In the Budget, the chancellor will be trying to achieve three things which may not actually be compatible: first, do enough to ward off the risk of recession turning into prolonged slump; second, convince the financial markets that there is a credible path for returning the devastated public finances to health in the longer term; and, third, convince the public that any largesse now will not all be recouped in higher taxes in the future – otherwise we may save rather than spend in anticipation.

This will be all the more difficult to pull off given the alarming deterioration in the economy and the public finances since the pre-Budget report in November. Gross domestic product is now estimated to have fallen by 1½ per cent in the fourth quarter last year and all the signs are that the first quarter this year saw a similar decline. This puts the chancellor’s November forecast of a loss of GDP of only 1 per cent this year far out of reach. The consensus is now for the economy to shrink by 4 per cent (which itself could be an under-estimate) and do little better than stabilise next year, well short of Mr Darling’s projected 2 per cent bounce.

The weaker economy inevitably means a significant deterioration in the public finances over and above that assumed in November.

Net borrowing (excluding support to the banking sector) in 2008-09 looks set to significantly exceed the £78bn (5 per cent of GDP) estimate in the pre-Budget report and, similarly, anticipated borrowing of £118bn (8 per cent of GDP) in 2009-10 will prove well short of the peak even without any additional expansionary measures. Given the expanding deficit on the one hand and the shrinking economy on the other, borrowing will likely reach more than 10 per cent of GDP a year.

A discretionary increase in the budget deficit of some 1 per cent of GDP is already built in for 2009-10, reflecting the VAT reduction, increased personal allowance and extra public spending announced in November. While the burgeoning public sector deficit dictates some caution about additional fiscal stimulus, there may be room to provide limited assistance to the poorest in society and the labour market.

Dramatically higher budget deficits mean that government debt, even on the chancellor’s likely conservative estimates, could approach 80 per cent of GDP, double the previous 40 per cent limit. This will require many years of fiscal consolidation – spending cuts and tax increases – to correct.

It would however be a mistake to tighten fiscal policy before the economy is on a sounder footing which makes the original plan to start in 2010-11 look premature.

What the financial markets will be looking for on Budget day is a timetable of plausible measures to return the public finances to health in the longer term. Cutting public spending much further after the squeeze announced in the pre-Budget report will be painful and the burden will have to be shared with tax rises. Candidates include increased personal tax or national insurance contributions particularly for higher earners and higher VAT rates and / or extension of the VAT base.

There is no quick fix – returning the public finances to some semblance of health could take a decade.

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