Sunday, August 14, 2011
Labour's VAT plan would threaten Britain's AAA rating
Posted by David Smith at 09:00 AM
Category: David Smith's other articles


My regular column is available to subscribers on This is an excerpt.

Though they recovered some ground towards the end of the week, share prices have been reflecting huge uncertainty about America, Europe and the global economy.

Some of that uncertainty was already there but it was ratcheted up hugely by S & P’s downgrade of America's AAA sovereign rating to AA+. Few would quarrel with the decision itself, which reflected America’s lack of credible action on the deficit.

But with the eurozone in crisis and markets already falling sharply, the timing of S & P's decision - shouting fire in a crowded theatre - was hugely irresponsible. It may be shooting the messenger but in this case the messenger deserves to be shot.

Like the other ratings agencies it should be trying to repair its reputation because of its culpability in the crisis, giving AAA ratings to what turned out to be junk securities. Instead, it appears to be doing its best to create another crisis.

At the very least, the timing of these ratings announcements must be clearly signalled in advance, as with official data releases. The US downgrade, before the ink was dry on Washington’s debt ceiling agreement, was an unnecessary man-made shock to the financial system.

But the deed was done, with immediate knock-on effects on the ratings of Fannie Mae, Freddie Mac and Israel and concerns over France.

America, of course, has its Tea party, memorably described by Vince Cable as “a few right-wing nutters in the American Congress”. They have been blamed for making a crisis out of the raising of the debt ceiling and thus the downgrade.

Britain does not have a Tea party. It does, however, have the Labour party. You might have thought after the US downgrade Labour would have rethought. Instead, it gave us some political knockabout on George Osborne’s complacency, before resuming its call for a temporary cut in Vat and attacking the government for spending cuts that go “too far, too fast”.

I do not blame Labour’s junior Treasury spokespeople for this. They are new to it. I do blame Ed Balls, the shadow chancellor. He understands this stuff, or should. He must know the best way to ensure Britain would lose her AAA rating would be to follow Labour’s advice. For the Tea party in America, read the Labour party in Britain.

I write this as one with no axe to grind on behalf of the chancellor, who I criticised a lot for his tactics in opposition. I supported Alistair Darling’s temporary Vat cut from 17.5% to 15%, announced in November 2008, as a necessary measure to stabilise an economy that was falling off a cliff.

I argued, against widespread scepticism, such a measure would help. What mattered was not the 2.1% cut in the price of a flat-screen TV (when people bought rather than stole them), but the cumulative effect of lower Vat across a range of household purchases, boosting disposable incomes.

This is not November 2008. The economy is growing slowly, not collapsing. Consumers have been squeezed by many factors, of which January’s Vat rise was a minor part. They have lost their appetite for taking on debt, many would argue not before time. A temporary Vat cut, if it resulted in more spending, would be marginal at best, too marginal to risk the loss of fiscal reputation and the AAA rating.

The plain fact is that Britain does not have room for a fiscal giveaway, temporary or otherwise. The timing of S & P’s US downgrade was, as I say, appalling. The underlying weakness of America’s fiscal position is unquestionable, highlighted by Stephen King, chief economist at HSBC, using data from the Organisation of Economic Co-operation and Development (OECD).

America’s budget deficit peaked at 11.3% of gross domestic product in 2009 and will still be 9.1% of GDP next year, according to the OECD. Its primary deficit - adjusted for the cycle and excluding debt interest - will still be 5.8% of GDP next year.

If the eurozone was a single economy, its public finances would be quite healthy, a peak deficit of 6.3% of GDP in 2009, falling to 3% next year. The eurozone, according to the OECD, is on course for a primary budget surplus of 0.9% of GDP next year.

Britain is a lot closer, fiscally, to America than Europe, with the red ink peaking at 10.8% of GDP in 2009 and still high at 7.1% next year. Adjusted, Britain’s 3% of GDP primary deficit next year is projected by the OECD to be higher than Ireland (0.4%) and Spain (a 0.5% surplus), and close to Portugal (3.5%), Italy (3.3%) and even Greece (3.5%).

I do not blame Labour for all Britain’s deficit. But it was on its watch that it happened and many will regard it as a bit rich for Labour to now be nagging away at the coalition’s deficit-reduction programme. Labour should be trying to rebuild its economic credibility, which will take time, not indulging in this kind of opportunism.

There is no mileage at all, by the way, in the argument that growth would have been substantially higher and deficit reduction as fast under Labour’s plans. Growth has been hit by a variety of factors, most notably the unintended squeeze on real incomes from high inflation and fears of what Sir Mervyn King, the Bank of England governor, described last week as the “unimaginable”, “unmentionable” fears of a disorderly euro break-up. All that, presumably, would have happened anyway, as well as the downgrade the agencies were warning of at the time of the election.

You might argue a downgrade for Britain would not matter, and that growth and employment are more important than bowing to the whims of the markets and ratings agencies. American Treasury yields have stayed low despite the downgrade.

But it would matter. A loss of the AAA rating would not only be a blow to Osborne’s pride, it would have an immediate and damaging impact on those parts of the banking system that are owned or propped up by the government.

The danger to the AAA rating has not passed. The government has yet to deliver on what Osborne, in his emergency statement to the Commons last week, described as “a new model of growth”, not based on “more debt and government spending”.

Restricted credit availability, as the Bank pointed out in it s inflation report, is constraining the recovery. There is much to be done. Futile and risky gestures like a temporary Vat cut is not one of them.