The hole we are in and how to get out of it

The UK economy has become obese. The country has been bingeing on debt, and over-consuming without working off the excess. The result is an overweight economy with unproductive, clogged arteries.

The UK is entering recession in a vulnerable state, with high public and household debt, a growing structural budget deficit in the public finances, a large trade deficit and wasteful public spending, all predicated on over-optimistic forecasts of GDP growth and tax revenues.

The crisis in the financial sector means that this recession could be the worst since the War. It will feed on itself: next year, the credit crunch will give way to a consumption crunch and a “demand black hole”; and high defaults on corporate and household loans will put financial institutions under renewed pressure. More bailouts may well be needed.

The long-term health of the public finances is parlous. In its Pre-Budget Report, the Treasury estimates that the UK’s structural deficit will deteriorate to 7.2 per cent of GDP in 2009-10. In addition, the Government has very large long term spending commitments in respect of pensions and education. Taking these and the Chancellor’s fiscal stimulus into account, the UK faces tax increases of 10.2 per cent of GDP, or £140 billion per year – almost £6,000 for every family.

The Government’s announcement in the Pre-Budget Report of unfunded tax cuts present a paradox: for an economy which has been stricken by unsustainable levels of debt they recommend as a solution a further increase in debt. As Art Laffer has shown, the combination of higher taxes for high earners and lower taxes for low earners will depress tax revenues and worsen the hole. The public spending stimulus will take too long to take effect and will crowd out private spending.

The Chancellor’s fiscal stimulus package is not only likely to see poor results in increased economic activity; it is damaging in sending the wrong signals. The impact on consumption will be small and transient and likely to be offset by the loss of confidence. Just because it is favoured by the economic and business establishment does not make it right.

Crisis cuts in public spending advocated by some would also be a bad solution. They increase inefficiencies, by prompting the loss of experienced and capable staff. They are also self-defeating. As the experience of the mid-1990s showed, electorates react to perceived under-funding of the public sector by supporting higher spending later on.

In order to move beyond the obese economy, Britain has to consume less and work more. Households need a sense of direction towards a higher saving, lower tax economy. The short term objective is the same as the long term path to economic growth – to increase productivity. This should be the theme of Budget 2009, and the focus should be on three key areas:

  • The first days of a recession are the best moment to set the public sector on a path of taxpayer value. The Chancellor should announce that Budget 2009 will set out a new Comprehensive Spending Review. This three-year plan would undertake the programme of reform that the Government did not introduce in the good times.
  • Private sector productivity should also be boosted. A recovery requires a sustained transfer of resources and investment into the private sector. Supply-side reform, the promotion of industrial competition and deregulation in key areas are crucial to stimulate growth. The latent advantages in the economy need to be fostered to raise Britain’s competitive position.
  • Individuals will be vital to an economic revival. To create a mobile economy and reduce wasted talent in the recession, individuals need to be empowered to take control of their own lives, spend more of their own money and invest in their skills and careers.

The sooner the long term problems that caused the obese economy are addressed, the sooner the economy will start growing again. At the heart of this has to be a change of culture towards a fitter and healthier economy: a better ratio of income to consumption; a better balance between savings and debt; and a healthier mix between the public and private sectors, and between industries.