Page last updated at 07:14 GMT, Monday, 20 April 2009 08:14 UK

The chancellor's Budget dilemma

BBC economics editor, Stephanie Flanders
By Stephanie Flanders
BBC economics editor

Budget deficit

Here's my budget prediction: it's going to be messy.

However much the chancellor might want to talk about a "green recovery" and cleaning up the planet, he knows that this year's Budget is going to be about the mess that is the UK public accounts.

The biggest decision the chancellor has to make this year is how much to promise to clean up.

How exactly to cut borrowing after the election may not be a decision that a Labour Chancellor will get to make

Which mess are we talking about?

Well, there's the mess made by the recession, and there's the mess which we were in already, and the recession simply brought to the surface.

Alistair Darling is likely to focus on the first. After all, everyone understands that recessions are expensive for governments, because they push up spending and pull down revenues.

Hole in public finances

Alistair Darling
The Chancellor will deliver his second budget on 22 April

But strange though it may seem, it's the other, pre-existing, hole in the public finances that is going to cause us the most pain.

On Budget day, the chancellor is likely to announce that he expects the government to borrow around £170bn in 2009-10 and 2010-11.

That would represent a post-war high of nearly 12% of GDP. Borrowing was only around 6% of GDP in 1976, the year that Britain was forced to go to the IMF to bail out its economy.

Of course, the recession has played a big part in this plunge into debt.

Just one year ago the Treasury thought borrowing in 2010-11 would be just £38bn.

It also thought that the economy would grow by at least 2.5% this year and next. Now the latest city forecasts predict a decline of 3.7% in 2009 and growth of only 0.3% in 2010.

Structural problem

Woolworths branch
It's not just the recession that is troubling the Chancellor

That has come at a price, but believe it or not, that is not the UK's biggest fiscal problem.

The biggest problem is that experts such as the Organisation for Economic Cooperation and Development (OECD) and the Institute for Fiscal Studies (IFS) reckon that more than half of our record borrowing is structural - in other words, that it won't go away, even if the economy recovers its lost ground.

The OECD, for example, thinks the UK's structural budget deficit in 2009 will be 7.2% of GDP.

Does that mean that the OECD thinks all that borrowing is unrelated to the recession?

Well, yes and no.

If we were still living with the unsustainable boom we had before, a lot of that 'structural' deficit wouldn't exist (and of course, neither would the "cyclical" borrowing either).

In that sense that structural borrowing is very much related to the credit crunch. But the key word is "unsustainable".

Missing revenue

City dealer
Some parts of the economy may never recover their former size

What the government has discovered since last year's Budget is that a lot of the revenue from the City and elsewhere that it thought was a permanent feature of the landscape was actually a passing side effect of an equally transient boom.

That is what the Treasury meant when it estimated in the pre-Budget report that the credit crunch had permanently cost the government around 4% of GDP.

The other way to put it is that the boom had brought it a temporary windfall of 4% of GDP, which had now gone away.

Either way, the important implication for British citizens is that there is a hole that the government has to fill by raising taxes or cutting spending growth.

How bad could it be?

In the pre-Budget report last November, the chancellor announced a fiscal tightening worth around 2.6% of GDP - or £38bn a year in today's money - most of it in the form of slower growth in spending.

As we know, things have got a lot worse since then.

The biggest disappointment has been tax revenues.

They have come in well below expectations, even after taking into account the sharper-than-expected economic downturn.

We also now have a better idea of how much all the interventions to support the banking system might eventually cost. (Or at least, the IMF has come up with a plausible ballpark estimate of around 9% of GDP.)

Taken together, the IFS thinks that the bad news since November could push up borrowing so much that the public sector's cumulative net debt could be more than 82% of GDP by 2015 - compared to a Treasury forecast of 56%.

And at that time debt would still be rising, rather than falling, as a share of GDP.

Market confidence

Given the need to sustain market confidence, the chancellor will have to say something about how he is going to get borrowing back under control. The question is what.

Projected budget deficits

One option is to continue the approach he took in the pre-Budget report, announcing a further tightening of about £39bn a year by 2015 to fill the new hole.

As the IFS points out, this would mean tax rises or further cuts in the growth of public spending, equivalent to an average of £1,250 for every family in the UK.

However, many would say that this is not a time - economically or politically - to scare the horses any more than you need to.

The alternative would be simply to delay the day of reckoning, though the longer the government waits, the worse the mess will be.

In November the chancellor set out a "temporary operating rule" that the government would balance the current budget and start to bring down debt as a share of national income "once the global shocks have worked their way through the economy in full".

The IFS suggest that condition would be met by 2015-16, but clearly it's a movable target, especially when there is so much uncertainty surrounding all these projections.

The best guess is that he will go with a mixture of both options.

To satisfy investors, he will pencil in some further tightening - most likely on the spending side.

Thanks to the smaller economy, spending as a share of GDP could soon reach 48% of GDP, the highest level since the early 1980s.

Yet the spending plans he announced last November are already tighter than anything achieved in the 1980s or 1990s

So he may also suggest that debt may continue to rise as a share of national income beyond 2015.

That would mean that debt would still be rising, not just for the next general election but the one after that.

The benefits of uncertainty

It may not feel that way to him, but Mr Darling does have uncertainty on his side - both economic and political.

The Treasury and a lot of other experts have been wrong in the past about how much current borrowing was structural and how much was due to the economic cycle.

They have also been wrong about the future path of the economy, and what that would mean for borrowing.

Even in normal times, the average forecasting error for net public borrowing is at least £12bn, even forecasting just one year ahead.

And these are not normal times.

Given all those past mistakes, and the fragile state of the economy, you could argue that it would be unwise to plan too far ahead, especially when we may now be at the hardest point in the economic cycle, when things could be about to turn around.

There is a basic political logic to this position as well.

After all, how exactly to cut borrowing after the election may not be a decision that a Labour chancellor will get to make.

By next May, the voters might well have given that nasty job to someone else.

Long term debt

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