This year’s pre-Budget report (PBR) was given closer scrutiny than usual, for reasons largely unconnected with the Chancellor’s statement. Some tried to see it as Brown’s personal manifesto – the chance to spell out his long-term vision for Britain as part of his own career aspirations. Others tried to interpret it in terms of the next election campaign, expected to be on 5 May 2005. But economists looked at the fine print of what Brown said to see if his views accorded with their own. In many areas, he created the impression he was taking a bigger gamble than usual.
Nobody can doubt that the Treasury has an excellent forecasting record. When he predicted GDP growth this year of 3.0-3.5% in his March Budget, most independent observers said the Chancellor was too optimistic. The actual figure, as he said in the PBR, will be about 3.25%. This will make it 50 quarters of sustained economic growth, the longest since records began in 1870. To have presided over this and the highest employment in British history, the lowest jobless total for 30 years, and the best combination of inflation and base rates since 1945, he has a lot of credibility in the forecasting stakes.
Yet for the past few months there has been a feeling that the pace of activity is easing. For several years, the economy has been overly dependent on the domestic consumer. The combination of employment and earnings growth, plus lower interest rates to stimulate borrowing, resulted in consumers contributing a disproportionately large share of the UK’s above-trend growth.
But now employment growth has peaked and the heavily indebted personal sector is trying to cope with a 36% increase in interest charges over the past 12 months (base rates up from 3.5% to 4.75%). Incomes have not been rising as fast, so a higher share is accounted for by debt servicing and less is available for the high street. Similarly, the Chancellor is taking a bigger slice of our incomes than he used to, again leaving us less to spend how we choose.
So we have to look elsewhere for growth next year. Exports have been disappointing for a long time and a reversal of this trend next year seems unlikely. The dollar will remain weak in 2005, which will push up the selling prices of British goods in the US. Second, a weaker dollar means a stronger euro, and since the eurozone economy relies heavily on exports to generate growth, it points to further weakness in Euroland. This is a part of the world that usually accounts for about 55% of the UK’s exports.
With investment spending still sluggish, there will again be a reliance on government consumption to achieve the growth figure. This is where Brown looks most vulnerable. To spend he needs money, but his tax receipts consistently come up short. He has plugged the gap by borrowing, but is now pressing up against his own self-imposed credit limit – the fiscal Golden Rule. This means government finances have to be in balance over the life of the cycle.
At the turn of the century, he had some substantial surpluses (not least the £23bn for 3G licenses), but since 2002-03 he has been running these down. He seems to have little left to play with, but he skated over this in the PBR. So far, in the first seven months of this fiscal year, he has a deficit of £17.2bn (bigger than the same period last year), but his PBR forecast for the year was a deficit of just £12.5bn. He therefore needs a surplus of £5bn in the next five months, which seems improbable.
This is why there was so much scepticism about his forecasts and talk of the emergence of a so-called black hole. If Brown fails to get his tax receipts and wants to keep the Golden Rule, he has to curb spending or increase his revenue; in other words, increase taxes.
What is particularly worrying is that government finances are in deficit, even when the economy has been doing well. What will happen to the deficit if growth slows to 2.0-2.5% next year? It certainly will not shrink.
Although the PBR was not about interest rates, there could be implications for the Monetary Policy Committee. With growth this year above trend, base rates have been raised to offset the risk of inflation. The MPC expects the economy to respond by slowing down to 2.5% growth. While the evidence from the high street and the housing market supports this view, the Chancellor disagrees. What if growth is, as he predicts, again above 3%? The talk of rates peaking at 5% will be premature because the MPC would continue raising rates in 2005. All of a sudden, cracks are starting to appear in the house built on a Brownfield site.