Hamish McRae: We must seize the opportunity to radically rethink our government

Economic View

Politics move more quickly than economics. The events of the past week may mean that the present Government can hang on a little longer, and those of us who expected Alistair Darling to be replaced by Ed Balls have been proved wrong.

But come next summer, maybe much sooner, we all know what will have happened. So it is time to starting thinking about the scale of the problem that the next government – and we as citizens and taxpayers – will face. Unfortunately, a change of government will not change the fiscal arithmetic.

Let's start with the better news. By next summer, the economy will be growing solidly, maybe strongly. In the past week we have had encouraging news from the service industries, which are now experiencing some growth, and from house prices, which seem to have stopped falling. The economy will have contracted in this second quarter and may well do so too, but by the end of the year it would be very odd (and profoundly disturbing) if growth had not resumed.

What we cannot say anything sensible about is the quality of that growth and in particular the extent to which it will have been sustained by the huge increase in public borrowing and spending. Those of us who have been critical of the surge in public borrowing (and more of that in a moment) have to acknowledge that it must be having some impact on demand right now, restricting the scale of the decline.

But next summer, as growth resumes, a clear path will have to be set out for fiscal consolidation. It may have to come sooner. If this Government does make it through to November, it will have to present another pre-Budget report, setting out the debt profile for the next few years. That could trigger a market revolt. Or it may just be that at some stage through this summer will come a crisis of confidence, perhaps triggered by a downgrading of UK debt. In any case, once growth resumes, there will be no excuse for delay. We must tackle the deficit.

Come next summer we will be into a period of fiscal austerity such has has not occurred since the 1970s. To put this into perspective, we had two great surges in debt to pay for the two world wars. The present projection for the debt, which will peak somewhere between 80 per cent (on the government's figures) and 100 per cent (on some market estimates) of GDP, is lower than either of those two previous peaks. On the other hand, it is by far the greatest rise in debt that has ever occurred in peacetime.

The two previous peaks were paid back in rather different ways. During the 1920s and to a lesser extent the 1930s, the government had to pay it back in real money because prices fell in the 1920s and rose very little in the 1930s. After the Second World War by contrast, the deficit was eventually inflated away. This time will probably be more like the inter-war period because it is hard to see any early rise in inflation, though that remains a possibility in the medium-term. How big a burden will that be?

Start with servicing costs. Debt interest is about 1.5 per cent of GDP, pretty small. Tax revenues are about 35 per cent of GDP so debt interest takes a little more than 5 per cent of tax. Interest will rise to around 4 per cent of GDP on the government's own figures, more if you take the forecast from the Institute for Fiscal Studies. Just to keep the debt steady will take more than 10 per cent of tax revenues. We have not been in that situation since the 1970s.

It gets worse. We have to start paying down debt, which means a deficit that is smaller than the growth of the economy. The deficit will have to be below 2.5 per cent of GDP, the long-term trend growth rate. This year it will be close to 10 per cent. People have no idea at all of how serious the squeeze on public spending will be and how long it will last.

The obvious parallel is the situation that the Tories had to cope with when they came to power in 1979. Public spending had peaked under Labour at just under 50 per cent of GDP, as it will peak next year. But they had two advantages then that they don't have now. One is that it was possible to cut the public investment budget by much more than is possible now. The other is that they could sell assets. Public investment will be cut: indeed, under the present Government's plans it will be slashed. But less fat is available to be trimmed than there was in the early 1980s.

As for selling off assets, there is not a lot left to flog, or at least not that will fetch reasonable prices. Privatisation or part-privatisation must be argued on management grounds (as this government is seeking to do with the Post Office). The fiscal grounds for selling assets off are pretty minimal.

There are further differences. It was possible to squeeze the military budget in the early 1980s, as this was much larger relative to total spending. Now it simply isn't big enough. Even if we were able, magically, to spend nothing on defence, we would still have a huge gap to fill. The same goes for public sector pay. It is not a question of holding back growth in pay, as occurred in the early 1980s. Suppose there were a public-sector pay freeze for three years? Not realistic, but even if it were, it would not be enough to make much of dent in the deficit.

We will have to do it cold turkey. Next summer we will have higher taxes, not just on the rich but on everybody. I expect VAT to go to 20 per cent. We will have had a radical review of all spending, something that has never happened before. It has to be radical because salami slicing can't do it.

There, surely, is the great opportunity. It is a chance to re-think government. What functions do we want government to provide and how should these be financed? Because the scale of the problem is greater than in 1979, the opportunity is greater too. To try to sketch "new government" would be to go far beyond the scope of this column and, in any case, the ideas will take months to develop. One of my greatest worries is that the Opposition, and the people around them, have only just begun to try to think this through.

But the good news is that at least the economy is in much better shape than it was in 1979, so there is a better base on which to build, and remember too that by next summer the big economic numbers will be going up, not down.

We'll all be more stable if China and the US can become more balanced

Something much bigger than our political splatter happened last week on the other side of the world. The US Treasury Secretary, Tim Geithner, visited China and seems to have allayed Chinese fears that the US will try to inflate away its debt. This matters because China holds some $768bn (£482bn) of Treasury securities, and a further $1,400bn of other assets.

The US Federal budget deficit is broadly similar to the UK's, relative to GDP and, as here, there is no clear plan to get it back under control. The positive difference compared with us is that it has a new administration, so the deficit is not the responsibility of the incumbent. The negative difference is that it is more dependent on foreign inflows of capital to finance its deficit, so keeping China on side is important for the security of the dollar. It seems China has maintained the flow of funds in recent weeks.

So a holding deal has been done. However, that will not stop China trying to reduce its dependence on exports to the US to maintain demand, as the Chinese authorities very much appreciate that it is not in its long-term self-interest to pile up US assets or to rely on exports to keep the economy growing.

But then, it is not in the interest of the US to be owned by China. So I think this meeting will come to be seen as an important stage in the resetting of the countries' relationship. The "China lends to the US to enable it to buy its stuff" period is coming to an end. China will remain a huge creditor and both sides will have to live with that. But over the next decade, the Chinese trade surplus will decline – it has already – and the US will start to save enough to finance its deficit. That trend is in place too.

For the rest of us, this is encouraging. The next growth phase of the world economy has to be better balanced than the last. Attention has been directed towards one aspect of that imbalance, the growth of the debt burden, but there was another, the trade imbalance between China and the US. The first is being fixed. The second is starting to be fixed too.