Leading Article: Budgeting for a recovery

YESTERDAY'S figures for manufacturing output are a far cry from what the Chancellor might have hoped, and even farther from the rosy picture painted until recently by the same series, now much revised downwards. The manufacturing-led recovery that seemed so secure earlier in the year is now clearly fragile, buffeted both by continental recession and by exporters' decisions to raise their prices rather than use sterling's devaluation to boost their sales.

It would be easy for the Chancellor to argue, in his Budget on 30 November, that the upturn is still too hesitant for him to take any further risks by raising taxes. After all, Norman Lamont's tax increases are still to come, and will remove nearly pounds 7bn in spending power from the economy in the financial year beginning in April. Employees' national insurance contributions go up by 1 percentage point and VAT will be charged on fuel at 8 per cent.

However, that course runs two risks. The first is that the financial markets at some point panic about the scale of the Government's budget deficit, insisting on much higher long-term interest rates or a much lower exchange rate for the pound if they are to buy the necessary government bonds. That in turn might provoke a sharp rise in short-term interest rates, and undermine the recovery.

The second risk is that we are left - much nearer to a general election, when any spending cuts or tax increases become more difficult - with a budget deficit of Italianate proportions. It would not then be possible to use budget policy to support the economy during the next downturn.

The way out of the Chancellor's dilemma is to cut interest rates sharply to ensure that the upturn continues, but to reassure the financial markets with another small step towards a sustainable budget deficit next month. In time, the Chancellor will need to raise taxes or cut public spending by about 1 per cent of national income - some pounds 7bn - if he is to stabilise the national debt compared with the size of the economy, and if he is also to assure his inflation target of 1 to 4 per cent.

Next year, he should be able to make some contribution by reining back public spending, particularly on defence and in the Chancellor's own revenue-raising departments. But the Bank of England's judgement that the Chancellor might raise half the amount this year in taxes seems about right: a package that took 1.5 per cent out of domestic demand might be offset by a 2- percentage-point cut in interest rates, even after allowing for the depressive effects of high personal and corporate debt. Sterling might dip a little more, but it would soon be supported again as German interest rates continue to fall.

Such a Budget would also ensure that the pattern of the recovery is right. Britain's trade deficit means we cannot afford another import- boosting, consumer-led splurge: we need a recovery soundly based both on export success and on business investment. A brave Budget would hold home spending in check, while an interest-rate cut and some temporary easing in sterling would bolster Britain's traders.