Hamish McRae: Next year's fiscal options are limited whatever bickering economists say

Economic view

Sometimes you want to weep. Economists at their best are thoughtful and humane people who try, despite their imperfect understanding of the way economies work, to explain what is happening and why and then maybe give some guidance as to what might be done to make things work better. Sure, they – I suppose I should say we – get things wrong and sometimes spectacularly so. But it is better, I always feel, to carry a flickering torch into a dark cave than plunge in to the blackness with no light at all.

But sometimes, instead of illuminating the cave, we shine the light into the eyes of the onlookers and blind them. Last week we did just that. Last Sunday there were 20 economists writing to a newspaper to say that the government should make a start on cutting the deficit next year and then on Friday another 60 economists in two different letters to another paper appeared to say pretty much the opposite – that early cuts might undermine the recovery. The Tories seized on the first lot as justifying their stance (whatever it is) and Labour trumpeted that the other lot justified theirs. Both groups had eminent names on the list: some prima donnas to be sure, but mostly sensible, competent people. Several are good friends. So what on earth should we make of all this?

The first thing to be said is that the next government may have no option. The decisions as to what it does will not be made by economists but by savers. It has a huge deficit to finance, the largest relative to GDP in the world. Yup, we have the gold. To finance that deficit we have to convince savers that we can pay the interest on the debt, and eventually repay it, without a collapse in our currency. Those savers will be largely abroad. More than one-third of our national debt is held by foreigners and that proportion has risen steadily over the past decade. We use the loose term "markets" but actually it is savers around the world who decide.

So, and this is the second point, there has to be a medium-term plan after the election to bring the deficit down. All those economists would agree on that. I cannot imagine a single one who would argue that the deficit next financial year should be larger than the deficit this year ... all right, I concede that there is one on the second list who has nutty views and he might. But even he would have to admit that there should be a medium-term fiscal consolidation plan.

There are some issues. One is how much should be done in the first year and how much should be left to later years. A second is the balance of the burden between tax increases and spending cuts. But think about the practicalities. The new government will not be able to introduce its Budget until June. We will already be a quarter of the way through the year. You can do some tax changes immediately and I do expect VAT to go to 20 per cent. But other tax changes take time to make an impact and all spending decisions take months to feed through. So the reality is that not a lot can be done in year one. It sounds an important distinction between cuts now and cuts later, but in practice it would make little difference. This great clash between the first lot of economists and the second is an academic debate rather than a practical one.

There is a third point, which not many people appreciate; indeed, I didn't fully grasp what was happening until I saw the chart from the IMF that I have reproduced here. All G7 countries, including us, have experienced a fiscal boost this year. Governments have increased their borrowing over and above what it would otherwise have been to increase demand in the economy. Our own government has done what all the others have done. If you look beyond the G7 to the G20, that is including the main developing and emerging nations, again there has been a solid boost to the economy.

Now look what happens next year. The rest of the world is keeping the accelerator pedal down. Germany is actually increasing the boost; even Italy is doing a bit. We are not. These are Alistair Darling's plans, as outlined in the Pre-Budget Report. True, we are not actually tightening policy under those plans but we are no longer loosening it. We are not loosening policy further because we can't. We went into this downturn with too high a deficit to be able to do anything more. The magazine is empty; the ammunition has been fired; there is nothing left. It may well turn out, if we do have a proper Budget before the election, that Darling will start some modest tightening because the PBR figures are widely seen as not very credible.

So whatever happens in the election, the policy thereafter will be pretty much the same. The new government will have to bring in a plan to correct most of the structural deficit over the life of the next parliament. It will have to find some form of external validation for that plan because, given the experience of the past few years, the Treasury would not of itself be credible. That is sad, as under Darling it is now producing more credible public finance forecasts than it was under Gordon Brown. But the damage has been done. No country can run a budget deficit of nearly 13 per cent of GDP and expect its financial institutions to be trusted. The Tories' proposed Office for Budget Responsibility is their way of regaining authority, but even were Labour to retain power it would have to make institutional changes of some sort. Indeed it recognised that, by saying that there would be a legal requirement to cut the deficit. That would not work but it shows that the party accepts it cannot go on as before.

So, whoever forms the next government, the policy will be pretty much the same. Might a hung parliament stop a new government from being effective? Unlikely, because it would be very dangerous for a third party – presumably the Lib Dems – to bring down a minority government by voting against its fiscal plan. To do so would signal that it was against fiscal responsibility, a label no party would want to carry, particularly since it would spring an immediate second election.

So we get fiscal consolidation come what may. We will experience something on a scale that this country has never experienced in peacetime, of a quite different order of magnitude to the cuts under Margaret Thatcher. It will be an unenviable inheritance; and what worries me is that people have no idea – no idea at all – of the scale of the cuts, and probably tax increases, that have to happen.

The only chink of light is that others, including Canada, Sweden and India, have experienced severe fiscal squeezes which set them on a growth course; the boost to private sector confidence more than offsetting the impact of spending cuts. Now, if economists spent their energies telling us how to cut wisely, instead of sounding off in the newspapers, they would be doing something really useful.

Pressure builds on Greece as the EU grows more stern and anxious

The Greece story took on a new twist on Friday, with the replacement of the head of its debt office. No reason was given but the announcement was just ahead of talks between the Greek authorities and the EU over claims that the country had concealed the extent of its debt problems, a charge that is broadly accepted. What Greece does not accept is that it used devices developed by Goldman Sachs to hide its problems. All will be explained to the EU, a spokesman said.

Meanwhile another aspect of the Greek/EU relationship has been becoming clearer. Up to now the whole debacle has been presented as poor Greece being forced to go cap-in-hand for a bailout. But Greece holds a strong card because the EU cannot allow it to default. The country's prime minister, George Papandreou, in London on Friday, said Greece had to be able to borrow at the same interest rates as the rest of the Eurozone, warning that higher borrowing costs would drive up interest rates elsewhere.

"Higher interest rates for us mean higher rates in Europe," he said.

That is not quite correct because German interest rates have risen only a little since the crisis. But Portugal and Spain have seen sharp rises in borrowing costs, so there is enough truth in it to unnerve Europe. Contrary to the noises coming from Brussels over the past two weeks, no settlement is yet in sight.

Meanwhile two different approaches to the way the Eurozone might impose fiscal discipline are emerging. One, which seems to be the German position, is that rules are rules and must be enforced. So Greece must be compelled to get its borrowing back from the present 12.7 per cent of GDP to the Maastricht limit of 3 per cent. Its present plan, if you believe it, is supposed to cut the deficit to 4 per cent next year. The other approach, more a Brussels line, is to say that Greece should not be compelled into changes that generate social unrest but, rather, should submit to longer-term scrutiny of its budget procedure if the EU is to bail out Greece – in effect, a loss of sovereignty.