Clarke's conundrum: The Chancellor's future depends on getting next month's Budget right. Stephen Castle and Robert Chote report

DORNEYWOOD, the red- bricked grace and favour mansion to which the Chancellor, Kenneth Clarke, and his Treasury team retired last week, is renowned for its antique furniture, its Rex Whistler murals and its fine porcelain. But a less celebrated attraction, enjoyed frequently by visiting politicians including Winston Churchill, is bagatelle - a game more of chance than skill. It makes an appropriate metaphor for the task that faces Mr Clarke as he ponders the enigma of Britain's on-off recovery.

When the Chancellor presents his first Budget on 30 November, more than the future of the British economy will be at stake. Too little stimulus could return a sickly economy to intensive care; too much could plunge Britain into another overheated boom, leaving the Tories to administer unpleasant medicine just before a general election. On Mr Clarke getting it exactly right depends not just the jobs of millions but also the Chancellor's personal political future.

Within the past few months, MrClarke has become the undisputed heir to the premiership. Nobody doubts his political nous; nobody doubts, too, that he will deliver his Budget with compelling nonchalance. (One civil servant tells of drinking seven pints of beer with Mr Clarke before a meal in the Pimlico Tandoori; the minister then returned home to work on his red boxes.) But he has made his reputation out of taking on and beating interest groups in the health service, education, police and prisons. The Treasury is a different sort of job that requires the Chancellor to set out in black-and- white his economic strategy and to be judged by the results. Mr Clarke must be uncomfortably aware that two of his three immediate predecessors as Chancellor are now widely reviled. And his critics, particularly on the right, will be watching closely to see if he can dispel what one called 'the general view that he is a brilliant politician who does not know his subject'.

All Chancellors get conflicting advice; Mr Clarke's misfortune is that he is also getting conflicting information. Last week, for example, brought news of manufacturing output down (bad), unemployment down (good), exports down (bad) and inflation rising (bad). Perhaps his most significant meeting was not in Buckinghamshire on Friday, but back in the more drab surroundings of the Treasury. On Thursday Mr Clarke met his most senior economic advisers and forecasters to ask whether recovery was truly under way. The officials were unwilling to offer a view. Like much of the rest of Britain, the Treasury is baffled about the state of the economy.

FEW retailers are prepared to commit themselves about the recovery one way or the other. Several companies, including Sainsbury's and Texas Homecare, refused last week even to discuss this year's sales or to comment about economic prospects.

Mark Effendowicz, spokesman for the JohnLewis Partnership (which includes Waitrose supermarkets) reported that sales for the first six months of this year were down on the same period last year. But, he insisted, 'we are well set for a good recovery in the second half of the year'. A spokeswoman at Asda's headquarters in Leeds said: 'This year has been a struggle - it's been very tough. We are fighting to stay where we are.'

Only Stanley Kalms, chairman of Dixons, the electrical goods chain, allowed himself unqualified optimism. 'There's no doubt consumer confidence is rising firmly,' he said. 'There's been positive signs since spring.'

Despite the steady but modest fall in the jobless figures, fear of unemployment still inhibits consumer spending. 'I've been saving all my spare cash in case something happens,' said one north London shopper last week. Yet, in the City of London, champagne sales are booming again. 'Everyone I know is definitely spending more now,' said one City worker as he left Marks & Spencer with an armful of champagne bottles. 'No one thinks twice about blowing money on eating out or going on holiday.'

Sudden recovery is clearly not expected even by Conservative sympathisers in the City. Francis Maude, the former Treasury minister now working for the City firm Morgan Stanley, argued: 'We have all the supply-side benefits just at the time when the supply side of a number of European economies is slowing down to be sclerotic. But it always takes time to feed through in any consistent way. We have had two or three false dawns so there is a bit of scepticism which will prevent confidence entrenching itself in consumers' minds.'

'The biggest single problem,' one minister said last week, 'is consumer confidence, it is saying to a very hard-hit general public 'here is a recovery now trust it'. If we thought there was a return of confidence and people were daring to start spending again we could be chipper. But that's not something you can legislate for.'

Ministers concede that the recovery is patchy; 'things are improving,' said one senior source, 'but, for example, anyone reliant on the export market, particularly the European market, has been screwed'. Another Conservative source added: 'We have been here before. People forget how slow the recovery from recession was in 1981. The difference is that then we could pin the blame on years of Labour and left-wing Tory governments.'

Amid last week's mixed economic news it is easy to forget that the economy is still doing much better than most economists expected earlier in the year. Norman Lamont's swansong Budget in March predicted growth of 1.25 per cent this year. 'Look how the world has changed since then. Growth is stronger than expected, unemployment lower, inflation lower, the PSBR (public sector borrowing requirement) a little lower and the trade gap much smaller,' argues Kevin Gardiner, economist at the City firm Warburg Securities.

By May, Treasury economists were forecasting growth of 1.8 per cent. They still believe pretty much the same. But last week's factory output figures showed how hesitant these forecasts are and how fragile the recovery remains.

A secret briefing document prepared for the Chancellor by Nick Catton, of the Treasury's economic analysis division, was surreptitiously faxed to the Labour Party on the day the figures came out. It described the 0.4 per cent fall in factory output in August as 'disappointing' and concluded that the Treasury's most recent forecast of third-quarter factory output would only be met if production rose by an unrealistic 2 per cent in September. 'This . . . is likely to further fuel media speculation about the economy running out of steam,' Mr Catton wrote to the Chancellor. And so it did.

Treasury forecasters - like their opposite numbers in the City and academia - failed to predict the boom of the late 1980s and the length and depth of the recession that followed. It should come as no surprise that they have are still having difficulty assessing the economy's prospects.

IF BRITAIN is enjoying a recovery at all, the Government can take little credit for it. We are getting the benefits of what Norman Lamont disparaged 15 months ago as 'the cut and run option . . . cut interest rates and a run on the pound'.

Treasury economists, in a confidential study, have concluded that forecasts for national output early next year would have been as much as 2 per cent lower if Mr Lamont's policy of defending sterling's parity inside the exchange rate mechanism had succeeded.

What of the 'strategy for growth' that the Government so proudly announced last year? The evidence suggests that it has made little contribution. Two months after the pound left the ERM, Mr Lamont's Autumn Statement included 'a number of special measures to help rebuild confidence and foster economic recovery'. There were, for example, tax breaks for investment in plant and machinery. But investment now is no higher than it was in spring last year. There was permission for local authorities to invest all their receipts this year from the sale of council houses. But local authorities have raised only two- thirds of the pounds 1.8bn the Treasury expected them to raise. The abolition of car sales tax was supposed to boost the motor market but, after a short- term boom late last year, sales have petered out. Extra money for housing associations to buy unsold houses and more guarantees for exports to risky markets may have made some difference - but the limited improvements in house prices and exports have owed far more to lower interest rates.

So can Mr Clarke do better? His Budget judgement hinges on two pieces of educated guesswork. First, is government borrowing yet under control? Second, is economic recovery sufficiently entrenched to do much about it by raising taxes or cutting spending, both of which drain spending power out of the economy? The Treasury is baffled by both questions.

The optimists say that the economic outlook is no worse than in March and that the Chancellor should therefore opt for masterly inactivity. Mr Lamont announced in March that taxes would be raised by pounds 10bn over the next two years. If that was tolerable and tough enough in March, it should still be so now.

Taxes need not be raised significantly and interest rates need not be cut to compensate, they argue. The Chancellor should get to his feet on Budget day, tell the House of Commons that his predecessor has done all that needs to be done, and sit down.

But last week's trade figures and factory output data highlighted an important potential weakness: the depressed demand for British exports among European economies still in recession. Exports to the rest of the EC fell 5 per cent in July alone and are 11 per cent down on the start of the year.

The other main threat to recovery is the tax increases already announced by Mr Lamont. In the looking-glass world of economic theory, consumers would already have budgeted for imposition of 8 per cent VAT on domestic fuel and increases in National Insurance contributions in April. In reality, they will still come as a rude shock and consumers will probably tighten their belts.

If the recovery slows further, it will take longer for the Government's borrowing requirement to be reduced by the natural revival in tax revenues and the fall in social security benefit spending that comes with a pick-up in growth. The Chancellor has already said that this would make him more inclined to raise taxes again to get borrowing down. The options are numerous (see panel, left).

The Bank of England has urged in a confidential paper that Mr Clarke should raise an extra pounds 7bn or so in the next three years, up to half of which should come in the form of higher taxes in next month's Budget. However, higher taxes would slow recovery further - they would have to be offset by further cuts in interest rates.

Fresh base rate cuts would boost exports and deter imports by putting downward pressure on the pound. They would also reduce the cost to industry of stocking its store-room shelves and investing in new machinery. And they would reduce people's mortgage payments and make them more inclined to borrow. All that sounds good. But part of the conundrum for Mr Clarke is that lower interest rates could lead to a fall in the pound and a rise in import prices. That could push underlying inflation alarmingly close to his 4 per cent target. The crux of the Budget will be whether Mr Clarke finds this a risk worth taking.

THE CABINET has already clashed fiercely over whether the Government should tackle its spiralling deficit by public spending cuts rather than tax rises. A strict overall ceiling on public spending had been agreed but right-wingers such as John Redwood, Secretary of State for Wales, wanted an even lower ceiling. Mr Clarke saw them off. But he and his Chief Secretary, Michael Portillo still have to wield the axe over departmental plans and negotiate which spending items should be cut. (Hence the present arguments over defence spending.) They are showing signs that they prefer cuts in capital spending. Politically, this is an easy way out - 'if you don't get your fighter plane or hospital this year,' said one Tory, 'you can always tell people they'll get it next year'.

Only once the spending cuts are decided will ministers concentrate on the Budget. It is probably the last chance to make big changes, which will hit middle-class voters, before the onset of an election makes them too risky. That makes further erosion of mortgage interest tax relief likely.

But there are risks, too, this year, with a fragile majority and backbench MPs contemplating mutiny over the imposition of VAT on domestic fuel. Any new tax-raising measures will arouse further dissent. Even the imposition of VAT on books and newspapers - politically much less sensitive than other areas, such as food and children's clothing - could easily unite 10 rebel Tory MPs.

In other circumstances Mr Clarke might be tempted to tough out such unpopularity. But, with one eye on a possible Conservative leadership contest, Mr Clarke will not want to produce a Budget that upsets his potential backbench voters.

The expectation is that Mr Clarke will not raise huge extra sums in taxation; he is, after all, in the luxurious position of being able to blame the coming increases in VAT and National Insurance on his predecessor. If he does raise taxes, he will try to do so in a way that will allow the revenue to build up gradually as the recovery becomes stronger. Knowing his track record, colleagues expect at least one 'flashy' element to the Clarke Budget speech.

But, more than a month before Budget day, many important decisions remain to be taken. One senior source said last week: 'In a sense they have gone to Dorneywood too early. They should have sorted the public spending round out first and then gone on to Budget discussions. The Chancellor will want to hold his finger up to the wind a couple of weeks before the Budget and see what the economic position is then.'

As the Conservative Party conference drew to a close a week ago the portly figure of Mr Clarke was seen in the foyer of the Imperial Hotel, checking out before the Prime Minister's speech. He was, the Chancellor joked loudly to a fellow Conservative, determined not to make the mistake of his predecessor Norman Lamont, who last year left Brighton with a pounds 900 conference hotel bill outstanding.

Mr Clarke's Budget will provide a more important opportunity for theChancellor to mark himself out from his predecessor. His dilemma remains the same as that faced by Mr Lamont: how does he convince the City he is serious about the deficit while not strangling recovery? It is, one Tory MP said last week, 'unquestionably the crucial event of the autumn; if he fails this opportunity his political lustre will begin to dim'. So, too, would the Government's prospects of winning the next general election.

AMONG THE OPTIONS

THE BUDGET options that Treasury ministers are likely to have discussed at Dorneywood(right) include:

Cut mortgage tax relief: The economists' choice, as it would reduce distortion in the housing market.

Extend VAT to newspapers, books and magazines: Circulation wars might prevent consumers being hit - but it would imperil Mr Clarke's good press.

Impose VAT on fuel at the full 17.5 per cent from next April (the present plan is to impose it only at 8 per cent and leave the full amount to 1995): This would get the political pain over, but could lead to annihilation of the Tories in next year's European elections.

Fail to raise income tax allowances in line with inflation: The effect is the same as a straightforward rise in the rate of income tax, but is less obvious to voters.

Restrict personal allowances to the 20 per cent income tax band: Again, a tax rise for most people but even less obvious to average voter.

Increase National Insurance contributions: Unlikely, since a one-point rise is already planned for April. But the self-employed may be hit.

Make further changes to taxation of company dividends: Lucrative, and remote and baffling to ordinary voters.

Lower interest rates: Almost certain if there are increases in taxation, particularly cuts in mortgage tax relief.

Additional reporting by Jason Bennetto.

Christopher Huhne, Business, page 8

(Photograph and graphic omitted)