By Nick Louth, 22/04/2009 00:00

Budget day's £1.2 trillion cloud

For all its spending detail and tax breaks, Alistair Darling's second Budget was overshadowed by a looming cloud of debt and uncertainty, a fiscal darkness unmatched since World War II.

National debt is set to reach a cumulative £1.2 trillion by 2015/16, almost 80% of the nation's annual output and twice the debt burden that Labour inherited in 1997.

But it could turn out even worse, economists warn. Paying for it will overshadow all government ambition, Labour or Conservative, for a generation.

In this pervasive gloom the chancellor held up a flickering match of optimism, predicting that the economy would sag by only 3.5% this year.

"I expect the economy to start growing again by the end of this year," the chancellor said, forecasting a 1.25% rise in output in 2010 and 3.5% the year after.

That, as opposition leader David Cameron was quick to point out, requires not just vigorous growth, but a "trampoline recovery."

The dangers of too much optimism
While most economists forecast a contraction in output closer to 4% and debt peaking at £1.5 trillion, even the chancellor's optimistic view represents the weakest economic performance since demobilisation in 1945, a fact underlined by a rise in unemployment to 2.1 million announced just before the Budget.

"The Budget projections look like a triumph of hope over experience," said Andrew Smithers, chief economist at KPMG.

The biggest danger isn't perhaps the debt itself, it is that the chancellor of the Exchequer has taken an enormous risk in talking up a recovery which, if not borne out by events, could damage Britain's capacity to borrow. We're not just talking about borrowing today or in a year's time, but when these huge debts need to be rolled over in a decade hence.

The Red Book, the all-important Treasury funding document that accompanies each Budget, foresees £220 billion of debt being issued this year.

But according to Stuart Cheek of BGC partners, the way this debt is is structured through syndication, may make the total "closer to £260 billion." That is a massive increase on the £150 billion expected even a few weeks ago and quite unprecedented.

According to the Conservatives, the borrowing in the next two years alone is more than every chancellor in history has accumulated.

Debt man walking?
Either way, you can forget prudence, the 16-years of uninterrupted growth, the fiscal hair-shirt and the other Brownite labels. The government is trapped beneath a debt that even chancellors like Norman Lamont in 1993 and Denis Healey in 1976 never had to face. If Britain was the sick man of Europe in the 1970s, is it now the debt man walking?

The big question is whether the government was right to try to spend its way out of the banking crisis and recession. Was there any alternative to rescuing the banking system, something which alone Darling reckons cost 3.5% of GDP?

David Cameron had no doubt. "Every claim they have ever made to economic competence is dead, buried, finished," he roared in his reply to the statement.

Modest, as a Budget in itself
In fact, the Budget isn't exactly loose. It only adds a half point of GDP in extra spending and measures outlined in it will claw back 0.8% a year in each of the subsequent five years.

There is £1.7 billion for employment support, £500 million to spur house building, a doubling of capital allowances, £1 billion boost for climate change actions, plus £6 billion raised from increased duties and income taxes for high earners.

There is a dollop on top of an extra £9 billion of 'efficiency savings', something which never quite seems to match up to forecasts.

Still, hammered by a plunging tax take from the City, plummeting profits and stamp duty revenues, public borrowing this year will rocket to £175 billion.

That's quadruple the £38 billion forecast in the Budget a year ago. It is still massively above the £118 billion predicted in the pre-Budget report in November and double the £90 billion borrowed last financial year.

Peak borrowing
At the end of March, the government owed £743.6 billion, about half a year's GDP. Even this single year's net addition to borrowing (that is the Public Sector Borrowing Requirement) will be 12% of the value of everything produced in the country this year, and almost this amount will be borrowed again next year.

That is higher than that for most countries, but less than that of the US (13%), Ireland, Spain and Greece, plus almost all of Eastern Europe. Darling's forecast GDP fall is better than OECD forecasts for the US, where it expects a 4% fall, and better than Italy (4.3%), Germany (5.3%) and Japan (6.6%).

Quite apart from the accuracy of those glossy predictions, the biggest worry here is how the government will find the investors it needs.

Who is willing to spend £220 billion this year and about the same next to fund all this, especially against a background of a gloomy IMF report which estimates that the ultimate cost of the global credit crunch is likely to reach £2.75 trillion? Gilts, which were stable initially, soon fell by a full point as these issues sank in.

Funding fears unwarranted
In some ways, the situation may not be quite as bad as feared. The market for government bonds (gilts) has actually been very buoyant recently despite the knowledge that hefty new issues would be sold.

That buoyancy of gilts is actually little to do with their returns. It is much more about fear of further stock market falls. Right across the world, conservative institutions like pension funds have fled to safety in government debt.

The weakness of sterling has also attracted in foreign buyers, who hope for an eventual rebound in the pound. The important thing is that their faith in the British government's fiscal competence should not be shaken by reckless forecasts. They have long memories.

Far worse in history
However, a little historical perspective may help. Although total British debt may hit 80% of a year's output, it has actually been far worse than that before. Cumulative national debt as a proportion of GDP peaked at 250% in 1950.

If a weak and war-ravaged economy which still endured rationing could manage that debt burden, there is no reason to see why the more modern and flexible trade-based UK economy cannot do likewise.

The last time Britain was in a recession as severe as this, in the 1930s, national debt stood at 150% of GDP and remained there until the cost of re-armament caused it to climb further.

"80% of national income is high, considering where we started from, but it is not out of line in international terms," said Gemma Tetlow, senior research economist at the Institute for Fiscal Studies.

The figures also become less terrifying if we look at them as a kind of domestic family budget. The towering national debt in 1950 was equivalent to a family earning £30,000 having borrowed £75,000. Loaning two and a half times income is, after all, very much the average for a mortgage bank.

Alistair Darling, by contrast, is in the position of the same family owing £24,000, which in domestic terms would usually have been considered under-mortgaged.

We are already in debt
Indeed, right now, the entire British household sector already owes more in secured and unsecured lending than it earns in a year, according to accountants Grant Thornton.

Fortunately for Alistair Darling, the government is able to borrow at pretty low rates in historic terms thanks to the near zero-interest rate environment around the world. Although it is quite possible that it will have to offer a considerable premium to some other countries to insure against sterling weakness, the interest burden will not be as great as it might have been, at least initially.

Borrowing cost benefit...for now
"If borrowing costs remain where they are at the moment, the interest burden (on taxpayers) would only be the same as for the debt we had in the 1990s," Tetlow said. Much now depends on how long the government can lock in these rates.

The biggest worry is a few years out, when the government will need to refinance some of the cheap short-term debt. If the economy has not started to expand sufficiently, then international investors could take fright and the pound would fall.

What does seem likely is that the inflation that has already been stoked into the system with billions of pounds of banking bailouts, public spending and liquidity measures by the Bank of England will in a couple of years emerge as inflation. That will quickly deflate away some of the pain of the debt that Britain is facing.

Nevertheless, the shadow of this Budget and the debt Alistair Darling felt forced to take on will still fall across each of us as taxpayers, long into the future.

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