Inflation may be falling but the chancellor has only few options open to him after Moody's credit warning
In normal circumstances it should have been a good day for George Osborne. There has not been an awful lot for the chancellor to cheer about lately but news that inflation came down with a thump last month to 3.6% provided hope that the intense squeeze on living standards will abate during 2012.
The better news on inflation was, however, only scant comfort to the chancellor as he sought to explain away the decision by Moody's to put Britain's AAA credit on negative watch. This was no easy task. Back in 2010 Osborne said the decision by one of Moody's rivals, S&P, to take the UK off negative watch was a vote of confidence in his handling of the economy. On Tuesday he sought to explain why being back on negative outlook was also a ringing endorsement of the coalition's deficit-reduction strategy. It was all a bit tendentious, frankly.
More than that, it leaves the government in a political fix because by this stage – almost two years into the parliament – the plan was for the economy to be steaming ahead, unemployment to be falling, exports to be booming, and for a sharply lower budget deficit to be fuelling speculation about voter-friendly tax cuts in the pre-election budgets of 2014 and 2015.
The chancellor woke up to the prospect of a grilling on the Today programme about the possibility that the credit rating agencies were now having second thoughts about the viability of the government's economic approach. There is, according to Moody's, a one in three chance that the UK will suffer a downgrade in the next 18 months.
Osborne is discovering that trying to make Britain's debts more sustainable in a low-growth environment is an extremely difficult trick to pull off. Few doubt Britain has a potential debt problem: it is not just that the country has borrowed more since the middle of the past decade, in cash terms, than it has since the dawn of time. It is also that there are a whole host of liabilities – from the cost of the private finance initiative to the future cost of public sector pensions – lurking off the balance sheet.
In itself, the level of the national debt does not matter. The key relationship is between the country's accumulated debts over the centuries and the current size of the economy: the so-called debt to GDP ratio. When the economy is growing strongly – as in the three decades after the second world war – the debt ratio comes down quickly. If the economy is not growing, the only way it can be reduced is through tax increases and public spending cuts. But that can lead to still weaker growth, extra borrowing and higher debts. Countries end up running faster just to stand still, as is currently the case in Greece.
Osborne is not yet in the same predicament as policy-makers in Athens; there will be no tightening of the austerity screw in the budget on 21 March and, instead, the issue for the chancellor and his advisers will be what scope he has, if any, to cut taxes or increase spending in an attempt to boost activity.
There are those who say that the Treasury should follow the advice of Maynard Keynes who, back in the 1930s, argued that if governments concentrated on getting growth rates up and unemployment rates down the budget would look after itself. Osborne, however, is not a Keynesian and, even if he were, would be wary of taking the great man's advice.
Britain is a much more open economy than it was in the 1930s and is far more dependent on foreign investors to finance its debts. As a result, turning deficit reduction on its head in favour of a go-for-growth approach would risk alienating financial markets, potentially causing both a collapse in the pound and a run on government gilts. Having spent the past two years trying to build up his credibility in the markets, Osborne is not going to U-turn now.
There are, however, three other strategies open to him. The first is to adopt the Mr Micawber approach and hope that something will turn up. This is not impossible: the most recent survey evidence has suggested that the economy hit rock bottom at the end of 2011 and has now started to recover slowly. There is optimism, perhaps misplaced, that there is an end in sight to the eurozone crisis. The American economy seems to be on the mend. Support for activity is being provided by the Bank of England, which has just announced a third tranche of quantitative easing (QE), the process whereby money is pumped into the banking system through the purchase of gilts. Over the course of this year the lagged effects of QE coupled with the impact of falling inflation on real incomes will start to feed through into stronger activity.
At the other end of the (currently deemed politically feasible) spectrum would be the sort of fiscal boost suggested by the shadow chancellor, Ed Balls. This is a five-point plan that includes a temporary reversal of last year's VAT increase to 20%, a cut in national insurance contributions for firms taking on extra workers, a £2bn bank bonus tax to create jobs and build homes, a VAT holiday on home improvements, and the bringing forward of infrastructure projects. Balls has not put a specific price tag on his package, but it would probably cost in the region of £15bn-£20bn. This would provide a growth fillip to the economy, but not an especially big one, given that gross domestic product is about £1.5tn, and part of the boost would leak overseas.
Osborne's fear is that a modest giveaway budget would be the worst of all possible worlds: not big enough to make a material difference to growth but big enough to give the financial markets the collywobbles. In the event that interest rates on UK government bonds rose, thereby pushing up the cost of long-term mortgages and overdrafts, that might negate the impact of the tax cuts and the spending increases.
Even so, the Institute for Fiscal Studies, the ultimate arbiter of what is and what isn't doable in the budget, has said it would be possible for Osborne to lighten up without causing a backlash in the markets. The government is likely to spend less in the current financial year than it planned, and the IFS suggests the savings of about £3bn could be recycled into higher public investment in future years. This sort of approach – Mr Micawber-plus – may look attractive to Osborne. It will look prudent and will show that he cares about growth. But there will be no fireworks. And scant impact on the economy.