COLUMNISTS How did the UK move from Gordon Brown’s initial “prudence” as chancellor to a state where, according to the Institute for Fiscal Studies, 19 out of 21 comparable countries have done more to improve their structural budget balances? I leave partisan theories to others. It all goes back to a seemingly technical mistake. It is common sense to allow the budget to move into deficit during a recession or slowdown and to accumulate a surplus during upturn or boom years. Mr Brown and his advisers were not content with doing this on a year-by-year basis, but insisted on relating their borrowing to the whole business cycle, the dates of which kept changing; so allowable borrowing today became dependent on highly conjectural computations going back to the 1990s. This, although backward looking, comes from the same kind of hubris as over-reliance on forecasts.
We are now faced with the conundrum of what to do when there is an excessive budget deficit but a near-term prospect of an economic slowdown. It is difficult not to agree with Mervyn King, Bank of England governor, that eventually tighter credit conditions will produce a check to growth even though inflation will still be “rising sharply”.
There are several precedents in recent British and US experience. One example was the US in the late 1990s, when events such as the dotcom crisis and the Far Eastern financial blow-out helped to produce a US slowdown. The memoirs of Alan Greenspan, the legendary chairman of the US Federal Reserve, remind us of what happened. He and Robert Rubin, Bill Clinton’s long-time Treasury secretary, both agreed that eliminating the budget deficit was a priority and it was left to the Fed to counter the recession threat. This double trick worked, even though the Fed, like nearly every other central bank, refused to say how many points on the Fed funds rate would come off for every $100bn (£50.7bn) cut in the deficit. The result was one of the briefest dips in American business history. Few remember that, at the time of Mr Clinton’s handover to George W. Bush at the beginning of 2001, a major topic of US political discussion was what to do with the budget surplus – not that Mr Greenspan, or other seasoned observers, worried too much about it.
The next episode could not have been more of a contrast. Under Mr Bush, the budget soon went into large deficit and Mr Greenspan shows very clearly that only a fraction of the deterioration was due to Iraq. So the Fed was left to fight recession threats unaided, and in 2003 short-term interest rates were down to scarcely more than 1 per cent. Many of those now talking bitterly about the “Greenspan put” were among the cheerleaders at the time. The fiscal problem will have to be resolved by the next administration.
UK policies were for a long time inhibited by fears about sterling. These had gone into reverse by the time of Geoffrey Howe’s famous or infamous 1981 Budget. Indeed, the business community was complaining bitterly about an excessively high exchange rate – so much so that I kept my head down at gatherings of self-appointed industrial leaders. The 1981 Budget gave priority to reducing the deficit and raised the tax burden despite the contemporary recession.
This action led to the well-known protest of 364 economists, who did not say what should be done instead but were sure that Thatcherite policies would lead to disaster. It transpired, however, that the real economy started to turn up from about the time this Budget was announced, emboldening Lord Howe to entitle a lecture many years later “Can 364 Economists All Be Wrong?” But it is fascinating how many different people subsequently rushed to claim credit for that Budget. The technical monetarists, such as Alan Walters, who disagreed with the Treasury’s definition of the money supply, hoped that a stricter fiscal policy would leave room to get both interest rates and the exchange rate down. The fiscal experts were worried that the budget was in structural deficit, irrespective of recession. But I suspect that the clinching considerations were simpler. The Treasury revised its budgetary forecasts in the direction of more red ink and this closed the gap between the mainstream advisers and the semi-detached monetarists.
There are some brave souls who have the courage to defend their signature on the original manifesto of the 364. One of the most interesting is Stephen Nickell, recently a member of the monetary policy committee. He maintains that, although output started to rise in 1981, the economy was still operating below the rate required to stop runaway inflation – in modern jargon, there was still a capacity gap. My problem with this explanation is that we do not, and never will know until well after the event, the size of the capacity gap.
Much less discussed was the strategy of former chancellor Norman Lamont, who, in his 1993 Budget, was also faced with a recession and a seemingly huge budget deficit. His solution was to announce a staggered rate of tax increase, which was designed to reduce the structural deficit without imposing heavy new taxes on a sagging economy. The approach of Lord Lamont would not have worked in 1981 as it would not have carried credibility. But it might just work again in 2008.
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