Financial phoney war spills into 2011

From the viewpoint of public finance 2010 was the year of the ‘phoney war’. After an extended period of debate and planning fiscal consolidation in the UK will finally start in earnest in 2011. The catalyst for fiscal consolidation was the banking crisis of 2008 which, while having a strong international dimension, was also the result of UK domestic policy.

The sub-prime crisis in the US may have been the trigger of the banking crisis but almost a decade of ‘light touch’ regulation of the banks and of profligate public expenditure places a heavy onus of responsibility for the depth of the crisis on the last UK Government. A measure of how much Labour relied on a booming banking sector can be gauged from the fact that financial intermediation generated 18 per cent of  London’s total gross value added (GVA) in 2007 compared with an already very high 12 per cent a decade earlier.

Over the same period the disparity in relative regional GVA per capita increased with London boasting a record 170 per cent in  2007 and  only London and south east England being higher than the UK average. For most countries and regions in the UK the decade was one of increasing economic divergence. Unfortunately, the impact of the banking crisis will not show a similar geographic pattern but will be felt most severely in the poorer countries and regions.

Few question the need for fiscal consolidation which can be achieved by a combination of four measures:

• Tax increases
• Public expenditure cuts
• Economic growth
• Inflation

These factors are interrelated. An increase in taxation can reduce economic growth. Spending cuts can militate against growth since the unemployment that inevitably ensues cuts tax income and increases public expenditure on welfare payments.

Populist politicians seek to simplify the argument into either being in favour of cuts or pro increased taxation. In practice, however, a balance needs to be struck between taxation, expenditure and growth. In the run-up to the UK general election little light was shed on this conundrum.

Interestingly the one factor no one spoke of was inflation. One way of shrinking national debt is to inflate it away and it is noteworthy that the Bank of England appears to have suspended its brief to target the Consumer Prices Index at 2 per cent over the medium term. It is a measure of the current uncertainty that analysts in the City are still concerned either about the dangers of prolonged inflation or an even less desirable deflation.

Political debate has centred on the respective contributions to fiscal consolidation to be made through tax increases and spending cuts. In the run-up to the election there was little to choose between the policies of the parties with none being ready to detail their plans for fear of exposing themselves to criticism: hence the phoney war.

Labour had much earlier set out in broad terms its plans for cutting public expenditure for the three years after the general election. In its 2009 budget it provided enough details to enable estimates to be made of the planned cuts in departmental expenditure. It was on the basis of Labour’s 2009 budget that it was shown (Agenda, Winter 2009) that the departmental expenditure limit for Wales would be cut in real terms by £1.33 billion by 2013-14. In an independent exercise some months later, the Wales Audit Office came up with an estimated cut of £1.50 billion. In practice under the new UK government the corresponding cut will be £1.52 billion. Capital investment is to be cut by 41 per cent in Wales which compares with Labour’s 2009 plans for a 45 per cent cut.

There are two significant differences between the new government’s plans compared with those of Labour. There will be a sharper cut in the first year and there will be substantial cuts in welfare spending. After a number of ranging shots the new government has committed to cutting UK welfare spending by £18 billion by 2014-15. The corresponding cut for Wales will be approximately £1 billion and these cuts will hit those least able to bear them the hardest.

The strategy behind the fiscal plans of the current government is rapidly (over four years) to bring the deficit back to more normal levels. The hope is that will engender confidence in the markets which will be reflected in lower interest rates and a strong recovery in the private sector. At the same time, cutting public expenditure should force greater efficiency in the public sector while the resultant job losses should be compensated for by growth in employment in the private sector.

That is the strategy. But questions remain as to whether it will work. Is there sufficient demand both in the UK and internationally to enable the private sector to grow employment rapidly enough? Will events elsewhere and particularly in the Eurozone derail an international recovery? Will the skills required by the private sector be matched by those losing their jobs in the public sector? Will the new jobs be created in the areas worst hit by public sector cuts? These questions are particularly pertinent in Wales with its low skills, high dependency on the public sector and its relatively weak private sector.

In Wales the cuts should be a ‘forcing factor’ to make us look long and hard at the spending priorities of the Welsh Government and the success or otherwise of its policies. Since the establishment of the National Assembly there has not been enough evidence based debate regarding public policy. Possible reasons for this are:

• Buoyant public spending did not force hard choices.
• The same party was in office in London and in Wales.
• The weakness of the Welsh media.

These factors do not mean that there cannot be high quality policy debate and formulation in Wales based on sound evidence. The Richard Commission and the Holtham Commission, both commissioned by the Welsh Government, stand out as two excellent examples of policy formulation at its best.

The coalition government in Cardiff announced its draft budget for the coming three years in November. Compared with the spending plans of the UK government for England over the next four years which claim to protect spending on the NHS (indeed, they plan to increase spending by a total of 0.4 per cent in real terms over the coming four years) the Welsh Government explicitly decided not to protect any spending programme but spread the pain in accordance with the priorities of the One Wales agreement. However, capital investment will fall sharply and it is a missed opportunity not to redirect some spending from an admittedly squeezed revenue budget to capital investment which would act as a counter cyclical stimulus.

In the election next May Labour and Plaid Cymru will face the challenge of defending the coalition’s spending plans while simultaneously seeking to differentiate their respective policies. The Conservative opposition in Wales reacted to the draft budget by declaring their intention to safeguard health spending in Wales even though this implied much deeper cuts to other programmes. After an uncertain start the Conservatives have now released a high level budget for the coming three years. It is to be hoped that the Conservatives will publish greater detail over the coming weeks to enable a constructive and vigorous debate to take place in the run-up to the National Assembly elections.