View from City Road: Tough fiscal test awaits Chancellor Clarke

The markets now have a Chancellor to reckon with. Kenneth Clarke is a powerful political figure with a following on the back benches, who is widely seen as an alternative leader. There could hardly be a starker contrast with Norman Lamont, reviled in the press and the City, and perhaps also among his colleagues. Moreover, Mr Clarke has presentational skills that could make the Treasury's job a lot easier.

But Mr Clarke's prestige and skills could be used to force through good or bad policies. Mr Lamont has put in place tax increases of some 1.5 per cent of national income, but this will still leave a budget deficit worth nearly 4 per cent of national income in 1997/8. By universal agreement within and outside the policy-making fraternity, the top priority of the new Chancellor, now that the recovery is under way, should be a renewed attack on the public sector deficit.

This will mean tough decisions on tax and public spending, many of which will offend Mr Clarke's finer wet instincts. Just as importantly, many of those cuts or tax rises should offend Tory party constituencies that the new Chancellor and leader-in-waiting would ideally like to coddle - middle class parents whose children's university fees are paid by the public purse, ancient army regiments that may be disbanded, rich pensioners who might lose their state pension, householders facing a further cut in their mortgage-interest relief.

The unanswered question is whether Mr Clarke not only has the political skills to take on these vested interests, but whether he also has the political will to do so. Does he care more about the next two years or about the next 10?

There is a bad set of policies into which Mr Clarke might slip as comfortably as his suede shoes. The new Chancellor is known to be a pro-European. He would carry credibility with the financial markets if he were to prepare sterling once again for membership of the exchange rate mechanism, and the effect would be to raise the value of the pound in the run-up to entry. This is precisely what happened in 1990. Between March and October, when we joined the ERM, the trade-weighted sterling index rose by 9 per cent.

A strong sterling policy has enormous political attractions. It can, in the short term, deliver lower import prices and inflation without any of the pain of tax increases or public spending cuts. It has been the preferred option of the Bank of England and the Treasury mandarinate since the early Eighties. The problem is that it is unlikely to be sustainable, and it sacrifices the health and prospects of the trading sectors of the economy. After all, it was the rampant overvaluation of sterling in 1979-81 that collapsed manufacturing and left us with today's balance of payments deficit even in the depths of recession.

But Mr Clarke is no fool. It is too early to say whether he will prefer the soft or the hard option, but we can at least hope that he will choose easy monetary policy and tough fiscal decisions, even if that mix proves less politically palatable in the short run.

Mr Clarke recently made it clear to Tory right-wingers that he would not press for an early re-entry into the ERM, and this makes sense. At the very least, German interest rates must have subsided to levels that are appropriate to Britain's circumstances.

Moreover, Mr Clarke is a former minister at the Department of Trade and Industry with a constituency in a manufacturing heartland, the East Midlands. His ear has been bent over the years by industrialists, but less so by financiers and Treasury mandarins. With luck, the result may be a sensible economic policy delivered with political skill.