The economy and public finances. Down but not out

Don't write off the chancellor of the exchequer

FOR the Conservatives under their new leader, David Cameron, the main target is not Tony Blair, who will bow out before the next election. It is Gordon Brown, the man who seems certain to replace him. This week must have appeared the perfect opportunity to take a pot at the chancellor of the exchequer. The day before Mr Cameron was declared leader, Mr Brown presented his ninth pre-budget report - in effect, a mini-budget - from a much weaker position than the commanding heights he has so often occupied.

Mr Brown takes pride in his new monetary and fiscal arrangements for running the economy and public finances. Unfortunately, they have not prevented some familiar old faults from emerging. On December 5th, the chancellor had to concede the inevitable: that the economy will grow in 2005 by only 1.75%, half the rate he had forecast in his March budget. Furthermore, he now expects only a modest pick-up next year, with growth of 2-2.5% in 2006, a lower rate than he predicted in March.

Along with a spluttering economy, Mr Brown had to own up to another set of disappointing figures on the public finances. The budget deficit will barely improve this year, edging down to GBP37 billion ($64 billion) from GBP39 billion in 2004-05 (worse than the GBP34 billion estimated in the budget). This is the third successive year in which the deficit has been at or above 3% of GDP. And in 2006-07, the chancellor expects a deficit of GBP34 billion, sharply higher than the GBP29 billion he forecast in March.

This was enough to cue an over-the-top attack from George Osborne, the Conservative shadow chancellor. Anyone listening to his speech might imagine that Mr Brown had totally lost his grip, and that the economy and public finances were going to hell in a handbasket.

It may not be the best of times for Mr Brown but in truth it is not the worst of times either. Growth of 1.75% this year is disappointing, given an underlying trend rate of around 2.5%. But for the fifth year running it compares favourably with the performance of Europe's other big economies. In forecasts published on November 29th, the OECD said France would grow by 1.6% in 2005, Germany by 1.1% and Italy by 0.2%; and it predicts that Britain will stay ahead in 2006.

A more pertinent worry is that growth will probably stay subdued over the next few years. At best, the prospects for consumers are dispiriting as stagnation in the housing market stifles the feel-good factor. As the economy shifts its emphasis from consumption towards exports and investment, it is likely to grow more slowly than usual. Furthermore, the underlying growth of capacity will be trimmed as high oil prices make some energy-intensive capital unprofitable to use.

Mr Brown is more vulnerable on the public finances than on the economy. An irresponsible spending spree and a string of deficits have undermined his earlier claim to be a prudent chancellor. The deterioration in Britain's budget balance since 2000 has been the second-biggest among rich countries.

Once again, however, the news is bad rather than terrible. A budget deficit of 3% of GDP, while unwelcome, is not disastrously high, especially since Britain's stock of outstanding public debt is low by international standards. More important, the public finances are arguably doing rather better than might be expected in a weaker economy.

Mr Brown pays especially close attention to the current-budget balance, which excludes investment. This is because it determines whether he will meet his "golden rule" of borrowing only to invest, measured over the economic cycle. The current budget remains in deficit, but the gap is expected to narrow from GBP20 billion in 2004-05 to GBP10.5 billion in 2005-06, a creditable reduction given the economic slowdown (see chart). Corporation-tax revenues from the financial sector have been quite healthy. And higher oil prices have boosted receipts from North Sea oil.

Whether or not this improvement can be sustained is moot. Most analysts reckon that there is a hole of at least GBP10 billion in the public finances. Judging by the measures Mr Brown announced this week, he agrees with them. But it seems that he will not fill the hole with a similar-sized tax increase in his 2006 budget. Instead he has taken a swipe at North Sea oil producers, helping himself to a further GBP2 billion a year. The move has infuriated oil companies (see box).

More unexpectedly, the chancellor intends to squeeze spending from spring 2008, when the next set of expenditure plans comes into effect. Current spending will grow in real terms by 1.9% a year in the three years to 2010-11, somewhat less than likely economic growth. The resulting squeeze will deliver spending in five years' time that is some GBP8 billion less, in today's money, than was previously expected, according to the Institute for Fiscal Studies, an independent think-tank.

Mr Brown is writing the third act of his lengthy stint as chancellor. In the first, from 1997 to 1999, he controlled spending rigorously and pushed up taxes. In the second, which started in 2000, he pumped up spending and ran big deficits, despite a substantial tax increase in his 2002 budget. Now the prudent-turned-prodigal chancellor plans to clamp down on spending in the second half of this parliament, when he expects to be prime minister.

Mr Brown cannot claim a return to prudence, however. For one thing, he is taking a risk by postponing the harsh medicine, since it leaves him with little room for manoeuvre if things go wrong meanwhile. For another, his forecasts assume that economic slowdown has opened up plenty of spare capacity, which will allow strong recovery in 2007 and 2008.

This optimistic view is not shared by the OECD, which said in a survey of the British economy in October that "output remains close to capacity". And Mr Brown has again altered the dates of the cycle over which the golden rule is assessed, so that it extends for 12 years to 2008-09. This latest change has robbed it of what little credibility remained to it as a guide to his fiscal performance.

Despite these risks, the political attractions of the chancellor's strategy are clear. It will be much harder for the Conservatives to argue for lower taxes if Mr Brown is already tightening spending budgets and seeking better value for money in public services. As long as the economy avoids a recession, Mr Brown will still be a formidable foe at the next election.