The outcome of Britain’s general election was a political disaster. No party achieved a majority of parliamentary seats, so the Conservatives were forced into an unnatural coalition with the Liberal Democrats. It’s designed to hold together for five years, but I doubt it will last two.
There are major policy differences between the two parties (especially their fundamentalist wings) on issues such as the UK’s relationships with Europe. And the new government is going to face intense public hostility to painful decisions it cannot avoid given the depth of the crisis in the nation’s government finances.
The big issue that politicians of all parties tried to avoid talking about in the election campaign was what specific measures they would take to tackle the nation’s enormous fiscal deficit. For every four pounds the British government is spending, it borrows a pound.
New borrowing each year is adding so fast to the national debt that the Bank for International Settlements (the “central bankers’ club”) reckons that without radical change the interest costs of state debt will double within a decade to 10 per cent of national output, and would reach an impossible 27 per cent by 2040.
The politicians dodged the question because reducing the fiscal deficit each year to an acceptable level requires a combination of spending cuts and tax increases on a horrendous scale.
Most experts reckon that, in addition to plans already announced by the main political parties, the average British household is going to have to pay between £2,500 and £4,000 a year in higher taxes or value of lost benefits.
Most voters are not yet ready to face up to the scale of the problem nor to pay the price of addressing it. Opinion polls have been showing this. Indeed, nearly half the 6 million-odd employees in the bloated public sector not only refuse to accept the need for cutbacks – they actually think state spending on public services should be increased.
Against that background, it is hardly surprising that the politicians preferred to posture, having heated arguments during the election campaign over their different proposals to cut the fiscal deficit by relatively trifling amounts.
There are major political disagreements about how the pain of paying for debt reduction should be distributed between spending cuts and tax increases, where spending cuts should fall, and what taxes should be increased.
Evidence suggests that cutting spending is more effective in reducing fiscal deficits than increasing taxes, and less damaging to economic growth. But those on the Left are more comfortable with higher or new taxes – providing they’re levied on “the rich” and on companies — than on deep cuts on spending on “public services.”
Their focus is on “fairness,” wealth distribution and equality, rather than on stimulating stronger economic growth. In this they reflect the predominant values of British society.
But this ideology-based political bias does divert attention from the need for the truly difficult large-scale adjustments necessary over the long term to deal with the huge fiscal deficit.
For example, the Liberal Democrats and others on the Left want to scrap the commitment to modernize Britain’s nuclear strike force of four nuclear-missile-launching submarines at a predicted cost of perhaps as much as £100 billion. But that expense would be spread over 25 years, and be a tiny fraction of state spending over that period.
This and other populist nostrums such as additional taxes on “the rich” (how you define that category depends on the strength of your socialist beliefs) would do little to address the problem of the fiscal deficit.
Huge tax increases are inevitable
That requires major surgery such as raising the basic rate of value added tax – essentially a broad-based consumption tax – from 17½ to 20 per cent, which would boost revenue by about £12 billion a year. Or increasing the basic rate of income tax from its current 20 per cent, where each additional percentage point would bring in almost £5 billion.
Arguments within the coalition over how to distribute the pain of dealing with the fiscal deficit must be intense as the new government prepares an emergency budget.
The much-publicised fear is that if the new administration does not act forcefully enough to address the fiscal problem, the markets will lose patience:
► If investors in UK government bonds (“gilts”) fear that Britain, with a level of relative over-spending even greater than Greece’s, could be heading towards a similar crisis, they will start demanding much higher rates of interest to compensate for the risk.
This would make it increasingly expensive for the Treasury to borrow the money needed to finance the government’s excess of spending over income.
More importantly, it would tend to drive up interest rates generally, damaging economic recovery.
► If investors in sterling assets of all kinds fear that the pound will lose significant value in terms of other currencies, they will be motivated to switch their funds into other currencies.
That can snowball, producing a sterling crisis. It has happened before when British politicians failed to show the courage to deal with major economic problems.
Such a fall in the value of the pound would squeeze British living standards and probably force the government to go cap-in-hand to the International Monetary Fund for a rescue. Bureaucrats in Washington would tell London how to run Britain. It has happened before.
There are two questions I’ll now try to answer – what ought to be done, and what do I expect to happen?
Internationally, there is currently a wave of hysteria about fiscal deficits and government debt. It is important to keep a sense of perspective.
There are two drivers of fiscal deficits. One is structural (permanent) over-spending brought about by irresponsible governments. The other is the economic crisis, which has depressed tax revenues and boosted the costs of providing welfare such as unemployment benefits.
The latter problem will largely right itself with economic recovery – although not entirely if, as I fear, the global economy has entered a long period of low growth.
Cutting billions out of state spending
Structural over-spending is a different matter. And tackling it is going to be extremely difficult politically. Inevitably the suffering will be focused on smaller businesses and the ordinary folk who constitute the bulk of voters. Politicians, bureaucrats, bankers, big companies and the rich will undoubtedly find ways to shield themselves against most of such pain, as they usually do.
Britain faces having to cut tens of billions of pounds from government spending to achieve the Treasury’s target of a halving in four years’ time of the level of budget deficit relative to national output – now at more than 11 per cent, the second worst level in Europe. Yet that target would still leave the annual deficit far too high, and not reduce by a single pound the national debt accumulated from financing past deficits.
While promising tough action to address the fiscal crisis, the coalition parties have actually taken policy decisions that make it far harder to do so:
► The agreement to bring about a coalition provides for huge additional spending or tax cuts. According to the Treasury, they would boost the amount that will have to be found from spending cuts and tax increases to meet the 2013-14 deficit reduction target from £37 billion a year to £57 billion.
To form a “stable government” in “the national interest” to tackle the fiscal deficit, the two coalition parties actually added £20 billion a year to the problem! How do you like that for political dishonesty?
► Because of guarantees that major politically-favoured areas of government spending – the National Health Service, education and overseas aid – will not be reduced, the full burden of cuts will fall on the rest. The deficit reduction target implies a 22 per cent cut in spending on “non-protected” items such as welfare benefits and defence.
to be continued – The truth about cutting out waste
CopyRight – OnTarget by Martin Spring