The giant gamble

Gordon Brown yesterday threw aside his caution in a bet that he can defy the laws of economics. If he is wrong, we will all pay the price

This is scary stuff. Gordon Brown traded on his reputation for prudence, whatever the substance behind it. His successor may, thanks to his mellifluous Edinburgh burr, present an even more polished image of care and caution. But the assumptions on which the whole superstructure of this Government's finances rest are really quite shaky.

In truth Alistair Darling's figures only add up if the global economic cycle is dead. If that proves the case, sure, we scramble by. But all past experience suggests that is unlikely in the extreme.

It is not, for example, what Alan Greenspan the former head of the Federal Reserve thinks. It is not, actually, what the Prime Minister thinks. Indeed that whole smart idea of Mr Brown all those years ago was to have a public finance regime that balanced current spending and taxation over the economic cycle. So the Government explicitly accepts that there is just such a thing.

But now there is no provision for it. We don't know the shape or timing of the cycle. What we do know is that there is no store of resources built up during the fat years, ready for possible leaner years ahead.

In that respect what this Chancellor is proposing is utterly different from what his predecessor did at the same stage in the cycle. In 1997, Gordon Brown started a war chest of budget surpluses. Now we have a slightly dodgy set of predictions.

So yesterday we had the new Chancellor melding together two set-piece statements – the annual pre-Budget report and the longer-term Comprehensive Spending Review – into the curtain-raiser for the election that never was. The appearance of prudence was still there; the appearance of more spending on health, transport and education was still there; the tax system was tweaked once more. As ever with this Government, the presentation was hugely political, the details opaque. But there was no acknowledgment of the chill winds now blowing across the world economy. It is a giant bet that nothing big will go wrong.

To see why, the best place to start is the economic forecast. The Treasury's expectation for growth next year has been cut from a range around 2.75 per cent to one around 2.25 per cent. That is already a little above the consensus of independent economists, which puts growth at 2 per cent. That may not be a huge difference and it may be that this turns out to be the case. But the forecasts beyond assume that after this slight slowdown next year things pick up again. And then things canter along fine into the middle distance, to 2012 and beyond. The Chancellor even managed to toss in a reference to investment to 2018.

But in the real world things happen. That is not say that the Treasury should predict a serious slowdown in its forecast. Rather it is to argue that plans for spending and taxation should take into account the huge uncertainties that the frothy housing market generates for consumer demand not just here but right across the developed world. You need a contingency reserve in your plans. There is none.

Move from the economic forecast to the fiscal position. On the official projections the budget deficit comes steadily down. But that is not happening in the real world. In the last fiscal year, the one that ended last April, the deficit was actually rather better than expected, thanks in part to higher VAT receipts, the result of the tail-end of the consumer spending boom. But this year it is projected to be significantly worse: worse than in 2006-07 and worse than expected in the last Budget.

It is difficult to see quite what is going wrong until we have had a few days to crawl over the figures but the main thing that seems to be happening is that tax revenues are coming in below expectations. If that is what happens when growth dips a tiny bit towards 2 per cent, what would happen were growth to fall lower still, as several financial market forecasters predict. What happens to spending if house prices start falling, as they are in Ireland and the US? There will be no spur to demand from higher public spending, as there has been for the past seven years.

The big point here is that the boost to demand from state spending is ending at just the time that demand from the consumer might falter – it hasn't yet but it might. Typically over those seven years public spending, financed by public borrowing, has been adding about half of one per cent each year to UK growth. It looks from the Comprehensive Spending Review as though it will not add any net demand over the next few years – i.e spending will grow slightly more slowly than the economy as a whole. You can have a debate about whether the money has been well spent. That matters a lot to those of us who pay taxes but in macro-economic terms it makes little difference. The fact that it is indeed spent adds to overall demand. That is now disappearing.

The result is that despite having enjoyed the country's longest ever boom, we are stuck with a deficit of a little under 3 per cent of GDP. That is about the top limit that is acceptable for a mature developed country. We are also stuck with a current account deficit of more than 3 per cent of GDP. We have been able to finance that so far, thanks to the flood of money coming into the UK. That in part does show confidence in the economy. But also reflects the fact that established British companies are probably quite lowly valued in world terms. We can go on like this for a while but not for ever. At some stage resources have to shift away from consumption to investment and exports. But if that were to happen VAT revenues would fall and the fiscal position would deteriorate. We are in a bind.

So what gives? Well maybe nothing. Maybe the country does scramble through, with taxes squeezed up just a bit, with house prices stagnant but not falling, with public services able to improve their performance without much more money to do so. Maybe the global boom carries on for the lifetime of this parliament. Maybe the new Chancellor is able to fiddle around with the tax rules so that people feel better even if they are not. The inheritance tax changes took the attention but those changes in capital gains tax may have bigger unintended consequences – we will have to wait a while to see.

Maybe, maybe, maybe. But it would be so much more comforting were Alistair Darling doing what Gordon Brown was doing at this stage of the cycle 10 years ago: building a strong fiscal position for bad times as well as good ones. He isn't.