Stephen King: The Chancellor's golden goose is no more and the cash has run out

A rebalancing of the economy may leave the Treasury permanently short of money

It turns out, then, that the Government signed a pact with the financial devil. Only through the housing boom, the lending glut and big City bonuses was the Government able to raise the revenues to fund its ambitions for education and health. With the onset of the banking crisis, the Government's finances have unravelled faster than a cheap pair of woollen socks.

A year ago, the Treasury thought the 2009/10 budget deficit would be £38bn. The latest estimate amounts to £175bn. As errors go, that is big.

Even worse, the Treasury has been sleepwalking into what is now a major fiscal crisis. Four years ago, its medium term projections provided absolutely no indication of the haemorrhaging of the public finances now taking place.

Two years later, in 2007, there was still no hint. The budget deficit was bound to improve, and the debt to GDP ratio would remain below the 40 per cent upper boundary set by Gordon Brown when he became chancellor back in 1997. Throughout this past decade the Treasury conveniently assumed that its medium-term fiscal numbers would add up. It had, apparently, relocated to Fantasy Island.

Of course, no one managed to capture the full extent of the downswing in global economic activity that has taken place over the last 18 months. Arguably, then, part of the fiscal deterioration now taking place is both understandable and forgivable. But surely not all of it. The Treasury is, after all, forecasting the biggest-ever peacetime budget deficit, even though it claims the current recession will not be as painful as those of the early 1980s and early 1990s.

In its new medium-term projections, the debt to GDP ratio continuously rises, going above 76 per cent by 2013-14 (and these numbers don't even include the additional debts taken on board to bail out the financial system). The only conclusion that can be sensibly reached is that, despite its fiscal rules, the Government waved goodbye to prudence many years ago.

The writing has been on the wall for some time. The Government decided a long ago to make great play of balancing the books through the course of the economic cycle. When life got difficult, though, the Treasury simply redefined the beginning and end of the cycle, as opposed to raising taxes or cutting spending. It made the fiscal numbers add up for a while, but this was, ultimately, a work of fiction rather than of hard analysis.

The bigger problem, though, has been the Government's increased dependence on a financial economy living in dreamland. To understand why this matters, it is important to examine the nature of economic growth in recent years.

Since Labour came to power, there have been only three major areas of jobs growth: financial services, construction and the public sector. Other areas either have delivered no job gains or – in the case of manufacturing – have seen job losses.

Growth of public-sector jobs, though, ultimately depends on growth in tax revenues generated by the private sector. In effect, then, the employment of more teachers, doctors and nurses in the public sector has depended critically on the boom in financial services and construction. Those parts of the economy created the extra revenues which allowed public spending to rise so rapidly in recent years.

Even before last week's announcement that the top rate of tax was going to rise to 50 per cent, the City had been an important source of tax revenue for Mr Brown and Alistair Darling, the current Chancellor of the Exchequer.

It is a source, though, that is now drying up. Income-tax revenues have fallen a lot further than the raw employment numbers might suggest, because those working in the City are seeing their bonus payments decline sharply in 2009.

The impact of this drop can be seen all-too-clearly in the monthly average earnings data. Through much of last year, earnings growth ran at an annual rate of between 3.5 per cent and 4.0 per cent, whether or not bonuses were included. Over the last couple of months, though, there has been a profound shift. Excluding bonuses, earnings growth is still running at a rate above 3 per cent. Including bonuses, earnings growth has collapsed. In February alone, that earnings growth rate dropped to just 0.1 per cent. This is bad news for the Government because City bonuses tend to attract the highest rate of tax.

Moreover, while private-sector earnings growth has collapsed, growth in the public sector remains very buoyant. Including bonuses, private-sector pay fell 0.5 per cent year-on-year in February while public-sector pay increased 3.7 per cent.

You don't need to be a mathematician or an economist to work out that a severe reduction in pay growth in the private sector will slash government revenues, thereby making it increasingly difficult to fund big increases in public-sector pay. The situation is clearly unsustainable.

Indeed, this is one of the reasons why the fiscal arithmetic no longer adds up. A year ago, the Treasury thought revenues would amount to 39.2 per cent of GDP in 2009/10.

By the time of the pre-Budget report last November, that number had come down to 36.2 per cent.

Now, though, the Treasury thinks revenues will amount to only 35.1 per cent in this coming financial year. Meanwhile, GDP itself is now a lot lower than it once was, owing to the depth of the recession.

In absolute terms, then, revenues for the coming year are now more than £100bn lower than forecast a year ago – a drop of over 18 per cent. The Treasury has simply run out of money.

A simple way out of this hole would be to see a rebound in financial sector health which, in turn, would help to restore tax revenues. That, though, is unlikely, not least because the Government now wants to distance itself from the excesses of earlier years, most obviously the City bonus culture. In his Budget speech, Mr Darling offered support for "advanced manufacturing, the creative industries and low-carbon technologies."

But if the earlier excesses left the Government coffers temporarily awash with revenues, a rebalancing of the economy away from these excesses may leave the Treasury permanently short of cash.

The big conclusion from all of this is that we are about to face years of public-sector austerity. The failure of the financial system has not just damaged the reputation of the City. It has also undermined the ability of the Treasury to raise revenues. Higher taxes and public-spending cuts – at least relative to current plans – are the inevitable consequences.

There is also, though, a smaller conclusion. There needs to be a much more transparent analysis of revenue sources. At the moment, the Treasury simply plots revenues against the overall growth rate of the economy, at least in its published assessments of the fiscal position, and offers only a token description of revenues by sector.

That is no longer good enough. There will need to be from now on a much better understanding of the sources of government revenue, particularly regarding the shape of economic growth.

An unbalanced economy is likely to distort the tax take. The last decade was a period of bumper tax revenues, fuelled by a housing boom and a buccaneering culture in the City.

Some of these revenues should have been saved but, instead, the Government chose to spend the whole lot on "essential" public services. Now that the Treasury has run out of money, we're about to discover that much of this extra public spending is essentially unaffordable.

Stephen King is managing director of economics at HSBC