Sunday, 9 November 2008

How bad is the recession - and what can be done?

According to the IMF the UK is going to have the worst projected recession in the rich world with the economy contracting by 1.3 per cent in 2009. What marks out the UK is the high level of indebtedness, particularly among households.

The IMF is encouraging countries to give a stimulus to their economies and the UK has been using both fiscal and monetary instruments. The one-and-a-half percentage points cut in interest rates was a bold move by the normally cautious Monetary Policy Committee, but just how quickly it filters through to the economy remains to be seen.

There are also some downsides. Just how far can the rate be cut? Well, notionally to zero, but the consensus figure is 2.5 per cent, although some commentators are holding out for 1 per cent. That means negative real interest rates, bad news for savers, but also potentially inflationary. If sterling falls, that could also be inflationary. But the Bank is caught between a rock and a hard place.

There is also going to be a fiscal stimulus. Robert Chote of the Institute of Fiscal Studies has suggested that in the pre-Budget report due later this month the Chancellor would have to announce lower taxes or higher public spending close to 1 per cent of national income or £15bn.

There is quite a lobby gathering for a cut in VAT from 17.5 per cent to 12.5 per cent, but that would have a big effect in revenues. It might, however, be possible to tweak both VAT and corporation tax payments to help company cash flows. One could also, in effect, give profitable firms encountering losses a tax rebate by allowing them to 'carry back' losses for three years rather than one as has been the case since 1997.

But at some point the bills are going to come in. As well as stimulating the economy, the Chancellor has to demonstrate that he has a medium-term plan for re-establishing fiscal prudence, once New Labour's watchword. The temptation will be to offer jam today and leave the bill to be sorted out after the next election, most likely by George Osborne (who has already stated that taxes might have to be increased).

A forecast from the European Commission implies £90bn of public borrowing next year compared with the Treasury's budget forecast of £38m. Paying that back implies some pain.

A breezy circular letter from my local (Labour) MP first of all blames the problem on the Americans, overlooking indebtedness in the UK. He then goes on to assert that the Government can afford to borrow more money in the short term 'because we repaid a lot of debt when our economy was growing strongly.' In fact, most independent experts agree that there was fiscal profligacy after the Government's first term in office.

If one was going to be generous, one could say this was Panglossian. I think that he really belives what he is saying, but that is what worries me.

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