Hamish McRae: Budget memo to the Chancellor: When you're in a hole, be honest

Economic view

So now it is official: the UK economy is in recession. But we knew that already; we knew a few weeks ago this had happened, just as recession has hit the other main developed economies around the world. More surprising has been the collapse of sterling and, more generally, the collapse in confidence in the competence of UK financial policy-makers. One sign of that has been the plunge in sterling; another, the rise, still muted, in the interest rate on long-term gilts. The prospects for the world economy have darkened a bit; the perception of how hard this will hit the UK has darkened somewhat more.

What should we make of all this? The world first, then the UK, then what we might look for in British policy in the Budget, now only about six weeks away.

On the world outlook, the first point is that the mainstream forecasters have caught up with the reality that this will be a serious downturn. At the moment the UK data is pointing to something more serious than the 1990s recession, though not yet as serious as the 1980s one. I looked back at what I was writing in these pages a year ago and I felt then that while 2009 would be worse than 2008 (something I could not find any mainstream forecaster predicting), we might get by with a less serious recession than the early 1990s. That view, which seemed pessimistic at the time, now looks too optimistic. But – big point – the world economy still looks to be within the "normal" post-war recession profiles, and I would be surprised when all is done and dusted if this is worse than the 1980s.

Some new forecasts from the Economist Intelligence Unit (EIU) on the possible profile of the world recession show, in the case of the developed world, a dreadful 2009 and only a weak recovery in 2010. But note that other parts of the world, while being dragged down this year, manage rather better than Western Europe or North America. It is not a pretty picture but it is well within post-war experience.

So why is Britain taking a pasting on the markets? The forecasts don't show a figure for the UK but the EIU notes that the UK will be hit particularly hard this year and, crucially, warns that government debt may rise to 90 per cent of GDP by 2013. That is the worst I have seen yet. I did some back-of-an-envelope sums and came to 80 per cent of GDP around 2012, but maybe that was too hopeful. It would be consistent with the new European Commission forecasts for the deficit, which suggest it will reach nearly 10 per cent of GDP in 2010.

So we will have gone from the lowest debt-to-GDP ratios of the G7 to one of the highest. "Prudence with a purpose", as Gordon Brown used to say, has given way to a collapse in the pound.

Having a relatively competitive currency is no bad thing in a global downturn. It helps exports and trims imports, and provided it does not lead to a surge in inflation, some decline is rather desirable (even if that decline is starting to attract adverse comments from the French finance minister, suggesting a wider concern in the eurozone). But there is a danger to UK creditworthiness if the slide becomes a rout. I am not worried about the credit-rating agencies downgrading UK debt, though they may do so. Nor is it realistic to worry that we may have to borrow from the International Monetary Fund, as we were forced to do in 1976. David Cameron's suggestion to that effect was more mischief than substance.

However, we do have to accept that it is not only the Government's credibility that is under suspicion. The reputation of the Bank of England has suffered, the joke being that every time the Governor makes a speech, the pound loses another couple of cents. The credibility of the Financial S ervices Authority is under a cloud and will remain so. Indeed anyone associated with this Government's financial management carries a taint. A whole new elite will have to take over and we must hope it performs better than the present one. Fingers and toes crossed, please.

Meanwhile there will be a Budget, possibly the last of this administration. Is there anything that Alistair Darling can do to help? He was dealt a dreadful hand, which he has played as best he could, but I am afraid that the measures announced in the pre-Budget report, in particular the cut in VAT, now look ill-judged and possibly counter-productive. There are, however, two things that might be done that could help rescue the Chancellor's reputation.

One would be to have honest forecasts for the economy and for public finances from the Treasury. We all knew that the October forecasts were tweaked, for there was an internal inconsistency in them. The public borrowing numbers could only be justified if the recession was going to be really dreadful, but the forecast downturn was not particularly deep or protracted. The reason was an effort to blame the soaring deficit on global forces rather than previous mismanagement, understandable politically but intellectually dishonest.

The other thing would be to have realistic forecasts for public spending. There are big cuts in real terms in spending plans but neither the scale nor the substance is being made clear. The public sector faces a 10-year squeeze because we do not have the tax base to sustain it at its present size, even with substantial tax increases, which seem to me to be inevitable. This Government cannot do anything about this – that will be the unpleasant task of the next lot – but it owes it to the public to be honest about the numbers.

If all this seems dispiriting, I am afraid that is what it is. If there is one point of relative cheer worth making, it is that thanks in part to the collapse in the pound, we may escape with a slightly less serious downturn than the eurozone. That is not what the European Commission or the EIU think, but the current forecast from Goldman Sachs is consistent with that outcome.

Looking ahead, it would be unwise to expect much growth until the housing market turns. All this talk of "green shoots" is infantile. What happens in a recession is that, despite the overall decline, some parts of the economy manage to thrive. So you always have green shoots but they are not sprouting with enough vigour to offset the autumnal browns elsewhere. Nor will they do so until well into 2010. Recessions typically last a couple of years, a bit less if we are lucky. And we are only six months in, for the economy grew pretty much until the middle of last year.

If we get to 2011 and things are still flat, we really are in big trouble. But let's not go there; there's no need to yet.

US borrowing capacity to be tested as never before

What a way to greet the new US President. If the UK GDP fourth-quarter figures were bad, expect some worse ones from the US to be released on Thursday. The consensus forecast is that US GDP will have fallen at an annual rate of 5 to 7 per cent. The American consumer went on strike and demand collapsed.

You would have to be profoundly cynical not to acknowledge the burst of American self-confidence evident after the inauguration last Tuesday. But also you have to be aware that the debt overhang (hangover?) can't be wished away.

We will get more feeling for the new administration's fiscal plans in the next few weeks, but already we can see the limits of monetary policy. Official interest rates are as near zero as makes no difference, yet they appear to be having no effect. The problem is not the price of funds; it is the availability of funds and the willingness of both borrowers and lenders to make the commitment. We have no idea if so- called "non-conventional" (untested) policy measures will change this.

Meanwhile, expect longer-term rates to climb as the scale of the fiscal gap becomes more apparent. We are talking something similar, in the US as a percentage of GDP, to that of the UK, the difference being the international borrowing capacity of the US is far greater.

So we are going to see the borrowing capacity of the US tested as never before and we simply don't know how the global financial community will react. What will China do? It has been criticised by the new President for its currency policy. Is that wise at this moment? He seemed to promise more responsible government at his inauguration, and those thoughts will resonate. But there is a trust deficit that has to be rebuilt, and fiscal boosts are only effective if their policymakers are trusted.

So while it would be wrong to be cynical about the new President's impact and still less about the thoughtful way he has begun, the position of the US economy will remain fragile for months to come.