Despite the Budget dodges, base rates must rise

`The real nightmare for the next Chancellor is not that spending numbers have been artificially massaged down by Mr Clarke, but that there is no spare capacity left in the economy'

This year's Budget preparations saw the Treasury taking hold of its piggy bank, turning it upside down, and shaking it for all it was worth. On finding remarkably little inside, the Chancellor could (theoretically) have chosen to abandon his plans to reduce the basic rate of income tax by 1p, a measure which had clearly been pre-ordained ever since the ink dried on the 1995 Budget.

In any year other than this one, that is almost certainly what he would have done. But in this pre-election year, even Mr Clarke, who has bravely stood up to almost everything the Right of his party has thrown at him over several years, decided that discretion was the better part of valour. The penny cut in the basic rate almost assumed the status of a "pre-Budget" measure, with everything else having to be built around that fixed point. Treasury officials would almost certainly have preferred a more contractionary Budget, but view the outcome as about the best that could have been obtained, given the political circumstances of the Government.

Undoubtedly, they feel that the net tax cut would have been far larger under almost any Tory Chancellor other than Ken Clarke. Clearly so, but it is hard from the outside to avoid the suspicion that a large number of corners were cut in the preparation of the Red Book figures, all in the aid of presenting a tenable path for the PSBR while also "affording" that penny tax cut.

The baseline for public spending failed to decline conveniently this year because of a favourable surprise on inflation, as it had in the previous two years, and spending departments resolutely refused to give ground to the Treasury in the autumn spending round. So, instead of relying on genuine savings, this year's "cuts" in public spending have required a series of subterfuges of varying validity. Luckily, all of these have been spotted by the financial markets.

So why is the Budget less tough on domestic demand than it looks? The simplest reason is that the lion's share of the cut in the PSBR next year (pounds 6bn out of the pounds 7bn drop) is not caused by policy measures at all, but by the automatic effects of faster GDP growth on the budget deficit. This should not really count as a policy tightening.

Then there are more detailed matters. First, while the Red Book claims that privatisation receipts will fall from pounds 4.5bn this year to pounds 1.5bn in 1998/99, the truth is that other forms of additional asset sales are hidden away in the figures, of which the most important are the sale of defence married quarters, and the student loan book. For reasons that have never been clear to me, these are scored as negative public spending within the control total, an accounting device which flatters the overall figure by around pounds 2bn.

Second, the Treasury has for the first time ever this year decided to base its forecast for social security payments on a forecast of declining unemployment, instead of simply assuming an unchanged jobless total. Literally hundreds of times in recent years, ministers have piously stated that it has never been the practice of governments to forecast the level of unemployment. All of a sudden, it is - and what a happy coincidence that this change has been made in a year when it is possible to forecast a fall of 400,000 in the jobless total, thus lopping another pounds 2bn off the spending total.

Third, there is the closing of tax and spending loopholes, which is supposed to reduce the annual budget deficit by pounds 3bn in three years time. The Treasury is bound to come under a great deal of pressure to justify this figure at the Commons select committee this week, since there must be a suspicion that this programme was plucked out of the air to make the Budget add up.

Treasury officials are apt to get quite indignant about this suggestion, arguing that the "spend-to-save" estimates are as soundly based as any others in the Red Book. There are, apparently, local pilot studies which "prove" that for every pounds 1 spent on extra checking, the Government saves pounds 8 in reduced fraud. But why has this only become apparent this year, following several years in which the government was abusive towards Gordon Brown whenever he suggested that money could be saved by closing loopholes? And why stop at saving pounds 3bn, if this procedure has suddenly become so straightforward? The answer is presumably that there are diminishing returns to this type of effort, but then how can we possibly know where they will set in? All in all, it seems awfully convenient that these savings have popped up just before an election.

Probably this is all a mite too cynical. This Budget could have been a whole lot worse, since it is certainly true that around two-thirds of this year's income tax cut has been offset by genuine tax increases elsewhere.

Furthermore, in one important aspect of preparing a Budget, the Treasury has been much more forthcoming than ever before. This concerns the crucial matter of how far below capacity the economy is now working (answer: the Treasury reckons there is an output gap of 0-3 per cent, with the Budget based on a central estimate of 1.5 per cent), and how fast the economy can grow on trend (answer: 2.5 per cent per annum). Combining these two figures with the rest of the Treasury's forecast, we can deduce that it expects output to return to trend at the end of 1998/99, at which point the PSBR should be dropping below 1 per cent of GDP.

If this calculation proves to be wrong, it is much more likely to be because the estimate of the output gap is wrong, rather than because any of the details of the tax and spending programmes proves misleading.

The real nightmare for the next Chancellor is not that the spending numbers have been artificially massaged down by an outgoing Mr Clarke, but that there is no spare capacity left in the economy. If that turns out to be true, then everything is about to go wrong, not just the PSBR.

That is now a matter to be addressed by monetary policy. The Bank of England will certainly have spotted the Treasury dodges, which means that the Governor is unlikely to share the Chancellor's view that the Budget has substantially reduced the need for further base rate rises.

As the graph shows, overall monetary conditions have been tightened sharply in recent months, even though base rates have increased by only a quarter point. But the reason for this is the 10 per cent rise in the exchange rate, which is included in the monetary conditions index shown in the graph.

Since neither the Bank nor the Treasury believes that sterling should be counted as an independent monetary instrument, this will not deter officials on both sides of town from pressing for more base rate rises soon. The Chancellor may not agree, but it is doubtful that he can hold out until the election all on his own. Good economics now requires higher interest rates, whatever good politics may imply.

Gavyn Davies is chief economist at Goldman Sachs.