Thursday, March 25, 2010

Politics and Economics of the Budget

The Pre Election budget is as much about political posturing as economic decisions. In that regard, the beleaguered chancellor, Alistair Darling came out fighting and offered a few crumbs for Labour's election chances. He offered the annual tax increases on the usual suspects - petrol, alcohol, cigarettes e.t.c.. There was the usual vague talk of cutting spending on red tape, efficiency savings e.t.c. There were a couple of minor tax cuts (e.g. stamp duty threshold) to give him some pre-election sweeteners. In fact it came across as a typical budget. But, the odd platitude can't hide the fact we find ourselves in an extraordinary economic situation.

Firstly, the admission output fell 6% last year is dramatic by any standards. It is an indicator of the level of spare capacity within the UK economy (the only surprise is that unemployment is not higher). It is interesting that many commentaries have placed so less emphasis on this record breaking recession - and more on levels of borrowing. There has been an assumption that the recession is done and dusted - but, the weakness of the recovery unfortunately, means this is not necessarily the case.

The large fall in GDP explains, at least in part, the other major problem facing the economy - the level of government borrowing - which has reached nearly 12% of GDP.

The Treasury often makes over optimistic forecasts - but, even with their optimistic outlook for a bounce in growth during 2011. It is going to take many years to bring borrowing back under 'reasonable levels'.

Some commentators waste no time in pointing out the parallels between the situation of Greek debt and UK debt. This is not entirely fair. There are differences (lower debt to GDP ratio, high debt maturity e.t.c) which mean markets worry about UK debt. But, it is hardly much comfort to be saying - well we aren't quite as bad as the Greeks / Iceland.

Yet, if we take this twin problem - Recession / feeble recover and Government Borrowing - which is the biggest problem? Stripping away the political posturing what is the most important issue facing the economy - reduce borrowing at any cost? or make sure the recovery is as robust as possible by maintaining fiscal slack?

There is no perfect answer. The amount of debt markets accept is always unknown territory - see: National debt ceiling. Though it is worth bearing in mind debt to GDP ratios have been higher; this is not an unprecedented calamity as some of the greatest fearmongers would have us believe.

The other juggling act is that the fate of government finances is strongly linked with economic recovery. The government admit that 50% of the planned deficit reduction is forecast to come from their (optimistic) growth forecasts. If sharp tax rises and spending cuts did plunge the economy back into recession, the deficit could actually increase. - It is one of the ironies of economics that policies to cut deficits can actually increase them (under certain circumstances)

The government will be taking heart from the news that tax on bank bonuses gained an extra £2billion than expected. This not only pleases the popular sentiment to tax the people who caused the crisis (a bit of a simplification - but not without some justification). But, it also shows how a profitable bank sector is actually quite important to the nation's finances.

But, before the government congratulate themselves too much on taxing the bad bankers, they have to be careful of being too greedy. There are tax rates, where banks / financiers may start to pack their bags and move to more tax friendly environments.

The chancellor was right to push for international co-operation on taxes. Though, don't expect much quick progress...

Whoever wins the next election will face a difficult balancing act. If growth remains sluggish it will be really very difficult. It will be difficult to reduce borrowing without further worsening the economy. To win the next election could even be a poisoned chalice. Never have we needed a strong rate of growth as now.

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