Economics: Paying the cheque for boom times

THE Chancellor's luck may be turning. His Budget pleased the foreign exchanges, his key market audience. The pound rose as dealers perceived that his postponement of tax increases to April 1994 would help encourage the recovery. That in turn would limit any further cut in Britain's 6 per cent interest rates, and close the gap with Germany's 8.3 per cent rates.

Nor did the Budget cause too much depression in the bond or equity markets. Despite the unexpected surprise of a forecast pounds 50bn budget deficit in 1993/4 (borrowing of roughly pounds 875 per British resident in the coming year), the gilts markets consoled themselves with the thought that the tax increases in 1994 and 1995 really would rein in the deficit. Most of the changes will be put into law this year. Unlike gridlocked American presidents, British governments can deliver.

Shares were a little off colour, despite the package to help business and the better prospects for a recovery. This was in part because an interest rate cut looked less likely (although there will probably be another before the bottom for this cycle) and in part because of the changes in advance corporation tax. The pension funds, yielding up most of the pounds 1bn from the ACT changes in 1996-7, suspect that they have been spotted as easy cash cows. The trick was to cut the tax credit (or rebate) that they receive to compensate for the tax on dividends deducted by companies.

There has rightly been a political hue and cry about the lack of measures to offset the impact of the imposition of VAT on fuel on the poor, but the surprise overall is surely that the reaction to the Budget has been so docile. Given that Mr Lamont added the equivalent of seven pence to income tax in 1995-6, he might have expected a lynch mob in Whitehall. After this precedent, the wheeze of announcing tax increases for future years is likely to catch on.

Timing was part of the cleverness of the Budget. The Government was right not to endanger any recovery by raising taxes now. The modest pounds 490m rise in net taxation in 1993-4 is more than offset by an above-trend rise in public spending. If anything, a Keynesian budgetary policy is injecting up to 1 per cent of national income into spending power this year. This fiscal stimulus allays an important fear about the prospects for recovery and is in marked contrast with Lord Howe's 1981 Budget.

But the Government is also right to reassure the markets that it will take its fiscal responsibilities seriously when the recovery is under way. It might otherwise have faced a sharp fall in bond prices and sterling, dramatically increasing both the risk of inflation and the cost of financing the budget deficit. The price of using budget policy to support the recovery now is that the deficit must be cut back when the economy begins a spontaneous expansion.

The outlook, though, is still very uncertain. The pace of the recovery depends crucially on consumers' and business confidence. If people remain fearful of their jobs and worried about their high debt, the recovery will be driven almost exclusively by businesses that can gain market share at the expense of overseas competitors. Since businesses that produce such tradeable commodities are only a fraction of the whole business community, the recovery is bound to be slow.

But if the national mood changes, the recovery could be more brisk. The most recent crop of indicators has raised hopes. Manufacturing output was up in January, and retail sales volume recovered to its pre-recession level in February. Best of all, unemployment fell by 22,000 in February, a figure that was so surprising that the Department of Employment counted the returns again just to be sure. The drop was probably a quirk, but it is possible that the labour market is turning round more quickly than anyone had dared hope.

The Labour Force Survey, conducted between September and November last year, gives some clues about what may have been happening. It shows that the workforce (those in work and seeking work) appears to have shrunk by nearly 900,000 between the spring of 1991 and the autumn of 1992. This usually happens during recessions because people become so discouraged that they stop looking for jobs. But on this occasion, the survey shows that the rise in discouraged workers over the period was just 35,000.

There are only the most speculative theories about what is going on. The first is that the Central Statistical Office may have pulled off its old trick of underestimating the growth of the economy, and that the labour survey may in turn have failed to spot people doing odd jobs. The recent volatility of the numbers of people joining the unemployment count is some support for this view, since such bounciness tends to occur near turning points.

But there are two explanations of the missing workforce and the fall in unemployment which are less encouraging about growth prospects, at least in the short run. Thanks to the passing of the baby boomers, labour supply has shrivelled. There are some 250,000 fewer 16-year-olds now than in the depths of the last recession in 1980. Moreover, far more of them may be staying on at school.

There may be another reason for the fall in the workforce, particularly in the South where a lot of women work. Unemployed men whose wives are still at work cease to be eligible for benefit after 12 months. They may have decided to stop looking for work, and instead to take on responsibility for the children. This is a rational decision when the cost of care can be pounds 70 per child each week.

The uncertainties in the outlook are a powerful reason for the Chancellor to be flexible in his approach to policy. If the economy is strong, he has the option of restraining domestic spending either by raising interest rates or by raising taxes. In the short run, Mr Lamont might well opt for higher rates and a rise in sterling.

Policymakers were shaken by the weakness of the pound after the interest rate cut on 26 January, which was perceived to be the result of purely political pressure from the Prime Minister. (In fact, Eddie George and the Bank of England backed the Prime Minister against Treasury reluctance.)

But a rise in interest rates and the pound is not a happy solution for a country with twin deficits: a big budget deficit and a big current account deficit. It makes more sense to raise taxes (or cut public spending) and to keep interest rates and the pound low. Home spending would then be kept in check by tighter budget policy, which would also reduce the budget deficit. A low exchange rate would encourage exporters.

This Budget would then be a downpayment on a medium-term programme of deficit reduction, not the last word. On Wednesday, Mr Lamont gave a foretaste of what is to come when he was careful not to rule out further extensions of VAT. The 1990s are likely to be peppered with ingenious Treasury schemes for raising revenue, and for stopping us from spending money on imports.

During the 1980s, we lived beyond our means. During the 1990s, the bills will have to be paid.

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