Economic Commentary: Draft not drift, please, Chancellor

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Andrew Feinberg

White House Correspondent

The mounting media speculation about tax increases in the Budget, for which this column must bear its share of responsibility, is becoming somewhat dangerous for the fledgling recovery in activity.

I have little doubt that the Treasury's game plan until a few weeks ago was to make the March Budget something of a non-event, and then do as much as possible to cut back public spending in the summer.

The early autumn was to have been spent assessing the strength of the economy and - all being well - the December Budget would have pre-announced some sizeable tax increases for the following year or two.

This would have been combined with further cuts in base rates to about 5 per cent by the end of the year.

Two spokes have, however, been thrown into this Treasury wheel. The first concerns the tricky question of what projections to include in the Medium Term

Financial Strategy, which needs to be published in March.

Since last year's MTFS the continuation of the recession has increased government borrowing by about pounds 20bn each year throughout the four-year planning horizon. Without announcing tax increases the Chancellor will be forced either to publish a financial plan showing a huge and continuing build-up of debt, or heavily to 'massage' the figures.

Neither of these alternatives looks at all appealing. The first would require him to spend the summer explaining why he was not putting up taxes, only for him or his successor to do an about-face in December. The alternative option - essentially to publish fiscal arithmetic which the Treasury already knows to be heavily rose- tinted - would be horribly transparent to the financial markets.

These problems could probably be negotiated by a skilled political operator. But the second spoke will probably be much harder to handle.

Like it or not, the tax hare is now running extremely fast in the public debate, and the Chancellor will not entrap it simply by sitting on his hands. A holding operation in March could simply leave the consumer fearing an undefined clobbering from tax increases in December.

The fear of this could easily be more damaging to the recovery than a fully mapped-out programme of phased tax increases announced in March, and accompanied by immediate base rate cuts.

I still think that it would be wrong actually to remove spending power from the economy this year, but the consumer's mind needs to be put at rest by an early announcement of how taxes will change in 1994-95 and thereafter. It will simply not be credible to continue pretending for another nine months that the PSBR can be indefinitely ignored.

In this case, cold reality may prove less unpalliative than the fevered imaginings of the press and others.

A draft plan would also eliminate the possibility of a financial crisis, which would certainly puncture the recovery, as Government borrowing surges this year. Draft, not drift, should be the Chancel

lor's motto in March. Drift, though, is a good description of the state of the economy right now.

The crucial uncertainty concerns the consumer. It is still not clear just how good or bad the Christmas period period proved to be.

'Christmas' nowadays needs to be seen as the whole of the period from mid- December to mid-January, and for the past few years the consumer has shown an increasing tendency to blow hot and cold at different times during these weeks.

This makes the retail spending data extremely difficult to adjust for 'normal' seasonal patterns, and therefore all the more difficult to assess.

I was talking to a senior retailer last week about what makes a 'good' Christmas. He said that the crucial thing was not the total volume of sales, but the split in turnover before and after Christmas Day.

His thesis is that the large retailers build up their stocks in early December to cover the entire seasonal peak in activity. They try to sell as much as possible at full prices before 25 December, and are then forced to dump the rest at bargain prices in the sales. (They cannot afford to carry sizeable stocks into the slack months of February and March.) The greater the proportion of seasonal turnover that comes after Christmas Day, the worse it is for retailers' profits.

This year saw exceptionally quiet activity until a couple of days before Christmas, and then remarkably buoyant traffic in the first two weeks of the sales.

On my friend's thesis this is the mark of a bad Christmas, since it shows that consumers are still unwilling to pay full prices for goods and are only willing to come out in large numbers if they spot an unusual bargain.

This year, this effect has been intensified by widespread press stories that prices for durable goods will soon rise sharply, reflecting the sterling devaluation. There was almost certainly an element of 'last chance saloon' in the record traffic jams that greeted the sales this year.

Another reason to be cautious about drawing any optimism from the traffic jams is that a dramatic split is developing between the amount of business in large and small stores. Essentially, large stores - which are concentrated in town centres and shopping precincts - have been doing well at the expense of their corner store brethren.

Small shopkeepers have been unwilling either to hold stocks or to offer discounts, and have therefore lost market share to the marauding giants.

The consumer bees swarming round the high street honey pots are easy to spot. The relative desertion of smaller stores scattered all round town is not.

This explains why overall retail sales volume actually fell by 0.7 per cent in December. An automatic bounce-back will probably happen in January and is already being picked up in the M0 figures for the first three weeks of the month.

But a strong January will not be enough to confirm that the consumer 'recovery' that was trumpeted in the press early in the new year is to be trusted. Casual observation suggests to me that it is still fashionable not to spend - to boast about picking up a bargain bottle of wine at the supermarket, to feel sheepish driving a flashy new car. One day this will change, but it has not done so yet.

Nor am I inclined to trust the strong recovery in business optimism which will be reported in today's CBI survey. The optimism series has been very volatile recently, and not closely related to activity data. I am inclined to place greater weight on the orders and output data, which are much less encouraging.

These are in fact in line with the forecasts emerging from the statistical (Vector Autoregressive Model) estimated last year by Mushtaq Shah and myself at Goldman Sachs. This says that, without further base rate cuts, growth in GDP in the course of this year will be less than 1 per cent (shown as the 'full VAR' forecast in the graph).

In order to produce a reasonable outturn of around 2 per cent, the model says that base rates must be cut to 5 per cent before too long.

Lower base rates reasonably soon. No tax rises this year, but a coherent plan for sizeable increases in subsequent years, pre-announced in March. That would be my strong advice to the Chancellor.

(Graphic omitted)