Stephen King: The economic mess began when profligacy replaced prudence

Saturday 17 October, 1964. Jim Callaghan sat at his desk in 11 Downing Street. As the new Chancellor of the Exchequer following Labour's election victory, it was Callaghan's job to sort out Britain's economic problems. As he went through the arithmetic, it dawned on him that Britain's difficulties were, in fact, much bigger than Labour had previously envisaged. Callaghan was inheriting a legacy of indiscipline from the outgoing Conservative administration, under which the country's financial affairs had lately been managed by Reginald Maudling. As Dominic Sandbrook relates in his highly-readable White Heat, "upstairs, in the flat, Maudling was finishing packing for the journey into opposition. On his way out, carrying a great pile of suits over his arm, he stuck his head around the door of his old study. 'Good luck, old cock,' he said cheerfully to his successor. 'Sorry to leave it in such a mess.' Then he smiled, stuck his trilby on his head, and sauntered off."

I'm not about to make any predictions about the outcome of next year's General Election (with the nation obsessed by second homes, duck ponds and moat cleaning, who knows what might transpire?) but, with opinion polls offering nothing but bad news for Labour at the moment, it's not difficult to imagine George Osborne sitting in the study at No 11 while Alistair Darling prepares to saunter into political opposition, obscurity or the House of Lords. Mr Osborne already knows the public finances are in a mess. But do the Conservatives have the stomach to sort the problem out? And will the expenses scandal deflect MPs of all persuasions from thinking seriously enough about the looming fiscal crisis?

The simple truth is that the public finances are out of control. Even on the Government's own numbers, the budget deficit ends up at a distinctly horrible 12.4 per cent of national income in 2009-10, by far the largest number in the post-war period. While the Treasury expects some improvement in later years, the deficit is still projected to be 5.5 per cent of national income in 2013-14, still huge compared with all but the most extreme fiscal moments in British economic history. Even worse, the ratio of government debt to gross domestic product continues to rise year-by-year. For those who worry about the sustainability of a given fiscal position, this is a worrying development. It's the equivalent of taking out additional credit cards to pay off the debt on existing plastic.

The Government argues that, given the circumstances, it had no choice but to increase borrowing because the alternative – a plunge into outright depression – would have been far worse. This Keynesian defence is true up to a point. The problem with the argument, though, is that the mismanagement of the public finances began before the onset of the credit crunch. When Labour came to power in 1997, they inherited a very strong fiscal position from the Conservatives. Against the background of a buoyant world economy, boosting tax revenues, and a commitment to stick to the Tories' spending plans in the first couple of years of Labour rule, the fiscal position improved still further. According to the Organisation for Economic Co-operation and Development (OECD), the budget surplus rose to 3.7 per cent of GDP in 2000. Seven years later, though, surpluses had become a distant memory. In 2007, the budget was in deficit to the tune of 2.8 per cent of GDP, a deterioration of 6.5 per cent of GDP in just seven years.

Across the G7 nations, this marked by far the biggest deterioration in public finances through the course of an economic cycle. The only other country to have come close was the US, where the budgetary position deteriorated by 4.5 per cent of GDP. Other countries were better behaved, recognising perhaps that, during the good times, it's not terribly prudent to allow the government finances to deteriorate too far: it makes a lot more sense to keep something in reserve for when the bad times arrive. Based on these numbers, the UK economy had been suffering fiscal neglect long before the credit crunch took centre stage. The Treasury's huge projected budget deficit for the coming year may be partly the result of a Keynesian stimulus but the primary reason was the decision, in earlier years, to exchange prudence for profligacy. As the economic upswing reached maturity, so the Government pretended the upswing would continue for ever and a day. Post-war history, though, is littered with examples of governments caught out by the UK economy's tendency to boom and bust. This Government has proved no different. Someone will eventually have to clear up the mess we're in. It certainly won't be good enough simply to assume that economic activity will rebound, thereby lifting tax revenues sufficiently to cover the budget shortfall. Even on the rosiest economic assumptions, it looks as though government debt will continuously rise as a share of GDP in the years ahead. Moreover, as the financial sector shrinks, so will the number of higher rate taxpayers, leaving the government short of revenue for any given level of economic activity. Austerity, then, seems to be the inevitable conclusion. Some mixture of higher taxes and public spending cuts will be required.

Whether, politically, this is an option remains to be seen. Callaghan's attempts to solve the UK's problems in the mid-1960s ultimately failed and, by 1967, Wilson's Government went down the devaluation route, damaging Labour's economic credibility for years to come. With the debate on MPs' expenses in the spotlight, it may be that the winner of next year's general election, like Harold Wilson's mid-60s government, will discover there is no austerity mandate, in which case the ability to act tough could be seriously reduced.

What, then, might be the alternatives? There is a possible "get out of jail free" card, although only a desperate man would choose to play it. The introduction of so-called quantitative easing by the Bank of England, supported by the Treasury, has blurred the lines between monetary and fiscal policy. The Bank of England is now buying some of the gilts issued by the Government via the use of the printing press. The extra demand for gilts stemming from this process has left gilt yields lower than might have been the case if financial markets were allowed to adjust freely. This is good news for the Government because its funding costs are lower than they'd otherwise be. Taken to the extreme, therefore, quantitative easing reduces the pressure on the Government to deliver austerity in the near future.

Who loses from this process? In normal times, the obvious danger is higher inflation which destroys the savings of the Government's existing creditors. But with an economy operating well below full capacity, it's difficult to imagine inflation rising any time soon. Not all of the Government's creditors, though, are based in the UK. About 35 per cent of gilts are held by foreigners who have lent to the British Government in sterling. A big drop in the exchange rate, then, could be just the ticket. A decline would boost British competitiveness, boost exports, squeeze consumption (via higher import prices) and rip off our foreign creditors. No wonder the ratings agencies are getting nervous about the UK's credit status. It's not just that we've borrowed too much. Through quantitative easing and its impact on the exchange rate, we now have the mechanisms in place to not pay back the money. Time, perhaps, for a "pound in your pocket" speech.

stephen.king@hsbcib.com