Jeremy Warner: City bashing won't help public finances

Outlook Warren Buffett says his eyesight isn't so good these days, but even if it were fine, he doesn't think he'd be seeing too many green shoots. Even Lord Mandelson, unreconstructed optimist though he appears to be, sees no more than "green seedlings".

The Labour-dominated Treasury Select Committee has meanwhile dismissed the Chancellor's forecasts of economic recovery by the end of year followed by a rebound to above trend growth of 3.5 per cent from 2011 onwards as unrealistic. The National Institute for Economic and Social Research also challenges the Chancellor's assumptions and forecasts the worst economic contraction since the Great Depression. Hardly anyone, it seems, is prepared to predict a return to sunnier times any time soon.

Yet the stock market is roaring away as if already bathed in glorious spring sunshine. Are stock market investors as deluded as the Chancellor, or are they right to see reasons for hope? Nobody can foresee the future, and as every former chancellor will tell you, most economic forecasts, both official and independent, turn out to be bunkum.

The latest Cips survey data – on past experience a remarkably accurate lead indicator – seems to confirm the stock market's optimism. If Cips is right, then the contraction is already bottoming out and the economy may be starting to recover by the end of the year. All that policy action was bound eventually to have some effect, and it now seems possible it will kick in rather more quickly than once thought. The Chancellor may not turn out to be quite as unrealistic as the Treasury Committee supposes.

All the same, it's a steep hill he has to climb to reach those forecasts. So deep has the contraction in the economy already been that it will need to stop shrinking altogether for the remainder of the year, or alternatively rebound very sharply in the final quarter, for the Chancellor to stand any chance of meeting his forecast of a 3.5 per cent fall for 2009 as a whole.

Further out, the forecasts look even more challenging. True enough, past experience is that growth does indeed rebound sharply after recessions, but this is a very different kind of recession from almost any other of the post-war period. The current downturn results not so much from a classic inflationary boom but from a financial crisis. Go further back into history and you find that recessions caused by banking implosions tend to be deeper and longer-lasting, while the recovery is slower.

We'll see. What is undeniable is that the sheer size of the debt overhang that now needs to be worked off, both public and private, will crimp growth for years to come. Assuming consumer demand recovers at all, and that's a big if given rising unemployment and continued constraints on the banking sector's ability to lend, it's soon going to be hit by higher taxes. Demand in the economy will be further undermined by real cuts in public spending as the Treasury attempts to re-establish its grip on the public finances.

As yesterday's Treasury Committee report notes, even on the Chancellor's own forecasts for public borrowing and national debt, we are staring at the worst fiscal outlook since the Second World War. As it happens, the Treasury has a better record of forecasting the economy than it does the public finances. Only sometimes is it too optimistic about growth. Yet it almost invariably proves too optimistic about borrowing, particularly in a downturn. Outside analysts such as the National Institute and the Institute for Fiscal Studies think the deficit likely to be significantly worse than the Chancellor's already calamitous forecasts unless addressed by much steeper tax rises and cuts in public spending than forecast in the Budget.

Britain will emerge from the current recession with a structural deficit of some 10 per cent of GDP and national debt rising within five to six years to around 100 per cent of national income. Of the developed economies, only Japan is in worse shape. It took years of pain to put the public finances back on the straight and narrow after the last recession of the early 1990s, and back then the structural deficit – that is borrowing which is not going to disappear once the economy returns to growth – was only 4 per cent.

The causes of this extraordinary deterioration are now wearily familiar. Essentially the Government conned itself into believing it had found the Holy Grail of non-inflationary, permanent growth and had thereby brought about an end to boom and bust. At the same time it manipulated to destruction the fiscal rules it had designed to ensure prudent conduct of the public finances. The figures were fiddled and the duration of the cycle was adjusted to suit. Then finally the Treasury mistook the windfall profits of the housing market and financial services industry as a permanent addition to the tax base and spent accordingly. With the golden rule now blown away, to be laughably replaced by something called the "temporary operating rule", the only thing holding the Government in check are the disciplines of the gilts market, and even here the markets are being prevented from properly imposing corrective medicine because of the Bank of England's programme of "quantitative easing".

All this is piling up the most terrible problems for the next government. The greatest punishment the electorate could serve on Gordon Brown is not to throw him out, but to re-elect him, for he would then be condemned to having to clear up his own mess as his party tore itself apart in disgust around him.

The reason why national debt of the humungous proportions now being accumulated is so dangerous to the country's future is that once established it means nothing further can be borrowed to finance investment.

It also means that a very substantial proportion of the money being raised from taxes goes into servicing the debt, rather than paying for vital public services. Like the individual who has borrowed too much on his mortgage and credit card, the nation becomes condemned to working merely for the benefit of its creditors. By the time the bankers have been paid, there's nothing left for the loft extension, going out and overseas holidays.

Fortunately, all is not entirely lost. Countries can and do recover from similarly serious states of over-indebtedness. There are more reasons for hope than all this gloomy analysis might suggest. By assuming a substantial permanent loss of economic capacity as a result of recession, the Treasury may have been more gloomy than it needs to be about the size of the structural deficit. Nor is the financial services industry quite the dead parrot it is generally portrayed as. First into the downturn, the banking sector ought to be the first out again, and whereas it seems unlikely the City will return any time soon to the levels of tax generation seen during the boom, recovery may be faster than assumed.

Signs of that recovery ought to be apparent in first-quarter figures today and tomorrow from Barclays and Royal Bank of Scotland. Impairment charges continue to rise at an alarming rate, but underlying profitability is recovering fast. Banks are coining it in many areas of wholesale markets.

These observations may be hard to reconcile with reports that the US Federal Reserve's stress testing of bank balance sheets has revealed a need for an additional $34bn of new capital at Bank of America alone, but in fact such capital raising is only part of the catharsis that needs to occur before banks can start operating properly again. Though many companies are still finding it desperately difficult to secure credit on decent terms, the capital markets do seem finely to be healing themselves. This is a necessary precursor to wider economic recovery.

There seems little justice in banks, now widely depicted as a form of original evil, being the first to feel the warm winds of economic spring, but for better or worse, the City remains Britain's most successful and innovative industry and it is obviously important to the nation's future health that it is not completely trounced in the regulatory backlash now underway.

Despite the bank-bashing tone of the political rhetoric, the Government gets this better than you might think. A Treasury-sponsored report due to be published today on the competitiveness of the City will reaffirm the Government's commitment to nurturing and encouraging this industry. If nothing else, ministers see the City as a vital source of revenues with which to rebuild the public finances.

Danny Gabay, director of the economics consultancy Fathom, calculates that in the two decades since Big Bang, the City has added approximately a quarter of a percentage point annually to overall GDP growth. That adds up to quite a chunk of growth. The "greedy bankers" tone of the policy debate risks significantly impairing that contribution. Undermining the success of the City would be like ripping up the railroads after they were built because in addition to delivering progress in public transport they also gave rise to some robber barons. Nobody would be the richer for destroying the City, least of all the now virtually bankrupt public sector.

The main threat, on the other hand, comes not from the UK Government, but from Europe. Europe has little cultural understanding of these industries, so only sees their flaws and bad points. In Paris and Berlin, political leaders are determined to use the crisis to impose a long-sought crackdown. Oversight plainly needs improving, but it is vital to Britain that the baby isn't thrown out with the bathwater.