Economics: Stand by for action on tax and spending

THE CABINET reshuffle marks the final demise of Thatcherite influence on economic policy. From the days of Margaret Thatcher's battles with the 'wets' in the early Eighties through to her resignation in 1990, every member of the Cabinet's economic committee was selected because they were dry on the economy: believers in the market; anti-interventionist; anti public spending; and pro tax cuts. Subsequent splits on the issue of the exchange rate between Lawsonian fixers and Thatcherite floaters should not disguise this truth.

Now there is only one member of the economic committee who is still unequivocally dry in traditional terms: Michael Portillo, the chief secretary to the Treasury. As the only member who is second minister in a department, he is also the most junior. The Prime Minister has been revealed as a closet wet who now presides over a Cabinet where the principal heavyweights - Douglas Hurd and Kenneth Clarke - are also from the centre or left of the party. The other economic ministers are like-minded. David Hunt, newly at the Department of Employment, is a wet. In economic terms, so is Michael Heseltine, the President of the Board of Trade.

The appointment of Mr Clarke, a lawyer whose political career has taken him rapidly through the Department of Trade and Industry, Health and Social Security, Education and the Home Office, also brings to an end Mrs Thatcher's practice of grooming her senior ministers by giving them a spell at the central department of Government - where they could be tutored by the Treasury knights in the ways of liberal economics and could acquire a healthy suspicion of pressure groups and spending ministers. For Baroness Thatcher, Norman Lamont was still 'one of us'. Mr Clarke, notwithstanding his bullying tactics with public sector workers when he was a spending minister, is emphatically not.

The lack of a Treasury education is no great handicap for an astute politician. Lord Healey had no experience at the Treasury before his elevation to the Chancellorship, and neither did Lord Jenkins. Both were admired by their peers. But the Chancellorship is quite unlike any other great office of state because the holder has to worry not only about his political audience but also the reaction of the financial markets, particularly the foreign exchange market. The travails of sterling have kept many a Chancellor awake at night. A word out of place can lead to a crisis rise in interest rates.

This big political shift in the economic team does not mean that there will be a seismic change in policy. After so many years in government, circumstances and pragmatism are a more profound influence on economic policy than ideology. But the key change in personnel is likely to affect many of the big decisions over the next few years, and their impact will accumulate. In five years' time, we will have travelled far away from Lady Thatcher's rhetoric and prejudices.

The new government will be more open to developments on the Continent and more worried about being left outside the mainstream of Community affairs. That does not mean we will re-enter the exchange rate mechanism quickly. After all, Mr Clarke has gone out of his way to state that he does not foresee our re- entry this side of a general election. But we are more likely to lean towards that outcome when the state of the German economy looks as if it will deliver interest rates that will also be appropriate to the state of Britain's.

Whatever the attitude at Westminster, the business community regards the epithet 'European' as a compliment, because it knows where its markets and profits lie. With Maastricht approved, we may find ourselves edging towards the fast lane on a single currency after all. Moreover, even a post-election re- entry into the ERM still leaves open the possibility of membership before the first 1997 deadline by which a single currency might be decided, let alone the more probable 1999 deadline.

In the short term, the more significant decisions over which Mr Clarke may temper the Thatcherite instincts of his predecessors concern public spending and taxation. Mr Clarke is no softie. Indeed, he is something of a bruiser, which is why some City people are optimistic that he will be able to deliver larger cuts in public spending than Mr Lamont ever could, whatever his private hopes and inclinations. On this issue, though, the jury is out.

Mr Clarke has a choice to make between good but difficult policies, and bad but popular ones. He undoubtedly has the political clout, talent and skills to pursue the good ones. These will involve an inevitable squeeze on public spending, combined with a sharp rise in taxation. It was right to run a large budget deficit while the economy was still in deep recession. But now that the recovery is clearly under way, that deficit must be cut back.

The prospective budget deficit is pounds 50bn this year, or some 8 per cent of national income. The interest cost of that extra debt alone amounts to some pounds 4bn each and every year, which in turn is more than 2 1/2 pence on the basic rate of income tax. If the deficit is not cut back sharply, either future generations will have to pay a rising burden of tax just to service the debt, or governments will be tempted to print the money and inflate their way out of trouble. Either way lies economic trouble.

SO THE deficit must be cut. Up to half may disappear in the course of the recovery through the natural uplift of tax revenues and the fall in public spending on unemployment benefit and nationalised industry deficits. A further half of the remainder might sensibly be regarded as legitimate borrowing against capital projects that will yield a respectable return for years to come - a logic any business person will appreciate. But perhaps pounds 12.5bn needs to be cut through hard decisions.

This is where the temptation to pursue a bad policy arises. Mr Clarke will be able to point to a dwindling public sector deficit merely because of the recovery. He will therefore have ample opportunity, at least for two or three years, to avoid harsh choices. Moreover, the risks that this course of action will pose for inflation will not become apparent for some time, and can be temporarily assuaged by pursuing in due course a tighter monetary policy: higher interest rates and a higher pound. In other words, Mr Clarke could opt for a dash of Reaganomics.

In so doing, Mr Clarke would be able to avoid pitched battles over the abolition of ancient army regiments, the cancellation of whiz-bang defence projects, the pruning of middle-class privileges such as free university fees and state pensions regardless of private means, and the increase in taxes whether on spending (which would push up inflation and threaten the Government's 4 per cent ceiling) or on incomes (which would not). He could, in short, avoid painful brickbats.

Then he could also adopt the policy that many senior officials in the Bank and Treasury like in any case. By letting sterling rise, he would buy lower import prices and inflation, and hence higher living standards for those still in work. The cost of this policy would be a harder squeeze on our exporters, and a worse balance-of-payments deficit. But those costs might only become apparent long after Mr Clarke had left the Chancellorship. He might even find an opportunity, the cynics argue, to displace his next-door neighbour at Number 10, an ambition he publicly avows.

This scenario cannot be ruled out of court, but I am more optimistic. John Major's appointment is not as brave as it looks, for any successes won by Mr Clarke will reflect well on Mr Major too. The Downing Street neighbours are yoked together for good or ill, sharing both glories and failures. Chancellors rarely succeed in undermining and then replacing their boss. Even David Lloyd George did so only after a period as Secretary for War, and with the support of disgruntled Tory coalition partners. Good Chancellors tend to be respected rather than popular. Mr Major should be safe.

The corollary is that Mr Clarke has a robust interest in succeeding Mr Major after the next election, rather than ousting him before it. He must therefore look to the medium- term effects of his policies. That means tackling the public sector deficit with enough urgency to enable him to deliver income tax cuts in time for the next general election between April and June 1996. Stand by for an exceptionally rough round of spending and tax decisions.

Such considerations should also drive the new Chancellor towards the right monetary policy. A steady tightening of fiscal policy will dampen government and consumer spending. It will mean that interest rates and sterling must be kept low if the recovery is to be sustained.

This may in any case accord with Mr Clarke's natural predilections. He is an East Midlands MP who has spent more time listening to manufacturers than City financiers. Like Churchill, he will prefer finance less proud and industry more content, and he will be right to do so.