Stephen King: Darling lacked the ammo for a salvo of election sweeteners

Having seen Gordon Brown, the pusillanimous Prime Minister, wave goodbye to the prospect of an early general election, Alistair Darling, the Chancellor of the Exchequer, can return to those subjects so beloved by his mentor. Yes, we're back to the golden rule, the sustainable investment rule and all the other prudent paraphernalia which traditionally accompany this Government's fiscal announcements. Oh, what joy!

Mr Darling will stand up to deliver his pre-Budget report (PBR) at 3.45pm tomorrow. He might, though, be seen scratching his head from time to time. The PBR is taking place unexpectedly early. Informed opinion suggested, with apparently good reason, that Mr Brown was gearing up for a November election. Presumably, Mr Darling had been half-expecting to delve into his red box to find a bunch of vote-winning tricks, suggesting that dear prudence would be placed on the backburner. Itwasn't to be.

With the opinion polls showing something of a Conservative renaissance – sparked by promises of inheritance tax cuts and David Cameron's ability to speak without an autocue (by implication, turning the entire cast of EastEnders into prime ministerial material) – Mr Brown has concluded that the risks of an early election are simply too great.

Those risks, though, are not confined to Mr Cameron's ability to talk off-the-cuff. It increasingly looks as though Mr Darling was never going to be able to conjure up a string of vote-winning initiatives in tomorrow's PBR. After all, as the Chancellor admitted last week, the Treasury is already hamstrung by a deteriorating economic environment sufficient to reduce the potency and credibility of any salvo of pre-election sweeteners.

Even before the sub-prime/Northern Rock/housing jitters of the last few weeks, the signs were that the Government was a little short of money. The Treasury's surplus on current budget was, for the financial year to August, a negative £11.7bn, up from £8.6bn a year ago (which is the same, by the way, as saying that your bank account is in surplus to the tune of, say, -£10,000, a very strange use of language).

Yet Gordon Brown, in his valedictory Budget earlier this year, planned to reduce borrowing (or should that be negative saving?) to just £4bn for the year as a whole, down from an estimated £9.5bn in 2006/07 (in the event the 2006/07 outcome was a better-than-expected deficit of £4.7bn). Already, then, the Treasury's coffers seem to be under a bit of strain. Moreover, none of this can be blamed on a shortfall in economic growth. The economy is still expanding at a perfectly reasonable rate, so it looks as though the Treasury simply got its fiscal sums wrong earlier in the year.

Unfortunately, however, it looks as though the economy will be sagging in 2008, and no amount of nips and tucks will make much of a difference. As the Chancellor admitted last week in an interview with the Financial Times, "... it would be prudent to assume that [the credit squeeze] will have some effect on us here." He hinted that the Treasury's own projections for economic growth in 2008 would have to be scaled back, in line with "consensus" reductions which have already occurred (earlier in the year, Mr Brown had hoped for growth in 2008 of 2.5-3.0 per cent, but that now seems too high). Lower growth means less revenue and, hence, either more borrowing or less spending.

Of course, this might have been a very good reason for calling a general election now. No one knows quite how the economy will progress in coming months. There's a better than evens chance, it seems, that economic life will become more difficult. Alistair Darling's job tomorrow, presumably, will be to argue that earlier prudence has put the UK in a strong position to withstand any onslaught from a tightening of credit conditions globally. Gordon Brown must now be planning to play the long game.

The difficulty, though, lies in gauging the extent of any economic deterioration. From the Government's perspective, the preferred scenario is one where the economy slows a bit, the housing market cools a little, inflationary pressures ease back and the Bank of England is able to deliver one or more precautionary interest rate reductions. The dream narrative, then, is a repeat of 2005.

The early months of that year were associated with elevated energy prices and a softening housing market, enough to persuade the Bank of England by the summer that there was a real threat to consumer and business confidence. In August, the Bank cut rates. That simple shot in the arm proved enough to reinvigorate the economy. Fears of a hard landing abated swiftly. Indeed, the economy stayed very much up in the air, triggering a subsequent round of interest rate increases.

For the current Government, this would surely be the ideal scenario. Mr Brown has until May 2010 to hold a general election, so a minor economic hold-up in 2008 might not be a significant problem, even if Mr Brown were to suffer a dose of the mid-term blues.

It is not, though, the only scenario. Back in 2005, the US economy was still recovering strongly, helped mostly by a booming housing market. That's no longer true. The US housing market is collapsing, and the economy's performance is now a lot more pedestrian.

Inflationary concerns were fairly modest back then. Today, with food and energy prices rising all over the world, there's more of a threat to price stability.

And, in 2005, the UK's own fiscal arithmetic was looking a bit flaky but Mr Brown could just about claim that he was sticking to his golden rule. Since then, there's been a bit of reverse alchemy, with the golden rule seemingly constructed of no more than base metal. There is no room for expansionary fiscal policy in next year's Budget. And then, of course, there's the impact of the credit squeeze.

So another possible scenario runs like this. The credit squeeze leads to an unintended tightening of monetary conditions. Mortgage and savings rates rise. Job losses in the financial sector begin to drive up the unemployment rate. Inflation remains elevated, reflecting the impact on raw materials prices of booming conditions in emerging markets. The trade-off between growth and inflation in the UK continues to deteriorate (I say "continue", because this has already been happening in recent years). As a result, the Bank of England is unable to cut interest rates particularly swiftly. The housing market then stalls, and house prices begin to fall. Credit standards are tightened even more and, before we know it, we're in recession.

A recession needn't be just around the corner. But a recession scenario – or at least a scenario of ongoing housing weakness and rising unemployment – is not entirely implausible. Indeed, the credit squeeze suggests that the probability of a hard landing has risen a bit.

That, surely, is the big risk for Gordon Brown. His Government still has a solid reputation for economic competence. In two years' time, that reputation could be severely damaged.

Perhaps the Prime Minister was right to wait. His decision, though, could easily play into the hands of the Opposition as the economic storm clouds gather.

Stephen King is managing director of economics at HSBC

stephen.king@hsbcib.com