Economic View: Brown and the borrowers

Basically, taxes follow spending. The harsh if obvious truth is that if we want higher spending we will have to pay more ta

Ten days to go before the pre-Budget report: the Chancellor's autumn statement of public spending plans and the condition of the economy, which sets the outline for the actual Budget in the spring. The issues are very simple. How far have Gordon Brown's ambitious spending plans been derailed by the slowdown in the economy and what is he going to do about this?

The first thing to look for will be the growth forecast. The UK has pulled through the downturn in pretty good shape so far, but growth has been distorted by strong domestic consumption and weak external demand. Consumer confidence associated with the housing boom, plus the surge in public spending, accounts for the former; the global slowdown, the latter. So we need to catch some feeling not just for the likely growth but also where the Treasury thinks growth is coming from.

The general view around the world is that, after a weakish recovery this year, 2003 will be a lot better. Everyone will benefit, including ourselves. That may be right but there are obvious risks and this year's disappointments will continue. Back in the spring the Treasury still thought that the percentage growth number for the UK would start with a two. Now the consensus is 1.5 per cent. The consensus for next year is 2.6 per cent. If that happens, then the UK would still be doing OK. (For the US, the consensus for next year is 3.1 per cent, for the eurozone 2.3 per cent, and for Japan just 1 per cent.)

But the risks are huge. Both the US and UK need consumers to remain confident and there are some signs that the "shop till you drop" mood in both countries is waning. Europe's largest economy, Germany, continues to disappoint and Japan, at best, will muddle along. And remember that we here will be hit by higher taxes next spring, with the rise in National Insurance contributions, both on individuals and on their employers. That money has to come from somewhere and some of it will come out of consumption.

Any weakening or growth over and above what has already happened will create a hole in the public finances. You can see how the Government has moved from surplus to deficit this financial year in the first graph above. Last year, Public Sector Net Borrowing bounced along more or less in balance. This year it is running into the red. The Treasury will miss its forecast of borrowing £11bn and it will be interesting to see how much it thinks it will miss it by.

Does it matter? Going into modest deficit certainly doesn't, but going into a large one does. You can see what has happened to government borrowing over the past 30 years in the next graph. Those twin peaks of borrowing are signs of fiscal failures that had serious consequences for the economy. We can safely borrow 1-2 per cent of GDP but not much more: once the numbers start rising much beyond that, the markets will start to fret. Long-term interest rates start to rise and the virtuous circle of lower borrowing cutting the interest bill and releasing resources for government services starts to unwind. As you can see, the last Budget projected a deficit of 1 per cent of GDP. That is fine, but if it rises much further we are into yet more tax increases or cuts in spending plans.

You can see the longer-term pattern of both spending and taxation – again as a percentage of GDP – in the third graph. Basically, taxes follow spending. The harsh if obvious truth is that if we want higher spending we will have to pay more tax. But in the early Nineties, when spending rose, it was to offset the effects of recession. The slightly disturbing feature of the present rise in public spending is that it is happening in a time of not-too-bad growth. Spending that is affordable provided the growth continues could become unaffordable if there were a longer period of lowish growth – and become completely unsustainable if the economy were to go into recession.

The Chancellor has promised that public debt will be "stable and prudent" over the economic cycle. The Seventies and Eighties saw a massive reduction in the size of the national debt as a proportion of GDP, as you can see in the final graph. In the Seventies this was largely a function of inflation. In essence, taxpayers stole from bondholders. But that game came to an end when those holders revolted and drove interest rates on government debt to the mid-teens, much higher than inflation. The fall in the late Eighties was the result of the combination of fiscal surpluses and rapid (but unsustainable) economic growth. The early Nineties recession did such damage to the Government's finances that, despite the recent boom and despite Gordon Brown's tax increases, we are still not down to the debt level of the late Eighties.

So, yes, debt can go up a bit as a proportion of GDP, but not by too much. The thing to watch for will be the extent to which the new projections for government borrowing are higher than those projections on the graphs here. It would be naive not to expect some deterioration. My guess would be that the real problems come next year, not this. And what can Mr Brown do then? Well, he can always try putting up taxes still more; the danger there is that that would have a dis-proportionate impact on the economy. The more sensible approach would be to roll out the increase in public spending more slowly, making sure in particular that we are getting value for money. But is he flexible enough to realise that he has to trim, and wise enough to move early? We will learn more in 10 days' time.