Hamish McRae: The squeeze on public spending has begun

Things are going wrong. We are a week away from the Budget, one that seems likely to be the most sombre since Labour took power in 1997. It is Alistair Darling's misfortune that he should be the poor chap that has to present it. What should we look for next Wednesday?

There are always two stories in a Budget: what is happening to the economy and what the Chancellor is doing to spending and taxation. For the past decade, the first story has been mostly an optimistic one. You can have a debate about the extent to which the foundations were laid by the previous Tory government but the fundamental story – that Britain is one of the best-performing large developed nations – could not be challenged.

The tone of the second story was also reasonably positive, though maybe less so the closer one looks. Leave aside whether the previous Chancellor was right to cut public spending so savagely in his early years and then expand it so massively thereafter. Leave aside the charge that he fiddled about with taxation, making it much more complex. Leave aside the parallel criticism that he tried to micro-manage the Government's spending through a plethora of targets, often leading to perverse results. The plain fact is that he just about managed, with a bit of creative accounting, to stay within the fiscal framework he set himself.

Both these broadly positive tales have now come to a natural end. The economy is about to slow, though we don't know by how much. More troubling, we can now see that its good growth was to some extent puffed up by rising house prices and rising debts. In addition, we have gone, over the past ten years, from running a current account that was roughly in balance to one with a deficit of some 5 per cent of GDP. Finally, inflation is the highest it has been since the early 1990s.

As for the public finances, whereas at this stage of the previous economic cycle the Budget was moving towards surplus, we are now stuck with a deficit of more than 3 per centof GDP. That is with the economy growing at more than 3 per cent a year, making you wonder what will happen as growth slackens. Well, that is the background; what are we likely to learn next week?

The starting point has to be what the Treasury thinks will happen to the economy. We should take this seriously because its judgement on the economy has been pretty good. It has in the past appeared to be over-optimistic about growth, leading to a fair amount of criticism from outside economists, including myself. Then, hey presto, it would turn out that the Treasury had got it right and it was the rest of us who were wrong. That happened last year, when growth turned out to be quite a bit better than the consensus of economists had expected.

Growth will be slower this year, with the consensus now expecting growth of about 1.7 per cent The Treasury gives its forecast as a range, not a single number. So if its forecast has a central point of 2 per cent or more in the growth range, we should take that seriously because it would be markedly better than most people now expect. That would be good news for employment, though maybe less good for homebuyers, for it would mean that any fall in interest rates would be more muted. If, on the other hand, the central point is 1.5 per cent or lower, then it is time to be concerned.

The other bit of the forecast to look for is the Government's borrowing requirement. There are two numbers, the current deficit and the total one. Ignore the current number because, though the previous Chancellor made a lot of fuss about not borrowing for current spending over the cycle, what really matters is total borrowing. For this financial year, i.e. the one that ends this April, this will be about £40bn – we won't have the final number because the financial year isn't over yet. But what matters is the estimate for next year. That will be the outcome of growth on the one hand and tax and spending policy on the other.

What we really need to know is (a) how bad is the underlying situation, and (b) is the Chancellor going to try and run a looser or a tighter policy. I cannot believe he will tighten policy, for that would make no sense to do so right now. The time to tighten policy is when the economy is growing swiftly, not when it is slowing down. There is certainly a problem, however. We just don't know whether it is a £40bn one or a £50bn one.

That moves us to the second story: the decisions about tax and spending. The tax thing has been fascinating. We have had rows about taxes in the past. But it is hard to think of any time when, ahead of a tax change, there has been such vigorous lobbying as there has been over the changes in capital gains tax and the treatment of non-doms. Yet the effect on the public finances of both of these is tiny.

The Treasury's own estimate of the addition revenue from non-doms is £800m, subsequently falling. That is less than 0.2 per cent of tax revenues. Actually, there are good reasons to suspect that the changes will be negative to revenue: the Exchequer may lose more than it gains. As for capital gains tax, it brings in less than £5bn, or 1 per cent of revenues. That is worth collecting, of course, but compare it with income tax, which brings in £150bn, or VAT, at £80bn. So you have another huge row about a piddling tax.

This makes no sense. You have a punch-up over big numbers, not little ones. So, for the Chancellor to find himself in this predicament suggests something else is going wrong in the decision-making process. It won't be just his fault. It may be that there is an interfering and dithering Prime Minister. It may be that the Treasury is demoralised by having a lot of good people being hauled over to No 10 to try to beef things up there. Whatever the cause, this is not good. You can always have one-off cock-ups, such as the mishandling of Northern Rock. But there is something deeper going wrong and that is troubling.

We may get more of an understanding when we see how the relationship between the Treasury and other departments evolves in the coming months and that, in turn, will depend on what happens to public spending. That is the final element of the Budget jigsaw.

The squeeze on public spending has now begun. It will go on for three or four years, maybe longer. How that squeeze will be presented will be fascinating: forced increases in the presumed productivity of government departments, so that the Chancellor (and the Prime Minister) can pretend there is really no squeeze at all? Or an acknowledgement that these are tougher times for all? But however the numbers are presented next Wednesday, expect a marked change in mood from the bombast of yesteryear – and not only because of the change of personalities involved.