Entangled Alliances

photo credit: HM Treasury

Britain’s Chancellor of the Exchequer Alistair Darling will present the UK’s budget on Wednesday. I think it’s fair to say that in the current depression-era climate this will be a fairly difficult task for Darling, akin to playing Scrabble in Aramaic or amputating a leg with a pair of scissors. As if his problems weren’t bad enough, his challenge is compounded, as we shall see, by the fact that he’s well and truly stuck between a rock and a hard place.

On the one hand, the latest figures on growth make alarming reading.  Despite Darling’s predictions in last November’s pre-budget report of a contraction of Gross Domestic Product this year of 1%, the Bank of England now forecasts contraction of 3-4%. Given that private investment has all but seized up, this means that the case is extremely strong for a significantly large fiscal stimulus – a Keynesian style government spending spree aimed at creating thousands of new jobs and bringing the economy back to life. That’s the rock.

However, along with the latest figures on growth come equally depressing figures on government borrowing. Over the next two years the government is set to borrow around £170 billion, or around 12% of GDP.  The Institute of Fiscal Studies thinks that government debt could be a whopping 82% of GDP by 2015, or about the same amount of debt as your average teenager with a credit card. That’s the hard place. And it’s really, really hard.

So the Chancellor is caught between the need for a stimulus and the need to avoid adding to the current levels of government borrowing. Now, many economists would argue that the need for a significant stimulus is more important than the risk of growing government debt. After all, if you don’t get the economy growing again then public borrowing will increase anyway. This argument  is fairly sound, especially when you consider that when compared to other major countries Britain’s current debt level isn’t quite as scary as many like to claim (while ours is 48% of GDP, Germany’s is 65% and Japan’s is a stunning 170% of GDP, which is approaching two teenagers with a credit card).  In fairness, however, it’s worth pointing out  that Britain can’t afford to do the massive, pile-on-the-deficits stimulus package of the United States, who are able to sell endless amounts of their debt to China.

Indeed, Britain’s problem is this:  in order to sustain its borrowing levels, it needs investors to keep buying government debt. If borrowing gets too high – or to be more accurate, if it appears to investors that it might get too high, then those same investors get scared and stop buying the government’s debt, which then has the knock on effect of raising the interest rate (or yield) which has to be paid on the debt it’s already sold. So the government ends up paying more for their debt they have and unable to sell any more. Bummer.

As far as I can see, this leaves the Chancellor with three options, none of them safe and none of them pleasant:

Option 1) Do as the Irish do

Ireland has just had an, uh, interesting budget. Two weeks ago the Irish Finance Minister presented a dramatic, sphincter-relaxing cocktail of tax hikes for everyone and massive public spending cuts. This was generally judged to be very odd behaviour in a recession, and made many people (i.e. me) suspect that it was a budget made after a massive Guinness-fuelled piss-up in Ireland’s Finance Department. In its defence, there is an argument that such strict measures will encourage investors to buy more of Ireland’s debt, thus reducing the interest rates the government has to pay on its current debt, saving them money and so creating a weird sort of stimulus effect. However, even if you believe this, there’s no reason for the UK to take such drastic measures. Borrowing wise we are in a much better position than Ireland, which isn’t difficult since investors believe the Emerald Isle to be even more likely to default on its debt than the likes of Spain and Italy. Oh, it would also be politically suicidal for Darling to present something like that. Then again, Labour have been in wrist-slashing mood of late… so who knows?

Option 2) Steady as she goes

A cautious approach would entail the Chancellor putting in place a small stimulus – a couple of billion, say, nothing to increase fears too much about public borrowing – while at the same time choosing to avoid any cuts in public spending or tax hikes, at least until after next year’s general election. This, in fact, looks like the route Darling might be taking – we’ve heard talk of £2 billion for job programs, but there’s no sign of any massive stimulus in the works and it doesn’t look like there’s going to any tax increases or spending slashes either. The problem, however, with this approach is that you get the worst of both worlds. A stimulus has to be of sufficient size to jump-start an economy into producing at the level it should be – you have to create a lot of jobs . By definition, the more cash you pump in the more  jobs you get. Meanwhile, an unwillingness to hike taxes means that the borrowing problem doesn’t go away, either. This option, then, is like standing completely still in quicksand: it’s not going to make you drown but it won’t get you out of danger…

Option 3) Wham, bam, I’ve paid for it, ma’am…

The Chancellor’s third option is to give Britain it’s much needed large stimulus effort… but then try to pay for it as much as possible without having to borrow further. One way of raising some money would be to rollback the ridiculously ineffective VAT cut that was put in place last November. That would save £8 billion. Next, the government already plans to raise the top tax rate to 45% for those earning over £150,000, which is projected to save around £1.6 billion. But why stop there? If you raised the top rate to 60% it would still be 30% lower than the top tax rate in the seventies. The merits of a tax hike for the wealthy (and they are wealthy; only 1% of the population earns over £150,000) are that it doesn’t impair the effectiveness of any fiscal stimulus, since it’s the poorest in the land that are normally the engine of growth a stimulus relies on; plus it would also show nervy investors in the UK’s debt that something is actually being done. Of course, despite these savings a large stimulus would probably still require some further borrowing, but hopefully not enough to put the scares into investors.

I think it’s fair to call these three options, in order: The Bad, the Bad and the (regrettably) ugly. Option 1 is self-evidently suicidal, while option 2 is a weak cocktail of too little stimulus laced with too little public savings. Compared to these two option 3 is pretty good, as it combines a sufficient stimulus with fair, sensible moves to pay for it. It’s still ugly though: the imposition of higher taxes while still having to borrow a little further  could leave Darling vulnerable on all sides. But I still think it’s his best move, albeit one he’s unlikely to take. Perhaps, in the end, only one thing is certain: given the choice between being the Chancellor right now or swimming in shark-infested waters with a gaping wound, I think we’d all agree that it’s time we went and put on our swimsuits…