Monday, November 30, 2009

A Tight Budget

The chancellor, Alistair Darling, has little room for manoeuvre at the moment. On the one hand, the UK economy is enduring its longest recession since the 1930s. Unemployment is rising and GDP has fallen by approx 4.5% this year. On the other hand, he faces a record peace time budget deficit of £175bn.

Faced with this awkward situation, the forthcoming pre-budget report is likely to be fairly neutral. There will be no new tax cuts or spending increases (The VAT rate will return to 17.5% in Jan as promised). But, at the same time, he won't want to make any radical spending cuts to tackle the budget deficit. The budget deficit is a problem to deal with later.

There are some who argue that the budget deficit is so alarming we should tackle it straight away. The leader of the opposition, David Cameron, has recently suggested that the size of the budget deficit threatens the future of the recovery.

But, as I discuss here - What should government do about its debt? it would be a mistake to tackle the deficit with great vigour when a recovery is so fragile. Though the deficit is a serious long term concern, cutting spending now could risk a second downturn, and a second downturn would definitely worsen the government's fiscal position. I think ordinary voters are amazed at the size of the government's borrowing; but, although it is a real problem, it is not the biggest at the moment.

Fortunately, there are signs of a modest recovery around the corner. This is fortunate in the sense that fiscal policy couldn't afford to be any looser. VAT will have to go back up in January.

One area of concern for the UK economy is how feeble the recovery is predicted to be. Tentative growth forecasts for next year suggest growth of 1-1.5%. This would be very disappointing given how much GDP has fallen since its peak.

Also, with long term productivity increasing at a rate of about 2.5% a year, growth of 1% a year is likely to create even more spare capacity. There is little hope of reducing unemployment in 2010, if growth proves to be that feeble.

Also, with a growth rate so low, it will make it continually difficult to increase taxes and deal with the budget deficit, even after the general election. Perhaps the UK economy will get an unexpected boost from a delayed Monetary policy or weak pound. Perhaps recovery in the Eurozone and the rest of the world will pull the UK out of recession quicker. But, that is not certain

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