Sunday, May 02, 2010
Darling's error leaves us all fearing the hangover
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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During the last election, in 2005, I ran a series here under the headline "If things are so good, how come it doesn't feel like it?" This time, you could almost turn that round. Things are bad, but for most people it doesn't feel that way.

This has become the central issue. Deferred pain is still pain, and nobody can deny that the tax rises and spending cuts that will litter the post-election landscape will be anything other than painful.

The most recent winner in the election campaign was not the Liberal Democrats but the Institute for Fiscal Studies (IFS) and its director, Robert Chote. Chotemania has not yet replaced Cleggmania but, by upbraiding all three main parties for their dishonesty over the pain that lies ahead, the IFS has seized the moral high ground.

A lot will have changed by this time next week. We will be beyond the election and into one of three permutations: majority Conservative government, minority Conservative government or minority Labour government. A majority Labour administration or Lib Dem government are possible but, on the basis of the polls, currently unlikely the latter particularly so.

Under the Conservatives, Sir Alan Budd, former Treasury chief economic adviser and monetary policy committee (MPC) member, would immediately get to work as temporary head of the new Office of Budget Responsibility, setting out what needs to be done. Within 50 days there would be a budget. Whether there would be a Lib Dem input into that budget in a minority Tory government remains to be seen. Initially at least, I suspect David Cameron would try to go it alone.

If Labour is the largest party, Alistair Darling has said he does not need a second 2010 budget and that the focus will be on the comprehensive spending review, setting spending totals for three years from 2011.

I doubt, however, that the markets and ratings agencies will bide their time and wait until autumn for a spending review. Labour would need to offer some red meat within weeks of the election.

The government made a big strategic error in not holding a comprehensive spending review before the election. It is hard to tell whether this was Darling's decision or was forced on him by No*10.

The chancellor, however, has always defended it robustly, arguing that a review in the middle of deep recession would be like trying to put up a tent in a hurricane.

Why was it a mistake? Four reasons. A review would have removed a central charge against Labour, dishonesty. It would have helped persuade markets that the government, with plans in black and white, was serious about deficit reduction.

It would also have made it more difficult for the Tories to pull the National Insurance trick of cancelling most of Labour's planned rise, paid for by cutting waste, which was only possible in a spending vacuum created by the absence of a review.

Most of all, it would have demonstrated that the fiscal pain may not be quite as nasty as it looks. How is that possible, when the IFS says that under Labour or the Lib Dems we face the deepest spending cuts since the post-International Monetary Fund period of 1976-80, and under the Tories the deepest in the post-war period?

In comparing the parties' spending plans, even the saintly IFS has not been able to factor in a split between current spending on wages, salaries and day-to-day public services and capital spending: on new roads, schools, hospitals and so on. This is because while the government has said what it intends to do about overall capital spending, the other parties have not. The point is not whether cutting capital spending is good or bad. It is that once those cuts are factored in, government plans allow for an average annual cash rise of 3% in current spending from 2011.

That is not as comfortable as it sounds, given the figures include rising debt interest and public-sector inflation. But Maurice Fitzpatrick of Grant Thornton, the accountant, works out that it still means flat current spending on services in real terms over the the three years from 2011.

Labour would have benefited from this being in the open, as would Britain's fiscal reputation. Now the fear is that adjustment will be too painful to be achievable.

As the IFS noted, in the initial phases of the Norman Lamont*/*Kenneth Clarke deficit cuts in the 1990s, the split was 50-50 between higher taxes and lower spending. Today all three political parties want the lion's share from spending cuts.

That may mean a bigger initial downpayment in higher taxes than is desirable. All three parties have holes of varying sizes in their fiscal numbers, mainly on the spending side, ranging from 34.5 billion for the Lib Dems, through 44.1 billion for Labour and 52.4 billion for the Tories.

Vat is the obvious fiscal stopgap. When the parties say they have "no plans" to raise it, that is like the football chairman's vote of confidence in his manager a week before the sacking. A Vat rate of 20% would be exactly in line with the EU average and raise almost 12 billion annually.

It would not have to be introduced immediately, or in one go, and could be phased in over two or three years. If the public finances turned out better than feared, some of the increases could be cancelled. But the announcement effect would be important and show that the new government, of whatever complexion, meant business.

All this presupposes that the recovery that has begun will last. Some challenge that. Bill Martin, formerly of UBS, now with the Centre for Business Research at Cambridge University, has written a fascinating paper, Rebalancing the British economy: a strategic assessment. There is not space to do it justice this week, for it raises questions that will matter for the next few years, so I will return to it. One of Martin's big fears, which is relevant this week, is that the economy will struggle to grow its way out of trouble.

"After the worst contraction since the Great Depression . . . companies are unlikely to invest, making good the collapse in capital spending, if expectations of growth remain depressed. Small and medium-sized businesses afflicted by an enduring credit crunch may permanently cut mothballed capacity. Output could stay below a level consistent with full employment. This is the message from any number of historic studies of banking crises.

"Years of slow growth would put further pressure on the government's budget and weaken the economy's taxable capacity. Large and persistent budget deficits may be financed without difficulty, as in Japan, by tapping private-sector savings. But financial markets may prove less accommodating . . . in a market hiatus, the budget might not be financeable at any price."

Everybody knows we face a post-election hangover. The hope has to be that it is not as painful as that.

PS: Hard on the heels of the election will come the Bank of England. Its first decision on rates will be on Monday, May 10, followed a couple of days later by an inflation report that will almost certainly raise its projections for the future course of prices.

Three members of the "shadow" MPC, which meets under the auspices of the Institute of Economic Affairs, think the Bank should grasp the nettle and raise rates straight away. This used to be how things were in the days when politicians controlled the interest-rate lever.

Other shadow MPC members are much less hawkish, and some think the Bank should be ready to add to its 200 billion of quantitative easing. As for the actual decision, I would bet on no change. The Bank, like the rest of us, will be waiting to see what the new government does on fiscal policy.

From The Sunday Times, May 2 2010