Hamish McRae: We've created this catastrophe – and now we must find a way to cure it

Economic view

What is the world going to do about budget deficits? Yes, the world, because while this is a particularly serious problem for the UK, it is a problem for almost every developed country. It is as serious as the great inflation of the 1970s, and, like that problem, it will take decades to fix.

Start with the numbers. We got more evidence last week that Britain was heading towards a deficit of £200bn, an almost unthinkable amount. As a percentage of GDP, it is the worst of any of the G7 countries, and there is little prospect of much improvement next year. The chart, from Consensus Economics, shows what forecasting agencies expect for the G7 deficits this year and next, and, for Britain, may be underestimating the outcome for 2009. The projected deficit for us is "only" £179bn, a figure that looks optimistic, given the latest data. But this is a much wider problem. We have created a catastrophe for ourselves and I believe this government will be harshly treated by history for that. Of the rest, only Canada has managed to keep its finances under control.

So what has gone wrong? Part of the problem is that this is a serious recession. But we would have been in trouble even with a modest one, as we were during the 1990s.

It was to prevent a repetition of that experience that Gordon Brown introduced his "golden rule" – that the country would only borrow for investment and would balance the budget over the economic cycle. That was backed by his second rule, that the national debt would remain below 40 per cent of GDP.

Brown quite rightly felt that there had to be fiscal discipline to stop the chancellor of the day from borrowing too much. We now know that the form he chose failed. Those of us who warned repeatedly about his policies have little sympathy for him, but I do think that we have experienced a failure of the system as well as a failure of the individual. The Government has just come up with another attempt in the Queen's Speech – promising to legislate the halving of the deficit within four years. The Opposition has its own plan for an Office for Budgetary Responsibility, which would also curb excessive borrowing.

But would either of these control the deficit if the fiscal rules failed to do so? The experience abroad is not encouraging. It was enshrined in the Maastricht Treaty that governments adopting the euro would have to keep their budget deficits below 3 per cent of GDP. The average deficit for the eurozone this year and next looks like being double that. So that method of forcing governments to curb deficits has failed. The US has the Congressional Budget Office, an independent agency which oversees fiscal policy for the two houses of Congress. In addition, Congress has to approve any increase in the ceiling on the US national debt. But, as you can see, the US budget deficit is second only to Britain's in the developed world. So that hasn't worked either.

If all this seems a bit daunting, think back to the 1970s. Then, after the breakdown of the Bretton Woods fixed exchange-rate system, we had a similar situation – except that it was monetary indiscipline rather than fiscal indiscipline. So, gradually, the world developed policy tools to tackle the problem. Initially it was money-supply targets; then in the 1990s most countries (though not the US) moved to inflation targets. And central banks were made independent.

Eventually, the policies worked, delivering low inflation for goods and services, though not for asset prices.. But it took 20 years, long periods of high interest rates and two worldwide recessions. But still we must work out a similar plan today. In one respect it will be easier than coping with the monetary problems of the 1970s and in one respect it is harder.

It is easier in that fiscal indiscipline has occurred before, whereas the monetary catastrophe of the 1970s was, from a global perspective, the worst inflationary experience ever. In Britain, it was worse than the great inflation of Tudor times, when prices quadrupled over a century, worse than the inflation that followed the Napoleonic wars, when prices nearly doubled, and worse than the experience after both world wars.

It is harder in that, while the world had some experience of independent central banks and so the institutions were in place to tackle the problem, we don't have independent offices for budgetary responsibility. Indeed such bodies as do exist, such as America's CBO, have proven to be weak.

That brings one right up to the key constitutional problem. To what extent should an elected government have its powers to spend money or raise taxes curbed by some non-elected body? The proposition, stated in general terms, that if a government wishes to spend money it must raise the taxes to pay for it, seems straightforward enough. But we have had our own experience of how, by fiddling with the dating you put on the economic cycle and by pushing costs off-balance sheet, forceful finance ministers can make it look as though they are staying within the rules when in truth they are not.

Still, a balanced budget requirement might be one option. Another would be for governments to seek external approval for their policies without ceding their constitutional powers. For example, it might make sense for the next UK government to get a seal of approval from the International Monetary Fund for its medium-term plan to cut the deficit. That might reduce borrowing costs and accordingly be a reasonable quid pro quo for what would seem a pretty humiliating course of action.

Europe will have to do something for the members of the eurozone to replace Maastricht. It would not be difficult to redraft the Maastricht guidelines so that the adjustment was forced on governments during the strong part of the growth cycle rather than the weak part. Quite what the US will do I don't know. Up to now it has been in the privileged position of supplying the main reserve currency, so it is able to get away with policies the rest of us can't. But that position won't last, and you have in any case to ask whether it is in the country's self-interest to rely so much on Asian savings to fund its budget deficit.

Attitudes shift. We may be at an inflection point on fiscal policy, just as we were a generation ago on monetary policy. It is quite hard now to imagine a government minister setting interest rates. It may seem equally anachronistic for one to be determining borrowing requirements in another 20 years' time.

If that seems anti-democratic, consider this. A government is elected by the voters of the day. But should they have the right to load debts on to their children, any more than they have the right to damage their children's environment? Surely not.

Trust is essential to economies and societies if we are to progress

Following on the thought from above, morality is an aspect of economic life so there should be a special welcome to the lecture from Professor Sir Partha Dasgupta to the Royal Economic Society this week: his subject is law and morality in economic life.

He will make a number of points, among them:

*Trust is the fundamental building block of societies – without it, there is no basis for co-operation, which leads to progress and economic development.

*It is a lot easier to destroy a society than to build it. Rebuilding a community that was previously racked by civil strife involves building trust and that inevitably takes time.

*To co-operate, people must not only trust one another, they must also co-ordinate on "laws" or "social norms" that everyone understands and accepts as legitimate. However social norms only work when people value the future benefits of co-operation.

*The Montreal protocol has been a success, the Kyoto protocol a failure. The main reason was that perceived benefits relative to the costs of curbing CFC emissions were high so it was much easier for large numbers of countries to reach an agreement than over curbing greenhouse gas emissions.

*The social infrastructures that are necessary for co-operation are all too fragile internationally. This does not bode well for Copenhagen.

I would add that there are two arguments in favour of a high-trust society. One is that it is more efficient: lawyers fees can be saved and contracts altered by agreement if circumstances change. Once a company or an individual gets a reputation for fair dealing, future business becomes easier.

The second is that humans like relationships to be based on something more than a narrow trading of advantage. That is why, when trust is broken – as for example in the Madoff affair – people feel so devastated.

Warren Buffett, one of the few financiers to retain his reputation, puts it this way: "It takes 20 years to build a reputation and five minutes to ruin it. If you think about that, you do things differently."