's biggest squeeze for decades will be hard to achieve.

So there will have to be some tax increases and the IFS has performed a service by coming up with a menu. Instead of merely raising Vat, it suggests widening the Vat base bringing in zero-rated items such a food, children's clothing and books would be more effective. Accompanied by extra help for the lower paid, this would raise a decent 15 billion a year and be a tax on spending rather than income. Vat could be imposed on financial services.

A comprehensive carbon tax would appeal to an incoming government and could bring in 13 billion, though it would hit large energy users. The IFS thinks there is scope for significant savings 10 billion a year or more from means-testing or taxing "middle class" welfare benefits.

Though imaginative, it sounds a bit grim. If you wanted to find optimism last week, look at the National Institute's new medium-term projections. Partly because of Britain's slower start but also demographic factors, our growth rate between 2012 and 2016 is put at 2.7%, above America (2.6%), the eurozone (2.2%) and Japan (1.2%).

One of the big debates is about how much the crisis has subtracted from the ability of economies like Britain's to grow over the medium term. Clearly there is scope for disagreement on this.

Michael Dicks of Barclays Wealth, in his chapter in the IFS green budget (which Barclays now sponsors), concludes that Britain's "trend" growth rate has been knocked down to 1.75% by the crisis. The Treasury still thinks Britain can grow at a 2.75% rate.

The National Institute is somewhere between the two on trend growth but thinks the process of catch-up after the recession will allow 2.7% growth (as in the first half of the 2000s) for some years.

If it is right, tackling the deficit will be easier. Barclays' projections, on the other hand, point to two austerity parliaments, with 50 billion of additional cuts or tax increases on top of the IFS's 13 billion.

Slow growth looks plausible seen from the perspective of an economy emerging slowly from recession, though these things can change. Tackling the deficit is one political priority. Getting growth going is another. Balancing the two will be tricky.

PS: The markets were right to expect a pause in the Bank of England's quantitative easing programme at 200 billion, though the monetary policy committee (MPC) was careful to retain the option of doing more if conditions warrant it. But I think this is the beginning of a process in which, very slowly, monetary policy is "normalised" in the UK.

That will begin with the Bank rate going up from its current 0.5%, though not for many months. Eventually, and slowly, the Bank will sell back the assets, mainly gilts, it has purchased.

Did quantitative easing work? It contributed to an improvement in financial-market conditions, though we cannot know whether that would have occurred anyway as fears of a collapse in the banking system subsided. Its effect on the money supply was less obvious, though perhaps the effect here too was to prevent a collapse. Some worry that creating money would be inflationary. My concern was always whether it would work. We still cannot be sure about that.

Meanwhile, the Bank can look for new influence in George Osborne's Eight Benchmarks for Britain, published last week. The benchmarks are about as uncontroversial as the Antiques Roadshow but they confirm the Tories would retain the Bank's oft-criticised 2% target for consumer price inflation, alongside its new prudential supervision role.

The Bank, indeed, would have power coming out of its ears. The pace of spending cuts and tax rises would be set by the Tories in co-ordination with the Bank.

From The Sunday Times, February 7 2010