25 July 2019
Now you see it…
Sajiv Javid will not have £25bn up his sleeve.
by Frank O’Nomics
As jokes go it fell very flat. When the departing Labour government Chief Secretary to the Treasury, Liam Byrne, left a note in his desk saying: “I’m afraid there is no money”, few thought it funny. Unfortunately, when the Office for Budget Responsibility suggested that the current government had over £25bn of fiscal headroom as recently as April, that was not meant to be funny, but may still prove to be risible, and as mirthless as Mr. Byrne’s quip. We have just been through a Conservative leadership campaign that was very much about the end of austerity and how the fiscal largesse might be shared out. Sajiv Javid, the new Chancellor of the Exchequer, is faced with numbers suggesting that either these plans will have to be put on hold for some time, or that the government will have to massively adapt its fiscal rules.
The problem with the public finances is that the deficit is always the difference between two very large numbers; government spending and tax receipts. Spending is very much like a super tanker, once the course is established it is very hard to change direction. Tax receipts, on the other hand, can suddenly drop off a cliff if there is a sharp downturn in the economy. Anyone who read last week’s article will have an idea of what I think about the current state of the economy, and the latest government borrowing data would seem to support the view – we are very close to recession.
Compare April with June. In April government borrowing was reported as being at its lowest for 17 years and, as a result, the OBR was able to improve its underlying forecasts by £33.7bn, suggesting that the Chancellor had £26.6bn of fiscal headroom, up from a previously estimated £15.4bn. This prompted waves of requests from government departments all wanting to get their share of the additional resource. It also allowed the leadership campaigns to focus on tax cuts and spending increases, and a mad dash by Theresa May to endorse additional spending to create a legacy other than the Brexit mess. These pledges could only ever be described as long-term objectives, given that Boris Johnson’s plans have been costed by the IFS at to over £32bn and Jeremy Hunt’s at £46bn – almost as much as the Shadow Chancellor’s plans at £48bn.
Fast-forward just 2 months to the June data. Public sector net borrowing was £7.2bn for that month, compared to £3.8bn for the same period last year, and the highest for June since 2015. What could possibly have changed? A part of the problem has been interest payments on government debt, much of which is linked to inflation, which the fall in sterling has increased (you might argue that this £2.1bn increase might have been foreseen but let’s skate over that). Of greater concern are the deteriorating levels of tax revenue. To a combination of a shortfall in VAT (people are clearly cutting back on their spending), and undershoots in income and corporation taxes as activity declines, one has to add a sharp drop in stamp duty, as house prices fall along with transaction levels in both residential and commercial property. This element of the finances was only £1.5bn below that received last year but given the ongoing levels of uncertainty surrounding Brexit, could signal the start of a trend that could continue at least until Halloween.
The National Institute for Economic and Social Research thinks that there is a one in four chance that the UK is entering a recession. Even if we just undershoot the previously forecast growth numbers the outlook for public finances looks bleak. If a no deal Brexit were to knock 5% off GDP as is widely forecast, instead of government borrowing falling to less than 2% of GDP by 2020 as targeted, the figure could be as high as 2.7%. You might reasonably argue that this may not matter. If the government is able to borrow at rates of less than 1%, to help generate a nominal GDP in excess of 3%, surely that is good business? However, in such an environment, the scope to increase public spending by £25bn could prove to be very difficult for a government that needs to maintain its fiscal credibility. Any significant slippage could lead to a further sterling underperformance, a rise in inflation and a dangerous upward spiral in the interest rates at which the government can borrow. Lowering the nominal growth rate and raising the level of interest rates leaves you with a much less attractive proposition.
The key question then is whether the new regime continues to commit to the goal of a falling debt to GDP level every year, or whether, as a result of anti-austerity spending commitments, it changes its fiscal rules in the autumn. In the meantime the new Chancellor may try to operate under the assumption that there is some headroom for spending. However, if the data continues to deteriorate, the markets will start to question those assumptions and the government’s prudential credibility.