By Nick Louth, exclusive to MSN Money, 15/04/2009 00:00

Keep cranking the economy

As Budget day approaches, Alistair Darling must take some comfort that almost every other industrialised country across the globe is in the same fix as Britain: a weakened economy, rising unemployment, a frail banking system and a gigantic hole in the public finances.

Economic misery loves company, even if it is only to allow politicians to claim that what the country is experiencing is only "part of a worldwide phenomenon". The question remains though, how do you get the economy working again under such circumstances?

1930s economics
Ever since the 1930s, the first response of government to recession is to spend taxpayers' money to replace what cautious and worried consumers are not spending.

No matter that governments don't have the money now, they can borrow it through bonds and then pay down the debt by taxing the economy once it returns to growth.

Ever since Roosevelt's New Deal in the 1930s, such Keynesian "counter-cyclical" fiscal policies have been the norm, usually combined with lower interest rates which spurs investment and borrowing.

However, the sheer scale of the global slump in activity and the simultaneous multi-trillion dollar cost of rescuing the international banking system have left the normal economic armoury looking empty.

Almost everywhere outside the eurozone, interest rates are so near zero that further cuts would be ineffective at stimulating demand, while government budget deficits are straining the ability of long-term funding.

As Iceland discovered, and Belgium almost did, when your banks have lent more than your economy produces in a year, you no longer have the power to borrow enough to rescue them.

Video: which tax would you like cut?

The importance of the G20 deal
That is why the G20's move earlier this month to reinforce the firepower of the International Monetary Fund was so important.

The trebling of IMF resources to $750 billion and the extra $250 billion in special drawing rights for existing members are both a safety net for weaker countries like Ukraine, Hungary and Iceland, but also give greater confidence for commercial lenders, both national and overseas, operating within those countries.

Larger economies have fared less badly. Britain's GDP will fall this year by 3.7%, the OECD reckons. However this is better than expected for the US, where it expects 4%, Italy 4.3%, Germany 5.3% and Japan 6.6%.

British unemployment is predicted to remain below EU and OECD averages, even as the government deficit soars to 60% of a year's GDP.

Where nations differ
This is partly because Britain and the US have taken such prompt action to reflate their economies, while Germany and France, for example, have been more reluctant to bend the rules of fiscal rectitude.

President Obama's $787 billion package, which passed Congress this month, is a blend of tax cuts, aid to hard-hit Americans, plus investment in infrastructure, education and energy aimed at creating 3.5 million jobs.

The cost will lift America's public debt burden from 60% of GDP to 100% over three years. While this is easily a record, it is well within affordability, just as a £35,000 mortgage would be manageable to a typical British family which earns this amount annually.

China and Japan, both nations heavily dependent on exports, have also taken radical action to reflate their economies. China's 4 trillion yuan ($585 billion) expansion was announced promptly last year, while in Japan, Taro Aso has announced a total 56,800 billion yen ($569 billion) of spending, state aid and loan guarantees.

This is easier to fund because both nations have access to huge domestic capital. In China's case, the government has the savings of $2 trillion in foreign currency reserves.

In Japan, it is the private consumer who has the savings, while the government, after repeated fiscal packages to stimulate the economy since the deflation of the 1990s, has debt of 150% of GDP, which is a record among OECD nations.

The British position
Britain, similarly, is not quite up against the wall in its ability to borrow, but the sums are still staggering.

The government's deficit in 2008/09 is expected to be about £95 billion and will soar to around £150 billion or so this year, which is about five times a typical public sector borrowing requirement during Labour's early years.

Unlike previous recessions, there is little hope that an improved economy will be able to pay down that debt within a few years.

Much of this borrowing is actually outside the government's controls. Tax revenues plummet in a recession. A quarter of the tax take comes from the City - both corporate and income taxes - and that has been devastated.

Add in the logjam in housing which has hammered stamp duty to weaker consumer sales hitting VAT and the chancellor's income will be well down. In future years many businesses will use accumulated tax losses from 2008 and 2009 to offset tax payments well into the future.

On the spending side, welfare payments rise with unemployment and depression, family break-up and crime all lead to a long tail of increased social security and disability spending lasting years.

Big borrowing to go on and on
According to the Institute for Fiscal Studies, public sector net investment is on course to overshoot the forecast made at the time of the pre-Budget report by around £4.3 billion, while tax revenues are set to undershoot by £12.5 billion.

Putting those figures into the Treasury's economic forecasting model means the government will have to continue borrowing about 2% of national income each year until as late as 2016.

Irish eyes aren't smiling
To see what would have to happen in a worst case scenario, we can look west to Ireland, in which housebuilding and property account (or once did) for a huge chunk of the economy.

The former Celtic Tiger has just had an austerity Budget in which finance minister Brian Lenihan forecast a jaw-dropping decline of 8% in GDP in 2009, the biggest economic contraction in Irish history, and more than twice that forecast for the UK.

The Emerald Isle has lost its coveted AAA borrowing status, which will make raising debt more expensive and is on target to have debts of 70% of GDP.

Consumers feel more borrowing pain, not less
Lenihan, like Darling, has been faced with the opposite aims of trying to balance the government's books while stimulating the economy.

Seeing as the main source of government income is taxation of its citizens it cannot do both simultaneously. Lenihan's tax increases on incomes, capital gains and cigarette duties were predictably unpopular.

However, getting the economy moving again isn't just about the raw power of spending so much as where that spending is focused and how quickly it is undertaken. Within their overall spending, countries have chosen some different routes and measures.

Car scrapping
France, Germany and Italy have all instituted scrappage plans for older cars, subsidising purchase of new vehicles.

Despite the fact most UK new car spending goes abroad and the crazy economics of this (which the Financial Times described as paying people to break windows to keep glaziers employed) it could well emerge in some form in the Budget.

Ireland has become the first major nation to establish an agency to acquire the non-performing "toxic" loans of the banking system, a move that has long been thought necessary for many countries as a way of purging the most damaging liabilities.

Darling hasn't gone down that route, but it could be worth charting the recovery of the Irish banking system against our own to see which path is more effective.

Let them eat cake, but more cheaply
Finally, France has cut the rate of VAT on restaurant meals from 19.6% to 5.5%, to help keep its citizens eating out.

Whatever comfort there is for Alistair Darling in being able to blame a global event for Britain's suffering, he will have limited financial firepower to do much more about it.

The spending that has already been undertaken, the radical interest rate cuts and the quantitative easing should already be having an effect in the economy, even if that is not yet in a position to be measured.

What he has to do in the Budget is make sure that any new spending measures make up in accuracy what they lack in size and that he reinforces Britain's monetary and fiscal credibility to ease the task of raising the many billions that Britain has already committed to spend.

Laugh your way through the recession with a signed copy of Nick Louth's 'Funny Money'