A pressing question sidestepped by Darling

Anthony Hilton
1 Sep 2008

The warning over the weekend by Chancellor Alistair Darling that Britain is facing some of the toughest times in 60 years is one way to let the world know the holidays are over — and the party conference season is soon to begin. While it is almost certainly an exaggeration — the economy was in worse shape in the 1970s than it is now — it gains full marks for dramatic effect. Henceforth, when things do indeed turn out badly, no one can say he did not warn us.

But if softening us up to expect hard times is one reason for him to break cover when he did, another might well be that he has had some early warning from the Treasury that the public finances are looking none too healthy. In a few weeks, he will begin work on the autumn statement and Pre-Budget Report, to be published in November. That picture is likely to be fire, and perhaps he realised that as the game would shortly be up anyway, he might as well get his excuses in early.

Potentially, the Government is in real trouble here. People seem to have forgotten everything learned in past recessions, and one thing they should remind themselves about is the effect it has on the public finances. Norman, now Lord, Lamont was the unfortunate Tory Chancellor in the early 1990s who happened to be in office the last time growth came to a halt and the economy began to contract.

He had to grapple with revenues that fell far short of target because the economy has stopped growing, and because people and companies earned less and spent less. At the same time, the demands of the public purse ballooned as the demand for unemployment pay soared and associated social spending rose too, on things like paying the mortgages of the unemployed so they would not be made homeless and become a further burden on the State.

The Government had to find ways to increase taxes in the midst of recession in an effort to bring the budget deficit back under control, and at the same time impose sharp cuts in Government spending. This is probably the nightmare that is beginning to haunt Darling. Luckily, unemployment has not yet risen significantly and there is still the possibility that much of the strain of job losses will be absorbed by eastern European immigrants whose response might well be to return home where the prospects look brighter.

But there is no equivalent rabbit waiting to be pulled out of the hat on the revenue side, where incomes are flat, company profits are being squeezed, investment gains are thin on the ground and VAT receipts are hit by the slowdown in consumer spending.

When the economy slows, it is almost impossible for revenues to increase, so the prospect looms large of a fast-expanding deficit and a major rise in the Government's borrowing requirement.

The big issue is whether Darling will be able to get through just by borrowing, or whether he will also have to cut spending significantly and increase taxes at a time when the party is behind in the polls and an election looms ever closer. So we can see that Darling's comments over the weekend only told us what we already know — that the economy is flat — but did not even begin to answer the more pressing question of how the Government's finances can cope with this change of fortune.

End in sight to US surge
The US is supposed to be the basket case while Europe, and in particular Germany, is the model of economic resilience. But a recent collapse of business confidence in Germany and a sudden surge of growth in America appears to have turned this on its head. As a result, the European Central Bank is under attack for continuing to focus on inflation while all around it growth rumbles to a halt.

But there is an easy explanation for this change of fortune on both sides of the Atlantic. The US has taken a leaf from the economics of the 1930s and exported its problems by allowing its exchange rate to plunge. The dollar recently fell to 1.60 against the euro, exactly half the value it had in the early days of the single currency in 2000.

The change in currency values has a dramatic effect on the price of exports, and German exports have hit a wall, causing a mini-recession, while American exports have soared, causing a surge in growth. As Capital Economics points out, the US export growth has also been greatly helped by a doubling in the price it can get for its grain exports.

Such wild swings are not new — the dollar behaved similarly in the 1980s against the Deutschmark and the yen. The way the dollar is now strengthening against sterling and the euro suggests that the pendulum has already begun its long swing back. This is probably as good as it gets for US exports.