The UK government's programme announced yesterday is all part of a political strategy. It is not underpinned by new budgets to try to control and then reduce the burgeoning public sector deficits.
There will be a great deal of heat but little light shone by the political exchanges over the weeks ahead. The government will assert that the difference between themselves and their main opponents is they will invest in public services and avoid cuts, whislt their Conservative Opposition will introduce 10% cuts in departmental budgets other than education and health. The Opposition will say that is not their plan, but will say they on taking power will have to make some reductions to start the process of reducing the deficit. In turn they will allege that on Labour's own plans for public spending there will need to be substantial real cuts outside health and education programmes.
So what is the truth behind this bitter exchange of soundbites? Public spending is very high and expanding rapidly, partly owing to the recession and partly owing to policy choices of the current government. Everyone acepts that spending has to rise when more people are out of work, as a natural stabiliser, but there is a difference over how much extra spending governments should undertake when public finances are stretched. We read this week that the cost of welfare budgets now for the first time exceeds all the revenue from Income Tax.
The government has decided to avoid a Public Spending review and publication of new public spending targets for after 2010. It presumably wishes to avoid publishing figures which show reductions in programmes after the Election, and is clearly not in a position to publish figures showing continuing increases. The Opposition is prepared to say reductions need to be made, but is confining its detailed work to identifying a few obvious programmes like ID cards, health computerisation and regional government where it would save money by cancellation or reduction.
In practise any government is going to have to cut the deficit. The longer action is delayed the more difficult it is going to be. So far the government has been able to finance it, as it has embarked on a large programme of quantitative easing, and has engineered substantial buying of gilts by pension funds and banks. Action in curbing borrowing and spending may well be delayed until after May 2010, the likely date of the General Election. The longer things drift, the more likely that markets will become concerned about the large imbalances. We advise investors to avoid UK assets in the meantime. The current rally in shares and sterling provides another opporutntiy to switch to faster growing and better fiananced parts of the world.
We belong to the camp who thinks the longer term rate of growth of the UK is going to be lower than the past trend of 2.5% and the Treasury's official view of 2.75%. In the last decade the growth rate was flattered by heavy borrowing in both the private and public sectors. It is not going to be possible to extend borrowing on the same scale in the years ahead.
Meanwhile, the main issue for markets from here is how the US and UK authorities move from quantitative easing to more normal monetary policies, and how far the ECB goes with more assistance to damaged banks. We think we have seen the best of the quantitative easing boost to markets. We are left with the twin realities that western banks are still damaged and recovery in the industrial economy is so far poor or non existent.