No reward in a 'give-away' Budget

BY THE end of last week the markets were decidedly concerned about the prospect of Tory laxity: a "give-away" Budget on Tuesday week, to be followed perhaps by a cut in interest rates. True, share prices were close to an all-time high, but sterling - against the deutschmark at least - was at an all-time low, and gilts were weak too.

Yet if you look at the British budgetary position in a world context, it really does not appear too bad. The accompanying graph shows some projections for next year's deficit for the G7 countries. Naturally, one should take into account each country's different propensity to save (the more people save, the less the government has to), its point in the economic cycle (the closer to the peak, the smaller the deficit ought to be), and its demographic profile (the faster it is ageing, the greater the pressure not to run deficits at all).

International concern about fiscal prudence is an absolutely crucial background element to the success or otherwise of this Budget, for if it is not acceptable to the markets it becomes absolutely impossible to engineer further interest rate cuts. If it really bombs we will be into base-rate rises before the year is out. So, if on the crude figures outlined in that graph, Britain does not seem to be doing too badly, why do the markets seem to be more concerned about the UK than about several other countries with, on the face of it, worse fiscal positions?

There are several reasons. For a start they are worried about other countries too. The US dollar, for example, has been weak in recent days because of the threatened US debt default, and despite the reasonably small fiscal deficit. The Italian budgetary position gives everyone the shivers and will go on doing so; and Japan is something of an unknown quantity as far as overseas investors are concerned, for it is funded by Japanese savers who seem prepared to carry on doing so.

Next, markets are concerned about direction as much as absolute levels. In the past few days both France and Germany have taken steps to pare back spending on their social security systems, thereby giving confidence, showing the markets that they are at least aware of the problem and prepared to take some steps towards tackling it.

Finally, markets are always reassessing the balance between risk and reward. What has happened in the past few days is a small adverse shift in perception as far as the UK is concerned: the markets expect the Budget next week to be slightly less cautious that they did even a few days earlier. Is it justified?

What seems to have happened is this. Everyone knew that the projections for the public sector borrowing requirement were running above the Treasury projections last summer. (The Goldman Sachs estimates for the overrun of PSBR through to 1998/99 are shown in the right-hand graph.) Everyone knew that there would be tax cuts of some sort and the pounds 2bn figure for these that was "in the market" was deemed acceptable. Everyone also assumed that nothing much could be done on the spending side, or rather if the Government pretended that it could cut spending without being very specific about where the cuts were going to be made, it would not be believed.

In the past week or so there has been a shift of expectations. If anything, the PSBR shortfall is expected to be larger: perhaps another couple of billions higher than the market estimates of even a month ago. The tax cuts are expected to be greater: the pounds 4-5bn range is now being tossed around. And the prospect of a two-stage set of tax cuts, the first now, the second in November 1996, with more of the weight on the second tranche, has receded for the very practical reason that many people in the City think that the Government may not make it to next November anyway.

So the focus has shifted on to spending. The only way of meeting the electorate's expectations of tax cuts (and without these the Conservative election prospects are dead) is to take more out of spending. You can always trim a bit here and there, but the markets do not think that there can be any radical cuts. So they expect a series of fiddles: "cuts" which are really only transfers from the contingency reserve would be a good example. Add to this the Chancellor's known preference for holding base rates below market expectations, and there is a fine recipe for mistrust.

Beside all this the actual allocation of tax cuts seems rather unimportant. The days when a government could win support by trying to fine-tune a tax system are long past. The rhetoric continues, for chancellors (and their shadows) still talk in terms of governments being able to "provide" money for services as though it did not have to come from the rest of us in the first place. But the reality has moved on. As the row over VAT on fuel showed, holding down one form of tax merely means a higher one on something else.

There has been another change in perceptions of government fiscal policy which is starting to influence people's responses to Budgets. It is a growing awareness that deficits merely transfer taxation to some point, maybe some generation in the future. Do you want to pay your tax now, or would you prefer to pay a larger amount (i.e. present tax, plus interest) in a couple of years' time? One of the enduring effects of the present US tax tussle is to put the idea of a balanced budget on the global political agenda. It will, I suspect, have as seismic an importance for the next decade as privatisation has over the last.

So a Budget which "gives away" money now at the expense of higher taxation later does not chime in with the prevailing international mood. The political market into which Kenneth Clarke must sell his ideas has shifted.

All this means that the response to the Budget will be different from that of a Budget even two or three years ago. Tax cuts in themselves are much less effective; the prospect of reasonable growth, low inflation, and particularly low interest rates, is much more likely to receive a reward.

The reward is lower interest rates. Not a lower base rate, for in the very short-term, base rates can be determined by the Chancellor. Rather, the Chancellor needs lower long-term interest rates, for these would underpin his cheap money aims. Get long-term rates down and short-term rates will inevitably follow.

In political terms this is surely very attractive. Lower mortgage rates play to the thirtysomething homeowners whom the Tories seem to have lost. This has electoral consequences. Wave a threat of higher taxation over them and they will fret; wave a sharp rise in interest rates, and a resulting further fall in house prices and they might, just might, return to the Tory fold.

So see this forthcoming Budget not so much as a challenge to find the tax cuts; rather see it as a challenge to engineer lower interest rates. This can only be done by erring on the side of fiscal caution.

One of the most enduring features of British public life is the way the outward form remains but the function moves on. We still have the state opening of Parliament, where hundreds of people, most of whom are very unimportant, dress up as though they were part of the machine that runs the country. We still have MPs going through the motion of their debates, though these do not matter much.

And so we have a Budget which is billed as a "give-away" or whatever, but actually matters only in as far as it can convince markets in the City but also in New York and Tokyo that the finances of Her Majesty's Government are OK by world standards. I'm not sure that our oh-so-political Chancellor quite realises this.