Hamish McRae: Cuts hurt – but they can offer us an opportunity to do things better too

The period of denial is over. At last the Government is confronting the fiscal catastrophe it has created and is starting to look for ways of cutting spending. The Treasury is calling in the various departments to get them to set out what savings they might be able to make.

Bizarrely, our Prime Minister is apparently using the G20 summit as a platform to call for other governments to cut their spending, which is odd because we have the largest deficit relative to the size of the economy of any major developed nation. Most other countries could expand their deficit further next year if they wanted to, whereas we self-evidently cannot. I assume Gordon Brown is seeking some kind of political cover for a forced U-turn on policy, but, if so, it is pretty thin.

From a purely personal point of view I suppose I feel a sense of vindication and relief. Having banged on ad nauseam about the unsustainable nature of our public borrowing long before the present crisis stuck, I am relieved to see this issue being tackled at last. This is a moment rather like Jim Callaghan's, in January 1976, when he said: "We used to think that you could spend your way out of a recession and increase employment by cutting taxes and boosting government spending. I tell you in all candour that that option no longer exists ...."

Unfortunately, our fiscal situation is much worse now than it was then. The peak deficit in the 1970s was around 7 per cent of GDP. Now ours looks like being – wait for it – 14.5 per cent of GDP. The budget forecast of £175bn was a couple of percentage points below that, but the deficit is running somewhat higher. We got the monthly borrowing figures on Friday, which show that in the first five months of the financial year we had to borrow £65bn. A number of economic forecasters, including Capital Economics and PricewaterhouseCoopers, reckon that the Government is set to borrow something like £200bn this year.

Part of the problem is on the spending side, for investment is so far running nearly 38 per cent up on the previous year, but current spending is up 5 per cent, which is actually a little lower than the Treasury expected. But the thing that I – were I in the Treasury – would be even more worried about is the collapse in tax revenues. Graph 1 shows that, instead of running 6 per cent up in recent years, revenues are now coming in more than 10 per cent down, far worse even than government expectations at the time of the Budget.

It may be that, as the economy grows, revenues will recover somewhat. But it is unlikely that they will have the buoyancy they had in recent years because much of the revenues came directly or indirectly from the financial sector. The sector will recover, as rising share prices indicate – interestingly the Government is now showing a profit on its holding of Royal Bank of Scotland shares – but it will not be the cash cow it was before the crash. The result will be that more of the cuts will have to come on the spending side – and the sort of cuts that are at present being discussed don't look nearly big enough. It is not going to be the 9-10 per cent cuts of the leaked Treasury paper; probably more like 15-20 per cent.

Vince Cable, the Lib Dem spokesman, came up with some ways of cutting spending in a paper published by the think-tank Reform this week. These included a freeze on public-sector pay and various other radical measures. But, as he has been the first to acknowledge, what he is suggesting does not go far enough. He reckons annual savings will have to be of the order of 8 per cent of GDP, or upwards of £100bn, over four years. I expect it will have to be more like 10 per cent of GDP, though the timescale will have to be longer. Whoever wins the next election, the squeeze imposed by the next government will be much more severe than that imposed by the Thatcher government in 1979.

To say that is not to make a political point. It is to make a mathematical one. For the moment, the Government is able to finance its deficit because the Bank of England is buying the debt – part of its effort to pump money into the economy. That cannot go on forever, and when it stops, the Government has to convince would-be buyers that it has a plan to get its debt under control. Gilt yields are artificially low at the moment. That cannot continue.

There are three possible reactions to this. One is denial, of which there is still a bit about but which I think is pretty much past. Most people have grown up. The second is to be aghast at the scale of what has to happen and think that the inevitable result will be, if not quite the destruction of the welfare state, certainly radical cuts in the quality of public services. That will be the reaction of many public-sector employees and the people who bought the vision of Gordon Brown that one had to pump a vast amount of money into state services to try to achieve the sort of social outcomes that the Labour government sought.

There is, however, a third possible reaction, which is to use this as an opportunity not just to preserve the quality of services but actually to improve them. To say that is easier than to do it and I am not at all sure that we have the flexibility of mind within the public sector to do so, but I have been encouraged by several things in recent weeks that suggest we might.

One was the reaction when I was talking with some housing association managers, after I suggested that they would have to do more but with fewer resources. Several of them welcomed the idea, acknowledging that there were a lot of things they might do and welcoming the challenge.

Another has been the reaction of the private sector to the extreme pressure it has been under this year. It has found all sorts of ways to cut costs by being more ingenious and by working more flexibly. If the private sector can improve productivity, surely the public sector – where productivity has declined in recent years – could also achieve similar outcomes.

A third is that the top-down, Soviet-type directives and targets imposed on the public sector have been depressing for people who work there. Having to meet arbitrary performance measures is corrupting because it makes managers focus on doing what they have been told to do, rather than doing what the customers would like them to do. Many will feel liberated if micro-management from on high is abandoned, even if it means they have less money to do what they have to do.

This is not the place even to begin to sketch how public-sector reforms might be shaped. My point is the simple one, that this is an opportunity to do things much better. True, it is an opportunity forced on the country by past mismanagement, but it is an opportunity nonetheless, and it should be seized by whoever is running the show next year.

Don't get your hopes up over what this G20 summit can deliver

The G20 summit in Pittsburgh this coming Thursday and Friday will be educative rather than radical. The previous meeting in April was seen as strongly positive for financial market confidence as it showed that the world's main economies were pulling more or less together in their efforts to boost growth. The throttle was clamped wide open and a recovery of sorts is under way. Expect discussion now to switch towards the exit strategy. Somehow, governments have to start correcting their deficits and the main driver of growth will therefore switch from public stimulus to private sustained growth.

There will be a lot of stuff about the banks: regulation, bonus controls and so on. That will catch headlines, but will not have any material impact. There will also be discussion of global imbalances, though these have been massively cut by recession. For example, the US current account deficit has more than halved. But most of this will be background noise. The signals to listen for will be any hint of the timing of the fiscal pull-back and any feeling that emerges about the timing of a return to normal interest rates.

For reasons I can't quite put my finger on, I feel nervous about this G20 meeting. The bull-market run has been so strong for the past six months, and anticipated the upturn in the main economies, but it may need a flow of positive economic and commercial news to sustain it. The prospect of tighter regulation on the banking industry means that, other things being equal, banks will be less willing to increase lending. That is not good for growth. And the prospect, however distant, of an upturn in interest rates will hit investment sentiment further.

The big point here is that these unprecedented expansionist policies have stopped the recession deepening. But past experience suggests recoveries are never straight-line and we may have another couple of years of trudge before growth is assured. There is not much policy-makers can do about this and if we expect a lot to come out of this meeting we are likely to be disappointed.