Clarke holds key to pre-poll boom

The Bank of England is keeping its head when all around are losing theirs. As its chief economist, Mervyn King, said yesterday: ``It is somewhat premature to claim the recovery has come to an end.'' He thinks it more likely economic growth will accelerate over the next two years, and the Bank is clearly sticking to its ``wait and see'' policy on base rates for now.

More and more City economists, on the other hand, believe the time is ripe for a cut in interest rates. With each new monthly statistic pointing to slower growth and falling confidence, some see Britain teetering on the brink of recession. Who will turn out to be right?

The Budget holds the key. Mr King said the Bank was concerned about the medium- to long-term stance of fiscal policy, and would not be able to assess this until 28 November. Certainly the financial markets' verdict on base rates will depend on how they view Kenneth Clarke's tax and spending decisions. Tax increases this year played a big role in the slowdown. Tax cuts in the Budget might reverse it.

The Chancellor will undoubtedly claim he is sticking to the fiscal straight and narrow. The big figures for tax revenues and expenditure will deliver an acceptable profile for the Government's borrowing requirement, and Mr Clarke will renew his commitment to a balanced budget in the medium term.

In practice, however, the tax and spending cuts Mr Clarke is reported to have planned - several billion pounds off taxes financed by lower expenditure, especially investment spending - will stimulate the economy. The evidence for this is presented in a paper in the latest issue of the journal Economic Policy. Authors Alberto Alesina and Roberto Perotti assess fiscal policies in 20 OECD countries since 1960 to see how different tax and spending combinations affect budget deficits. They investigate which attempts to reduce deficits succeed in achieving a significantly lower debt-to-GDP ratio.

Their first observation is thatwhen governments want fiscal expansion they usually increase spending. But they usually increase general taxation to cut the deficit. Second, on the few occasions when a lower deficit has been achieved through spending cuts rather than tax increases, public investment suffers most. One consequence is that government expenditure on welfare payments has risen far faster relative to the economy than general current expenditure.

The budget reductions that last are also the rarest: those achieved through cuts in social security and public sector jobs and wages. ``It is not the size of the adjustment that sets aside successful ones from unsuccessful ones; rather it is the composition,'' the authors write.

Examples of successful deficit reductions include Ireland from 1987-89, the US in 1976 and Britain in 1969, 1977 and 1988. In 1988, then-Chancellor Nigel Lawson announced pounds 4bn of tax cuts in the March budget. The subsequent economic boom led critics to say he had been irresponsible. But as Lord Lawson complains in his memoir, The View From Number 11, public spending excluding privatisation proceeds was flat in real terms in 1987-88 and fell in 1988-89. There was a marked fall in social security spending as a proportion of GDP. Both years saw government surpluses - the first since 1969-70.

The earlier successful deficit reductions in the UK were both a matter of crisis management. In 1977 the Chancellor, Denis Healey, was implementing an International Monetary Fund programme, imposed after the previous year's balance of payments crisis. Eight years earlier, Chancellor Jenkins was continuing the post-devaluation austerity programme introduced by his predecessor James Callaghan, which included cuts in public spending plans and an incomes policy.

The Irish three-year squeeze is the clearest example of how to go about setting public finances on an improving trend, however. Between 1986 and 1990, social security transfer programmes were cut from 17.6 per cent to 14.3 per cent of GDP, government employment fell from 307,000 to 269,000, and debt declined from 120 per cent to 107 per cent of GDP.

The authors' conclusion is stark: ``Any fiscal adjustment hoping to be successful cannot avoid dealing with cuts in the welfare state and in government wages and employment.''

The Ken Clarke combination of lower taxes and cuts in public investment and other spending programmes will not keep the deficit on a downward track, even if social security spending is indeed one of the bigger victims - and even if the spending plans are achieved.

If the Budget lives up to expectations, it will boost the economy next year and lead to improvement in the government borrowing profile in the medium term.

As the Inflation Report argues, there will be other boosts to growth in1996. One of the most important will be the absence of tax increases, after big rises for the past two years. This means higher consumer spending will underpin growth.

As the Bank of England takes care to point out, judging the direction of the economy and interest rates is a matter of weighing probabilities. There is a risk the current slowdown will go too far. But if Mr Clarke follows up the Budget boost with a cut in base rates he will be tipping the odds heavily in favour of a pre-election boom.