By Willem Buiter
Published: December 9 2009 22:28
Who would volunteer to be chancellor today? Presenting the pre-Budget report under Britain’s dire fiscal circumstances is like swimming naked in a river full of piranhas: there’s bound to be a bloody mess. Either you tighten too much too soon and the economy risks stalling again, or you tighten too little too late and you provoke a sovereign debt and sterling crisis. The chancellor opted for too little too late.
Britain’s public debt and deficit are unsustainable, as is clear from the charts. The International Monetary Fund puts the average primary (excluding interest) structural government budget deficit at 8.29 per cent of gross domestic product for 2009-10. It also estimates the primary deficit that stabilises the public debt-to-GDP ratio to be 0.19 per cent. The UK therefore needs to permanently reduce its primary deficit as a share of GDP by 8.1 percentage points. With GDP averaging £1,414bn during 2009-2010, next year’s contribution to this permanent fiscal tightening would be public spending cuts and tax increases adding up to £114.5bn.
One can quibble with the details of this calculation, but as long as the interest rate exceeds the long-run growth rate of GDP, government solvency requires, on average, future primary surpluses. An 8 per cent of GDP fiscal correction is a lower bound on any reasonable estimate of the permanent fiscal pain the UK must face.
The pre-Budget report we got delivers nothing like what is required. The projected annual deficits (as a percentage of GDP) until 2014/15 are 12.6, 12.0, 9.1, 7.1, 5.5 and 4.4; the reduction in the structural (primary) deficit may be up to 2 per cent of GDP less. Fiscal sustainability will not be restored even in 2014/15. There are two reasons for this.
First, the election is looming. Hence the failure to come up with specific cuts, combined with great precision on the areas of public spending that will not be cut. Hence tax measures that combine populist appeal with a minimal revenue boost, like the increase in the top income tax rate to 50 per cent and the bank bonus tax.
Second, given the current weak state of the economy, immediate fiscal tightening would exacerbate economic weakness. If the government had fiscal credibility, it should announce a believable plan for future fiscal tightening. Anticipated tightening lowers long-term interest rates and weakens the exchange rate today, and so is expansionary.
However, this government, which committed itself to the “Golden Rule” and the “Sustainable Investment Rule” – yet acted in a resolutely pro-cyclical manner during the eight-year boom that preceded the crisis – is incapable of making a credible commitment to future fiscal tightening.
So what can be done? The government should inflict political pain on itself today, as a signal of its long-term commitment to fiscal tightening, by announcing measures that have limited negative effects on demand today but will have large medium-term and long-term desired effects on the budget. An example would be to raise the state pension age by one year each year, starting immediately, until it reaches 70 for both men and women. I am not holding my breath.
Postponing the fiscal pain is possible, but increases the magnitude of the fiscal adjustment needed. In addition, markets are bound to run scared when they observe government procrastination in tackling fiscal unsustainability. Britain’s triple-A credit rating is under threat. A rising public debt burden and the government’s unwillingness to tackle it head-on will raise the risk premium on UK public debt. A destabilising government deficit and debt spiral could result.
With the Bank of England likely to halt quantitative easing, this gilts purchaser of first resort will disappear soon. The authorities will be able to stuff gilts into the banks, thanks to the City regulator’s mistaken zeal in forcing them to hold more liquid assets. But the limit of that artificial appetite for gilts will be reached soon.
Then the domestic private sector or foreigners will have to be convinced to absorb the flood of gilts. They will do so for a while, at rising nominal interest rates, reflecting both higher inflation risk and higher sovereign default risk. Without further tightening, the final stage will be a sudden stop – where the government is unable to tap credit markets at all.
The Fiscal Responsibility Bill is Newspeak straight from the Ministry of Truth. No one will be impressed, least of all the markets that ultimately sit in judgment on the creditworthiness of Britain. The same holds for that other favourite of fiscally incontinent governments: efficiency savings. These never materialise.
Public spending as a share of GDP has risen relentlessly since 1999 and is likely to be above 50 per cent in 2010. Most or all of the required fiscal tightening should take the form of cuts in current public spending if Britain’s growth prospects are not to be damaged permanently. This government will not deliver such cuts.
This partisan political pre-Budget report ill serves the British public.
The writer is a professor at the London School of Economics and will shortly be Citigroup chief economist
Copyright The Financial Times Limited 2009.
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