Sunday, May 09, 2010
Who can survive the deficit's poisoned chalice?
Posted by David Smith at 09:00 AM
Category: David Smith's other articles


So now attention turns to what happens next. Will we see decisive action or prolonged dithering? Having expected a hung parliament, the markets still reacted adversely to that outcome, perhaps because they did not expect something quite as well-hung as this.

That said, what is needed from the politicians is as clear now as before last Thursday a decisive plan to convince the markets, and voters, that Britain's 163 billion budget deficit will be on its way down. The danger, thrown up by the election result, is that nobody will have the guts to do it.

In 1974, even if the then Labour government had wanted to take tough action, it would not have done so for fear of jeopardising its chances in a second election. That was an object lesson in what not to do. Down that road lies fiscal disaster. What, assuming a Conservative-Liberal Democrat arrangement, will it be this time?

The first budget of any new parliament sets the tone. This is the moment when any administration can blame everything on what went before. I do not think the next few weeks will reveal Greek-style holes in official figures for the public finances; the existing ones are bad enough.

To judge from the campaign rhetoric, the fiscal action we will see over the coming weeks will be all about putting detail on the efficiency savings and cuts in public spending that have so far been only sketchily outlined.

In reality, however, the first budget has to include tax rises, both to show the new government means business and to buy time before the spending review that will detail the cuts. Put simply, tax hikes are straightforward and visible, while spending cuts become real only when delivered.

On this, all roads lead to Vat. An increase to 20%, introduced on January 1 next year (it could be phased, but retailers and businesses would probably prefer to get it out of the way) would press most of the right buttons. Those who fear it would derail recovery should remember the economy grew through the reimposition of Vat at 17.5% at the start of the year, a 2.5-point rise from its temporary level of 15%. Retail sales were hit in January, when snow also affected sales, but bounced back in February and March.

How damaging would a Vat rise be politically, when the Tories and Lib Dems spent most of the campaign talking about tax cuts? Voters are not as dumb as they sometimes look, and know something has to be done. A Vat hike at the time of a scrapped NI rise would at least fit in with the Tory philosophy of taxing spending not income.

Vat has had a pivotal role in post-election budgets. The hung parliament in February 1974 was followed by what became known as "the short parliament", until a second election in October. The most notable policy in the short parliament was a July 1974 cut in Vat from 10% to 8%, with the chancellor, Denis Healey, saying his priority was to attack inflation "at source".

In those faraway days, it was believed that if you cut Vat, you could prevent inflation by stopping a wage-price spiral (Healey said he had cut inflation at a stroke). I hope we have learnt a lot since then.

The most famous Vat hike was in 1979, when in the first Thatcher budget, delivered by Sir Geoffrey Howe, it was raised to 15% (from a standard rate of 8% and a "luxury" rate of 12.5%. He described it as one of the "difficult choices" the new government had to make, though it was almost exactly offset by a cut in income tax from 33% to 30%, and in the top rate from 83% to 60%.

In 1992 the Tories ripped apart Labour's "shadow" budget and warned of Labour's tax bombshell, said they had no plans to raise taxes but then gave us not one but two tax-raising budgets in 1993, including extending Vat to domestic fuel bills.

Would an early Vat hike, along with the spending cuts that will emerge in the coming months, add up to the biggest poisoned chalice in history? Are Bank of England governor Mervyn King's reported comments correct, that the parties which put in place the necessary measures to rescue Britain's public finances will be out of power for a generation?

He will have a chance to put the record straight when he presents the Bank's inflation report this week. On the face of it, he had a point. Labour was out of power for nearly a generation after the IMF-ordered spending cuts of the late 1970s. The Tories lost in 1997 for many reasons but one was the tax rises and spending squeeze that followed the party's unexpected 1992 victory.

There are two things voters do not easily forgive: dishonesty and incompetence. All three main parties were less than honest in what they told voters about the fiscal challenges, so there is nothing to choose there. As for incompetence, time will tell. But there is a good chance that, when it comes to management of the public finances and the economy, the new government will find it fairly easy to appear competent. It will gain from appearing to have cleaned up the mess it inherited.

This is because the economy is recovering, which is far better than the alternative. It is also the case, notwithstanding a bizarre forecast from the European Commission that Britain will have the biggest budget deficit in the EU this year perhaps Brussels' last act of revenge against Gordon Brown that the public finances were showing signs of improvement even before most of the already-announced deficit reduction measures have kicked in.

As David Owen (no relation to the founder of the SDP), an economist at Jefferies, the investment bank, put it: "It is easier to undertake a multi-year tightening in fiscal policy when an economy is growing strongly and . . . when the rebalancing of the economy can be helped by a more competitive exchange rate. Looked at this way, the UK is far better positioned than countries in the eurozone."

There will be pain. Nobody likes tax rises or being on the receiving end of spending cuts. It need not, however, be either politically suicidal or economically disastrous. It does not have to be a poisoned chalice.

PS: What do the euro and dodgy financial derivatives that led us to the financial crisis have in common? Both were meant to offer protection against financial contagion but both spread it dangerously.

What would have been the effects of the Greek crisis if the country had not been a member of the eurozone? A true "what if?" assessment might show that Greece with the drachma could have devalued its way out of trouble. If not, a Greek debt crisis would have been like a European version of Argentina in 2001, or many other emerging-market debt crises. The IMF would have been called in, a recovery programme established, and over time Greece would come through it.

As it is, the Greek crisis has had nasty contagion effects on Portugal and Spain, spreading more effectively than swine flu. It has exposed the fundamental flaws of the eurozone. Without a fiscal policy counterpart to the monetary policy of the European Central Bank, the eurozone was lop-sided. It lacked the other essential components of a successful single currency: wage flexibility and geographical mobility of labour.

Greece would be better off outside the euro only join when you are sure you can keep up with Germany as would some other countries. One day, as I have long thought, some will leave it and re-establish their own currencies, as with previous monetary unions in Europe.

That cannot happen now, for it would deepen the eurozone crisis even more. European monetary union was supposed to bring stability. Instead it is proving to be a source of great instability.

From The Sunday Times, May 9 2010