Sunday, October 05, 2014
Don't forget the budget deficit's ugly sister
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.

We have had the two main party conferences and the big revisions to Britain’s economic numbers. We now know the economy’s pre-crisis peak was exceeded in the third quarter of last year rather than in the second quarter of this one. This is not, of course, the end of the story.

I want to try to draw these political and economic themes together. At the party conferences the biggest announcement, of course, was David Cameron's pledge to raise the personal tax allowance to £12,500 and the higher rate threshold to £50,000 by 2020. The cost of doing so, over and above the normal indexation of allowances, will be some £7bn.

This policy, as I wrote last week, does not in combination with weak wages growth make deficit reduction easy. In fact it seriously hampers it.

But some of the reaction to this pledge from economists and commentators is overdone. The prime minister clearly did not want to do a Roy Jenkins: emulate the 1967-70 Labour chancellor whose hairshirt stewardship of the public finances probably helped Labour lose the 1970 election.

And, if a £7bn tax cut, just over half the £12-13bn the coalition has spent raising the personal allowance during this parliament, is the worse that we will get between now and May - it may not be - we should relax.

As it is, the Tories are calculating that because Labour is perceived to have very little fiscal credibility, fairly or not, they can afford to lose some, and still remain well ahead in the credibility stakes. In fact, we can put a number on that. Labour's plans imply about £28bn less fiscal tightening than the Tories - becaused it has a less demanding deficit goal - and £7bn is a quarter of that. Despite the Cameron pledge, the Tories will continue to be seen by the markets and the public as more credible on deficit reduction.

Not that the rest of what we have seen during the party conference season was very encouraging on that score.

Ed Balls, for Labour, announced that he would limit the rise in child benefit to 1% a year until 2017, to demonstrate he means business about cutting the deficit.

George Osborne went much further. While the Balls plan would save a small amount – he estimates £400m, others less – the chancellor’s proposed two-year freeze on most working age benefits would save £3bn, part of £25bn of proposed spending additional spending cuts in the next parliament.

I have to say I was not very impressed with all this. Protecting the NHS, and in the case of the Tories anything involving pensioners, is seriously distorting the balance of public spending. Labour’s mansion tax will be a nightmare to introduce, and is a clumsy attempt to pull off the old political trick of offering the majority more while getting somebody else to pay for it.

Osborne, meanwhile, is determined to demonstrate only he can be trusted on the deficit, and that the best way to do this is to clamp down further on benefits, however harsh this sounds, not least because polling and focus groups show this to be popular. Those who would never vote Tory anyway will hate it but those who have been flirting with Ukip may be encouraged.

There has to be a better way. It is good that deficit reduction will be a theme of next year’s election – even if Ed Miliband forgot to mention it – but on the evidence of the last two weeks we may get more heat than light.

On benefits, for example, the chancellor has allowed himself to get way behind the curve. In the coalition’s first 2-3 years, welfare recipients, including many working people, benefited from the high inflation that squeezed wages hard. To make freezing them a pledge for the next parliament merely confirms how much work on the deficit Osborne has left himself to do.

There is still no sense that either party is thinking sensibly or strategically about the size of public sector the economy can afford. Before the 2010 election, the Tories looked and apparently learned from Canada’s experience in the 1990s, when a 20% reduction in the size of the state was achieved, affecting the majority of government functions. But in government the coalition’s approach has been piecemeal.

Labour promises a zero-based spending review, in which every item of spending will be up for grabs. I am not holding my breath, and this has already been partly over-ridden by the party’s commitment to put more into the NHS.

On budget deficit reduction, the parties will fight it out in the coming months over relatively small amounts of territory. We should take both parties’ plans – the Tories’ to achieve an overall budget surplus and Labour’s a so-called current surplus (excluding public sector capital spending) – with a pinch of salt until we get more detail. Osborne will probably win the credibility battle, though may lose some floating voters who find his approach too harsh.

I said I would bring this back to the new economic numbers. They were generally good news, particularly on investment, which is now seen to have been much stronger than previously thought. This stronger trend is continuing, with business investment up by 11% in the year to the second quarter.

Overall investment, up 9.1%, has made a much bigger contribution to growth over the past year, twice as much in fact, as consumer spending. This is encouraging, even if the continued disappointing performance of productivity – 0.3% lower in the second quarter than a year earlier – was not.

But there was another aspect of the latest slew of numbers that was also worrying; the balance of payments. Britain has its own extreme version of the “twin deficits” made famous by Ronald Reagan’s America in the 1980s.

Alongside a big budget deficit, we have a very large current account deficit. In the second quarter that widened to £23.1bn, from £20.5bn in the first quarter. It increased from 4.7% to 5.2% of gross domestic product. In fact it has averaged 5.2% of GDP over the latest 12 months, which is more red ink than we have ever had before, in records that go back to the mid-1950s.

Why is it so bad? Britain’s stronger growing economy attracts imports and export performance has been weak, but for once the trade deficit is not the explanation. It has been improving and was only 1.4% of GDP in the second quarter.

No, the reason was what is starting to become a familiar one. Britain used to have a surplus on investment income – we earned more from overseas investments than foreigners earned in Britain – but now it is the other way around.

Whether this is now the permanent state of things can be debated, though the current account deficit may turn out to be harder to eliminate than the budget deficit.

Whether we should be worried about it can be questioned. Ben Broadbent, the new deputy governor of the Bank of England, suggested in the recent speech that we should not worry overmuch. As long as Britain has what he described as hard-won credibility, the current account should not “pose some independent, existential threat to UK growth”. As long as capital can be attracted to Britain to offset the current account deficit things will be OK.

Let us hope so. But the twin deficits mean that the economy is reliant on investors to fund the budget deficit and capital inflows from abroad. Hard-won credibility can easily be lost. In a time of political uncertainty that threat is a real one.