Economics: The deficit will allegedly be halved in four years. But how?

The balancing act required of Alistair Darling in his pre-Budget report last month was the most challenging since the process was introduced in 1997. Faced with record levels of public sector borrowing, he had to plot a credible debt-reducing path that won’t hamper recovery from recession, but that can also protect frontline services, while setting out what amounts to an agenda to appeal to the electorate for the next general election, due by this June at the latest.

And if that was not enough, he had to satisfy his own MPs, the baying press and the public at large that the banks would not be able to take advantage of the current situation by earning huge profits or paying themselves yet more big bonuses.

His challenge was made more daunting by his unpromising starting point. Not only was the recession deeper than he had expected at Budget time in April (GDP is now likely to have shrunk by 4.75% in 2009, longer and deeper than in most other countries) but his deficit – equivalent to 12.6% of GDP – is likely to be bigger, at £178bn. This is the largest deficit in the UK’s history and the largest among the countries of the G20.

National debt, now at 56% of GDP, will rise to 78% by 2014-15. This is higher than the bad old days of Callaghan, Healey and the International Monetary Fund in the 1970s.

Despite his weak hand, Darling, in his typically measured and straightforward manner, played his cards as best he could. His GDP forecasts for 2010 (1.0%-1.5%), 2011 (3.5%) and 2012 (3.5%) remain unchanged from the Budget and are broadly in line with the Bank of England’s view. Inflation, after a short spike in the early months of 2010, will edge down to 1.5% by Q4, he thinks, well within the target range, implying continuing low interest rates.

His defence of his current policy (everybody’s expenditure is somebody else’s income, and so if the private does not spend, the public sector has to) is a logical one, but he also used it to explain why any sudden cuts in government spending could be counterproductive. The fact he was so light on specifics about how the government intended to achieve its fiscal objective of halving the deficit in four years means he failed on one of the key objectives of the PBR.

Throughout his speech, the Chancellor emphasised that his key priority is the need to ensure that the economy returns to growth and that this growth is better balanced, with more exports and investment and less consumption, for example. Few economists would take issue with this and some of his (very modest) tax incentives should be viewed in this context. The unwillingness to take risks with growth was also the reason he gave for delaying making serious inroads into his huge deficit, which in tax year 2010-11 is only expected to fall to £176bn.

Or perhaps it had something to do with the imminence of a general election that poll after poll suggests will be taken by the opposition. There were no detailed spending plans outside of help for schools, hospitals and defense, though he said there would be a squeeze on the public sector. The only change to VAT was restoring it to 17.5% and while there was no increase in income tax announced, there was a increase in taxes on income (another tweak on the national insurance rate, but not until 2011). The bankers seem to be getting their comeuppance, but even here all might not be what it seems. All the real pain, which the Chancellor admitted has yet to come, was delayed and the big issues seem to have been ducked.

He did, however, meet some difficult issues head on and risked a battle with the trade unions. He argued, rightly, that public sector pensions had to be brought into line with those in the private sector, a long overdue move.

Public sector pay will also be more tightly controlled after several years in which increases have outpaced the private sector. And there were the usual promises of “efficiency gains”, which few people now take seriously. If all the previously promised gains had been achieved, the public sector would today be operating like a Rolls Royce engine.

Darling is one of the very few cabinet ministers whose credibility and reputation has actually been enhanced in the past year and a half. Faced with economic and financial difficulties on an unprecedented scale, he seems to have been open, transparent, fair-minded and acknowledged the problems. He has also been right on many of the big issues. With his PBR statement, he has probably got his growth and inflation forecasts right and he has ring-fenced key public sector services. But in minimising the electoral damage of a tough fiscal statement, he has delayed the inevitable. And he has still not explained the key question markets need answering right now: how will the deficit be halved in four years?

Dennis Turner is chief economist at HSBC