Rarely has the economy dominated the news to the extent it has in recent
months. The combination of economic slowdown and banking turbulence has created
a climate of pessimism bordering on fear, culminating in regular downward
reviews in short-term expectations. After the negative growth recorded in Q3 –
the first fall in GDP since Q2 1992 – a technical recession seems inevitable.
The big question now is over the length and breadth of the downturn, and how
policymakers can mitigate the effects and stimulate a recovery.
Reliance on consumption and borrowing over a number of years to drive growth
and employment has created an unbalanced economy. In the personal sector,
accounting for almost two-thirds of final demand, cumulative debt now amounts to
£1.4 trillion, equivalent to 160% of annual earnings. On top of sizable debt
repayments, households have also had to cope with a rising tax burden and a rate
of consumer price inflation that is faster than the growth in earnings. Clearly,
discretionary income is being squeezed very hard and spending on the high
street, on leisure activities and on big-ticket items, is at the front line of
There are no quick fixes. Lower interest rates will help a bit. The
has reduced Bank Rate to 3% and could go even lower. If inflation falls as
expected to the 2% target next year, and earnings growth is maintained at around
3.5%, there will be some extra purchasing power. But the impact on total
spending and consumer confidence could be offset by a jump in unemployment. It
will be a couple of years before the personal sector emerges, chastened, from
this debt-fuelled haze.
If the consumer fails to respond, the government will step in to fill some of
the spending gap. Chancellors Brown and Darling have already pushed public
sector spending and borrowing to the limits of their Fiscal Rules, which will
now be put on the backburner. Any spending increases will be funded by
borrowing, thus pushing up the ratio of debt to GDP.
The exact size and balance of any package will become apparent only when
Darling presents his pre-Budget report on 24 November 2008 (after we’ve gone to
press, but before you read this). ‘Prudence’ will have to be given substantial
The press will make much from the jump in borrowing and debt, but while it is
hard to view it as a positive for the economy in the long term, the scale needs
to be kept in proportion. As Chancellor, Gordon Brown wanted to keep public
sector net debt at no more than 40% of GDP – the
Investment Rule. During his first few years at the Treasury, he
reduced the ratio from the 43.3% he inherited to a low of 30.3% in 2001-02.
He used surpluses to pay off some of the national debt, thus freeing up his
cash flow in subsequent years.
From 2001, however, Brown stepped up spending at a rate that exceeded the
increase in his revenues. His surpluses became deficits, borrowing increased and
the public sector debt to GDP ratio started to rise. By 2006-07, it was 36.6%,
still comfortably within the Rule, but in this year’s Budget, Darling’s forecast
for 2009-10 took it to 39.4%, perilously close to the threshold; this was taking
a minimalist view of government liabilities, and before the measures to underpin
the banking system were taken into account.
It should not be forgotten that last March, Darling still forecasted GDP
growth of 2% for this year and 2.5% next, which now looks ludicrously
optimistic. With recession looming, his expected tax revenues will be lower and
his projected spending on benefits higher. Not only will he have to account for
the bold banking measures the government is introducing, but he has now promised
to step up spending to support economic activity.
No wonder in his Mais Lecture in late October, achieving the fiscal rules
became a medium-term objective. There is nothing wrong with Keynsian
counter-cyclical spending by the public sector and, in fact, if nobody else is
spending, it is to be welcomed. Where the government is open to criticism,
however, is that it was also spending and borrowing when everybody else was and
so, rather than building surpluses in good times, it was adding to its debt.
Now, in difficult times, the debt figure is to rise even more, which will act as
a drag on the economy well beyond the end of any imminent recession and limit
the tax options of future governments.
But this extra spending, which might push borrowing above £70bn and increase
the debt ratio to 50%, should be kept in context. In the 1970s, the debt ratio
was even higher and less ‘affordable’ since interest rates were also much
higher. And, if public sector debt reaches 50% of GDP, it will still be half the
G7 average (93%), and less than the US (61%), Germany (63%), France (64%) and
The real issues are less to do with statistical fiscal rules and more about
whether the spending has the desired effect and how quickly the public sector
can give way to a renewed and buoyant private sector as the springboard for