Spending is the key to avoiding Ireland’s plight

Brian Lenihan and Sir Geoffrey Howe make unlikely bedfellows. Last week, however, Ireland’s finance minister produced a powerful echo of what Margaret Thatcher’s first chancellor, now ennobled Howe, did nearly three decades ago — raising taxes in the depths of recession.

There are differences. Ireland’s situation is incomparably worse than Britain’s even at its low point in the early 1980s, with the economy officially predicted to plunge by 8% this year and further in 2010.

The Howe tax rises were to make room for interest-rate cuts, then in the gift of the UK chancellor, whereas nothing Ireland does will have much influence on the European Central Bank, though the austerity budget might in time bring down Irish government bond yields.

Ireland took action after a downgrading in sovereign-debt status and was under pressure from Europe to cut a budget deficit heading for 13% of gross domestic product. Howe’s austerity budget in 1981 came when Britain was on the point of emerging from recession — not even an optimist would say that about Ireland today.

But the Irish example, which included a range of deficit-reducing measures, is one of which we should take heed. Lenihan succinctly summed up the situation: “The problem is our expenditure base is too high and our revenue base is too low.” That applies to Britain too. Prominent among Lenihan’s measures were tax hikes from 2% of income for those on the minimum wage, to 9% for those on 300,000 euros (£270,000). What price a similar budget in Britain, not on April 22, but as the first post-election act of a new government?

As I write, the budget is being worked and re-worked in the Treasury and I shall have more to say next week. As it stands, based on the interview I and a colleague did with Alistair Darling after the G20 summit, it does not seem he is planning a big new round of medium-term fiscal-consolidation measures — tax hikes and public-spending reductions — in the budget.

The Treasury view is that there is a lot in the pipeline, including higher taxes on the better-off from 2010 and a new 45% tax band on incomes above £150,000 in 2011; a 0.5% increase in employer and employee National Insurance contributions; and slower growth in government spending.

The thinking is that there are two opportunities a year for the chancellor to have a bite at the cherry, in the spring and autumn, and nobody is talking about the need for immediate tax rises. To announce further tax-raising measures now, even for the medium term, could be a sure-fire way to snuff out any green shoots of recovery.

Postponing the evil day makes economic sense, as long as the gilt market does not react badly to big budget deficits stretching as far as the eye can see. It makes political sense, as long as that day can be postponed until after the next election.

Last week the Institute for Fiscal Studies (IFS) set out in stark terms the challenge. The IFS is our most respected analyst of the public finances and its projections reveal how much, and how quickly, things have changed.

Each year the IFS produces a “green” budget ahead of the actual event. Its January 2008 report, six months into the crisis, was more pessimistic than the Treasury’s projections but not nearly gloomy enough.

Then it thought public-sector net borrowing, the budget deficit, would peak at £41.2 billion in the 2008-9 fiscal year and drop gradually to £32 billion, 1.8% of GDP, by 2012-13. Now its “baseline” for borrowing is £95 billion in 2008-9 (final figures will be published shortly), and annual deficits of about £150 billion for the next three years. In 2012-13 borrowing will be 8% of GDP.

That is a lot of red ink in a short time, reflecting the fact that the economy — and tax revenues — have deteriorated so much. In January last year the IFS thought government debt would reach 41.2% of GDP by 2012-13; now adding in the banking rescues it is looking for debt of 77.2% of GDP.

There is room for debate on some of these projections. Ben Broadbent of Goldman Sachs thinks the banking bailout’s cost will be less than the £130 billion the IFS is assuming. But the direction is clear.

If the downturn has been so devastating for the public finances, surely the upturn, when it comes, will be a great healer? Yes, but the problem is the permanent loss of output both the Treasury and the IFS think has happened, 4% of GDP. There is a hole that has to be filled, of about £40 billion, to get the public finances back into shape and debt under control by 2015-16.

That seems a lot, though the measures Darling announced in the pre-budget report will be worth £37 billion a year when fully implemented, mainly through tighter control of spending.

I have argued before that the burden of fixing the public finances should come on the spending side — we have to cut our coat according to our cloth — but the IFS points out how tough that will be and neither party is preparing the way for a radical paring-back of the state.

Indeed, you might get the impression that the debate over the public finances is between a prime minister determined to carry on spending and a Tory opposition prioritising cuts in inheritance tax.

Already public spending is targeted to slow to 1.1% a year in real terms from April 2011, compared with growth of 4% to 5% a year from 2000 to 2008. In future, moreover, spending will have to accommodate higher outlays on debt interest and unemployment and other benefits, implying a real freeze on departmental spending.

Freezing total public spending in real terms for five years would get you to the £40 billion of reductions the IFS says are needed, but only at the cost of real-terms cuts in departmental spending. It is achievable — government spending did not rise in real terms between 1984-5 and 1989-90, or between 1994-5 and 1999-2000, but the second of those freezes owed much to reductions in infrastructure spending and both occurred when the economy was enjoying a fair wind.

What about tax? Thanks to an inadvertent leak last November, we know the Treasury was thinking about putting Vat up to 20% as part of a medium-term plan to control debt. Raising it to 25%, the maximum allowed by the European Union, would bring in an extra £37.5 billion a year. I am not advocating this, by the way.

Raising Vat was the first thing Howe did on entering the Treasury in 1979. Do you ever feel history might be repeating itself?

PS: Perhaps it was Gordon Brown’s fault for unrealistically cranking up expectations of a co-ordinated fiscal stimulus. Maybe too many people look at everything through blue-tinted glasses and cannot bear to see the government do anything well. But one of the daftest criticisms of the G20 summit is that it came up with no new money for anything.

The latest to blunder into this debate is the Adam Smith Institute with an analysis by a “City financial analyst”, concluding that of the $1.1 trillion (£750 billion) programme of support agreed by the G20, only $25 billion was hard cash.

Anybody who has followed the long debate over International Monetary Fund (IMF) funding should know that the decision to treble its resources from $250 billion to $750 billion was a big deal, as was the $250 billion of additional special drawing rights. It is in the nature of these commitments that they are only drawn on when required, but the agreement to do so — to be rubber-stamped at the IMF’s spring meeting — was real.

If the G20 was all smoke and mirrors, the head of the IMF would be the first to complain. Instead Dominique Strauss-Kahn, its managing director, cannot take the smile off his face as a result of what he describes as the “huge increase” in IMF resources.

Originally published at About David Smith’s EconomicsUK.com and reproduced here with the author’s permission.