Rebalancing is a fantasy, the economy is dead in the water, the budget deficit is increasing – so what is to be done?
Look after the economy and the deficit will look after itself. That was the advice John Maynard Keynes gave to governments during the Great Depression of the 1930s and, if he were alive today, it would be the advice he would be giving to George Osborne.
The public finances are a mess because the economy is a mess. Deprived of the growth hormones of consumer debt and excessive financial-sector leverage, Britain has struggled to find new ways of earning a living. The flipside of austerity was supposed to be a fundamental rebalancing of the economy. Out would go high street spending sprees funded by asset-price bubbles; in would come what Osborne called the "march of the makers". This was a dazzling new world in which the cream of Britain's exporters would slug it out on global markets with the Germans, Americans, Swedes and Japanese.
A 30% drop in the pound's exchange rate between 2007 and 2009 was supposed to make rebalancing easier, yet since the end of 2006 the value of UK exports has risen by 29%. The comparable figure for the US is 44%, while for China it is 87%. The latest official figures show the trade deficit in goods and services at its highest level since modern records began in 1997. The CBI said that manufacturers had cut their production plans for the coming months. The predicament facing the government can be summed up in three short sentences. Rebalancing is a fantasy. The economy is dead in the water. The budget deficit is increasing.
Ministers will rightly be concerned about the deterioration in the public finances. July is one of the better months for the exchequer because it is one of four times a year when corporation tax receipts come rolling in, yet the deficit last month was more than £3bn bigger than in the same month a year ago. Nor was the July figure a flash in the pan: borrowing is £11.6bn higher in the first four months of the 2012-13 financial year than in 2011-12 once the one-off effect of transferring the Royal Mail pension fund to the public sector is stripped out.
City analysts were warning that borrowing could be £30-40bn higher than planned by the end of the year if the current trend were to continue. That would certainly raise a few eyebrows in the financial markets, and might even prompt a downgrade from the credit rating agencies, something the austerity programme is supposed to avoid.
So what is to be done? One option, urged on Osborne by free-market think tanks and some Conservative backbenchers, is for much more aggressive deficit reduction. Taking the axe to public spending would, they say, allow the chancellor to cut taxes and that would prompt a private sector led recovery. Osborne does not appear to favour this approach. He has responded to weaker growth over the past 18 months by extending the deficit reduction plan from five to seven years, even though this means there will be no let up in austerity until at least halfway through the next parliament. One reason for the bigger-than-expected deficit in July was that government spending on infrastructure was up.
A second option would be a package of tax cuts and spending increases designed to get the economy moving. Its supporters say this would mean a bigger deficit in the short term but a smaller deficit in the longer term because growth would be stronger.
Osborne does not seem keen on this either, and not only because it would require him to do the mother and father of a U-turn from which his political reputation would never recover. His economic argument is that it would require a massive stimulus package to make much difference to the UK's growth rate, with a real risk of higher interest rates should the financial markets turn nasty.
Within his self-imposed constraints, there are things Osborne could do, such as shifting the composition of public spending towards growth-rich investment projects.
But, in reality, the chancellor's strategy can only work if cheap money from the Bank of England boosts the domestic economy, if the crisis in the eurozone is resolved quickly, and if the economy is not really as broken-backed as it appears to be.