Hamish McRae: Recovery will bring a whole new set of problems

It is a horror story in slow motion, as every month the Government's borrowing rises yet higher. It is a measure of the scale of the disaster that in June it had to borrow "only" £13bn, against an expected £15bn.

So the Government is borrowing double as much this year as it did last. And last year it borrowed double as much as it did the year before. It is now spending £13.50 for every £10 it raises in tax. Spending will reach at least 48 per cent of GDP, roughly the same level as the mid-1970s peak. It is only during the Second World War, when spending reached 60 per cent of GDP, that the government has spent significantly more that it is set to do now. Total public debt, already higher than it has been at any time since 1979, will double, reaching the highest level as a proportion of GDP since the middle 1960s.

You can see this in the charts. During wartime of course spending surges; and during recessions it rises too. But what has happened in this recession is worse than during the 1980s and 1990s recessions and in some ways worse than during the 1970s, when the Callaghan government had to call in the IMF for an emergency loan.

This cannot go on. The annual deficit is larger as a proportion of GDP than that of any other large developed country. The only questions are how quickly the deficit can be brought under control and how this should be done.

Perhaps surprisingly there is not a huge difference between the two major parties on either question – insofar as we know either's plans. On the first, the timescale, everyone agrees that correcting the deficit will take the best part of a decade. You cannot do it quicker. Not only has the deficit to come down but more money has to be allocated to paying the additional interest on the debt. So the whole of the next economic recovery will be spent paying off debt. The aim must be to get public finances under reasonable control before the next downward swing of the economic cycle, in – who knows? – some time around 2018.

How should it be done? There has to be some kind of balance between higher taxes and lower public spending but most of it will have to come on the spending side for two reasons. One is that no government will want to put up taxes by much until growth returns: pushing them up too soon might abort the recovery. The other is that it is very hard to get more money in. At the moment tax revenues are more than 8 per cent down year-on-year. The recovery in revenues will be very slow. We know now that we relied too much on the financial sector, both the banks and other institutions and their high-earning staff, to pay the bills. Those earnings will recover a bit but they won't be back to where they were for several years, and while some might welcome that, if people in the financial service industries pay less tax everyone else will have to pay more.

But something can be done on the tax side. We should, for example, expect to be paying 20 per cent VAT a year from now. It is the third largest after income tax and national insurance. We should probably expect some kind of temporary increase in income tax, and not just for top earners. And other smaller taxes will go up too.

The success in cranking up growth will determine the scale of the cuts in spending. But savage cuts, particularly in capital spending, are already projected by the present Government in its last Budget and these are expected to be tightened further in the pre-Budget report. Tory plans are uncertain, as is perhaps inevitable at this stage of the electoral cycle, with some major areas such as health supposedly being protected. But the more areas that are protected, the greater the cuts elsewhere.

The truth is that whatever the political make-up of the next government and whatever its aims and objectives, economic realities will make the decisions for it. Because it inherited a strong economy and a rapidly-improving fiscal position, the Labour government in 1997 had an unusually large amount of freedom to take big fiscal decisions. If it wanted to spend a lot more money – which it did – it could do so. The next government will not have any such freedom. Indeed it is even possible that the forthcoming change in policy will come earlier. This Government may be forced to announce a fiscal consolidation plan this autumn, long before the Government's favoured date for an election next May.

There is one reason on past experience to be fearful. It is the mood of the markets. If you have to borrow the thick end of £200bn from them this year and next you need the lenders to be on your side. The mood of the world's financial markets has been to cut some slack for governments as they have fought recession. That is sensible. But as recovery takes hold, as it will through the winter and spring, the pressure for policy changes will grow. Paradoxically the stronger the recovery the stronger the pressure on governments to make a start on putting public finances on a sustainable basis.