Hamish McRae: We could return to growth next year but that won't cure our fiscal hangover

The Economic View

It is back to the 1970s, for the International Monetary Fund has kicked Britain again. We have not yet had to go cap in hand for a loan, as the Labour government did in 1976, though that cannot be ruled out. But if the new IMF forecasts are right, Britain will have the worst fiscal deficit of any G7 nation and be the second-worst- performing economy this year in terms of growth.

For those of us who remember the 1970s, this brings a sense of despair. Why can't Labour governments be fiscally responsible? What changed Gordon Brown from being the cautious, responsible Chancellor he was during his first term into the mad over-spender he became from about 2002? In a way he is the twin of fellow Scot Sir Fred Goodwin, late of Royal Bank of Scotland, in that he was a careful cost-cutter in his early years but then pressed on with increasingly ambitious goals, refusing to listen to anyone who opposed him.

There is a further parallel. Both were seduced by the bull market and thought the boom would continue. The collapse of international banking was not Sir Fred's fault but he failed to respond to it by retreating from the ABM-Amro takeover and continued long afterwards to insist that the bank's finances were strong enough to cope. The collapse of the world economy was not Mr Brown's fault but he failed to build up a strong fiscal position ahead of it and then continued to insist that the country's finances were strong enough to cope. They are probably both pretty similar personalities and so find it difficult to see what they did wrong and accordingly hard to apologise.

But we are where we are. How bad is it? Well, the fiscal position is worse than I could have believed possible. In his pre-Budget report (PBR), Chancellor Alistair Darling shocked everyone by doubling the forecast for the borrowing requirement this fiscal year to £78bn. With one month to go we have already reached £75bn; the final figure could be around £90bn.

If that is dreadful, the fiscal year starting next month will be far, far worse. As you can see in the circles above, the PBR forecast was for £118bn, but the IMF comes in at £165bn, and the ITEM Club and Capital Economics higher still. The important thing is that a relatively small proportion of this will be the fiscal measures brought in to boost the economy and support the banks. Put it high and say that the additional measures will account for £30bn to £40bn of the deficit and you can see how dreadful the underlying position is.

Had anyone said a year ago that we would be facing this position, I would have said that such a deficit could not be financed. Now part of this is being covered by the Government borrowing from the Bank of England by monetising the debt – "quantitative easing" or, in shorthand, printing money. For the moment the financial markets will wear it, because long-term interest rates remain low. What worries me, aside from the implications for inflation, is that the mood might suddenly snap and we find ourselves in the sort of emergency we were in the Seventies. The argument that the overall debt level of the UK is not particularly high despite these deficits did not wash in the 1970s, when our debt was well within the range of other developed countries, and might not wash again. At worst we could find ourselves having to increase interest rates before growth really recovers.

If the IMF's assessment of our fiscal position is dreadful, what about its view on the economy? Here I think it may be too pessimistic. We may actually come through in slightly less bad shape than most other countries. Alongside those dire IMF forecasts, I have put the latest from Goldman Sachs. As you can see, Goldman expects the UK economy to shrink by 2.5 per cent this year – less than the eurozone, Japan or the US. And next year it thinks the economy, far from shrinking, will grow by 1.7 per cent.

That is by far the most optimistic forecast I have seen in recent weeks and is much better than the consensus. On past form I would trust Goldman over the IMF. The latter has been so wrong in the past that this gloomy report looks like tail-covering, particularly when the IMF is asking its shareholders for more money to meet the crisis. It would look too bad to have to revise down the figures yet again; much better to revise up and then say the better outcome is thanks to its brilliance in keeping countries going.

The Goldman Sachs forecasts for the world economy are consistent with those of the IMF, if a touch more gloomy. As you can see, they are particularly negative about Japan, the US and most of Europe. But for 2010 they are quite a bit more optimistic, expecting faster growth for the world overall, and much better growth in the UK and US. In short, for next year the IMF thinks that Britain will be the equal worst economy, while Goldman Sachs thinks it will be the best.

Why? Well, looking at the world as a whole, it notes a number of things that might turn out better than expected. Consumers in the US have stabilised and in both here and Germany consumption is quite strong. There may be an earlier end to the US housing downturn and UK house prices may become more stable. The US is making a huge effort to steady the banking system with its purchases of toxic assets (aka bad debts), as indeed is the UK. Goldman also thinks there is a good chance of a successful G20 meeting in London on 2 April, and finally it notes better signs from China and other emerging nations.

I would add that we should not underestimate the power of a low exchange rate to boost things. I acknowledge that there is very little showing through in the export numbers, but then global demand is flat on its back. Anecdotally, in London at least, the fall in the pound is sucking in a lot of tourist trade to replace the hit to the spending power of the locals. Tourism is always most sensitive to exchange rate movements. You would expect exports to follow after a lag of up to a year, so by the autumn something should be happening on that front.

So a return to growth in 2010? Yes, that does seem reasonable. Even if all the G20 efforts fail, the self-healing powers of the world economy should have kicked in by then. Even those of us who are pessimistic about the results of this April meeting can square that with the expectation of 2010 being a better year.

Unfortunately, however, a return to growth will not correct the UK fiscal deficit. The prospect will be for higher taxation and sharp cuts in public spending for at least the next five years. And the fact that the rich will not be making many capital gains or getting paid large bonuses, and company profits will remain under pressure, will mean that the burden will fall on the middle classes. The question then will be how to build lasting fiscal discipline into our system of governance so that we don't have to go through all this again.

Good news for bosses: your bonus makes your employees happier

What makes for a happy workforce? A bit of job security would not go amiss in these troubled times, but leave that aside. You might imagine that greater equality of pay would help, and quite a lot of us would like to see Britain become a more egalitarian society. But apparently this is not the case, according to some research by Professor Andrew Clark, a specialist on attitudes to work, published in the latest edition of the Economic Journal.

He and his colleagues found that workers in companies where the bosses were well-paid were happier than those with more equal pay scales. The reason, he suggests, is that lower-paid workers think that at some stage they too will earn more. It may also be that companies and industries with money to pay the top managers well are culturally optimistic, or they attract more optimistic employees. But it squares with earlier research suggesting that in countries that have laws making it difficult for employers to sack people, workers are less happy than in those with weaker labour legislation.

The reason for this is that if it is hard to get rid of people, the less productive workers tend to be carried by their colleagues. That leads to resentment and makes for a general sense of depression. So, paradoxically, legislation designed to protect workers leads to them being more miserable. Contrast the service in a French restaurant with that in an American one and you can see what I mean.

None of this should be turned into a defence for bonuses on artificial profits or share options that encourage short-termism – or indeed a more general hire-and-fire culture. But it is worth making the point that there is a massive compression of pay differentials taking place at the moment – as well as a parallel compression of differences in wealth. Towards the end of the current boom, income inequalities became extreme and what we are seeing today is a reversion to a more normal distribution. But high pay is not in itself divisive.