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The Chancellor's Prayer


WHAT to make of the Budget now the media dust has settled? George Osborne must be saying a little prayer to the Treasury gods. Unlike last year’s disastrous presentation, he got away with it.

Mind you, it helped that there was nothing very much in the 2013 Budget.  By sticking rigidly to his austerity script, Osborne could do nothing but fiddle at the edges, fiscally speaking.

Sure, a raft of planned tax cuts were brought forward and the employer’s national insurance holiday for SMEs is welcome. But these changes were minor given the scale of the crisis – output is down 15 per cent on where it should be this year. And the tax cuts were paid for by departmental spending cuts that made the whole Budget fiscally neutral.

The penny off a pint was a cheap stunt while the ill-defined scheme for the Treasury (aka taxpayer) to underwrite mortgage lending has a fatal flaw: house lending is not being curtailed by excess risk. Rather, banks won’t lend because they are obliged to build up excessive capital reserves if they do. So don’t hold your breath waiting for an expansion of the property market to lead us to recovery.

However, I read a bit more into the 2013 Budget than the Chancellor marking time. Actually, I think this year’s Budget shows that Westminster’s politicians of all stripes have finally run out of ideas.

Osborne himself now seems content to rely on the new Governor of the Bank of England, Mark Carney, as a possible game changer. Carney will now preside over a very New Lady of Threadneedle Street. Not only does he control the levers of monetary policy and financial regulation, the Chancellor has now made the Canadian responsible for UK growth as well. It is all going to end in tears.

Let me redefine the economic problem in Britain: the price mechanism is buggered (if I can use a scientific term). Until it is allowed to work its own self-correcting magic, we are destined to wallow in stagflation very much as Japan has done for over a decade.  Osborne’s fiddles - not to mention any Ed Balls has in store for us – are only compounding the fundamental problem.

Capitalism allocates resources to where it is most productively used. That’s why it is the most successful economic engine of growth ever invented. Unfortunately, we have turned off the engine and the politicians are trying to push.

It started when Gordon Brown (with the connivance of Mervyn King at the Bank of England) engineered a financial bubble between 2003 and 2008. Brown ran a budget deficit equivalent to 3 per cent of GDP at the top of the boom? This was his ticket into Number 10 but where was he going to find the tax revenues when the boom faltered? Brown and King are also responsible for the lax banking supervision that tuned a bubble into a credit crunch.

All of this distorted relative prices disastrously, creating over-investment in the property market and insane house prices. All that George Osborne seeks to do, by the way, is restore this financial merry-go-round using subsidies from the taxpayer. Comparing him, as was done this weekend, with Margaret Thatcher is definitely misplaced.

Come the 2008 crash and we go a second round of price distortions. Banks that should have been allowed to fail (or at least see their proprietary trading arms disappear) were put on a state life-support machine – a mistake they did not make in Iceland and shouldn’t in Cyprus. Next, interest rates – the most crucial price signal of all – have been cooled to near zero by (effectively) printing money at the Bank of England.  What’s more, it is clear that the Bank under Carney will keep rates on the floor indefinitely.

Whatever the short-term gains to low interest rates (and they are many) keeping them low for a decade or more will inevitable come close to destroying the price mechanism altogether.

For a start, it is disguising the colossal mountain of personal and company debt that exists. The moment mortgage interest rates hit anything like normal, negative equity will destroy consumer spending. Average interest rates hovered around 6 per cent in the late 1990s and early 2000s. In the 1980s and early 1990s, they were double that!

Put another way, we live with near zero interest rates, destroying the will to save, or we risk blowing up the economy.

If you remember Sandra Bullock in the movie Speed, who couldn’t stop the bus or it would set off a bomb, then you’ll get the picture. The problem is obvious: we are trapped in a situation in which all investment decisions are being grossly distorted by these low interest rates. The entire financial system is being twisted – and Mark Carney is going to perpetuate that.

Chancellor Osborne is only adding to this mess. Consider: One way out of the pricing distortions I have described is a short, sharp fiscal shock. This is what the Baltic States did after 2008. You eliminate fiscal imbalances at one go, and reset the price mechanism.

 The Nordic countries did the same thing after their mini banking crisis in the 1990s. Provided you have a good stock of skilled labour and technology, the price mechanism will allow you to snap back into growth very quickly. Why? Because that’s what the price mechanism does – allocates productive economic resources to where they will be used efficiently, not where politicians think they should go.

It is a brave politician who would contemplate such a fiscal ‘purge’. They’d probably lose the next election, even as the economy recovered. It is also probably easier to execute such ‘tough love’ in a small nation where you can mobilise cross-party support. (Memo to the SNP: how will a newly independent Scotland find the fiscal room for manoeuvre it desires unless it sheds the debt overhang it inherits from Messrs Brown, Darling and Osborne?)  

Of course, George Osborne has not gone down this road, whatever Labour and Ed Balls argue. The Coalition Government has opted for a grand fudge.  It is not cutting total spending (so we keep the debts and high taxes) yet neither is it giving the economy a fiscal boost! In fact, Osborne now plans to spend circa an extra £245bn this parliament beyond his original estimate of 2010. That’s more than Alistair Darling was going to inject. But Osborne is tail-ending events. His extra borrowing is to make up for tax recipes he has lost through slowing economic growth.

Result: the UK economy is hogtied by high taxes yet simultaneously a National Debt that is increasing as a percentage of GDP. At the same time, the price mechanism is not being allowed to allocate resources, thanks to near zero interest rates and a plethora of state subsidies in housing and bank lending.

How is this mess going to lead to sustainable growth driven by private sector investment, as the Chancellor maintains?

Answer: it’s not. Welcome to the Japanese nightmare.