Taxpayers face a generation of pain

Fiscal stimulus was the economic tool, so long disparaged by the policymaking community, that came into its own during the economic crisis, playing its part alongside monetary easing and bank bail-outs in warding off a depression.

But the result of fiscal stimulus in almost every Group of 20 economy has been the rise of deficits to levels never seen in peacetime, debt so high there is not the ammunition to fight another economic war and a bill to clean up the mess that will be felt by tax payers for a generation to come.

The latest estimates from the International Monetary Fund show that advanced countries’ deficits averaged 1.9 per cent of national income before the financial crisis started in 2007. This year they are expected to hit 9.7 per cent, followed by 8.7 per cent in 2010.

Public sector gross debt is expected to explode from an average across advanced economies of 78 per cent of national income in 2007 to 118 per cent in 2014.

Emerging economies with their faster economic growth and greater constraints on borrowing expect much lower build-up of debt.

The greatest effect on deficits and debt has come not from discretionary stimulus measures but lost tax revenues and increases in public expenditure as unemployment has risen.

The problem for advanced economies is that plans for a great fiscal consolidation are needed at the same time as they are expected to cope with the retirement of the postwar “baby boomer” generation.

Few are under any illusion that this will be a difficult task. Jørgen Elmeskov, acting chief economist of the Organisation for Economic Co-operation and Development, argues that “stopping the rot is clearly necessary and will call for fiscal consolidation that is substantial in most cases and drastic in some”.

Dominique Strauss-Kahn, managing director of the International Monetary Fund, said this week that fiscal consolidation should be the “top priority” for the medium term in advanced economies once recovery was firmly established, because “the threats are greater, the politics are more complicated and the machinery of adjustment is more unwieldy”.

The IMF chief was speaking in London, which was apt as the UK has potentially one of the most difficult feats of fiscal consolidation to perform. Its tax revenues were heavily dependent on financial sector profits; public spending had been set to rise rapidly until 2011; and the country has very strong automatic stabilisers and an extensive means-tested system of state support, which automatically kicks in as people become unemployed.

The UK’s budget deficit is projected to rise from 2.6 per cent of national income in 2007 to 13.2 per cent in 2010, according to the IMF. Gross debt is forecast to more than double from an internationally low 44 per cent of national income to 98 per cent in 2014.

The UK has records on government borrowing and debt stretching back to 1691. The expected 50 percentage point rise in the debt-to-national-income ratio is similar in proportion to that experienced during the many wars Britain fought in the 18th century and is the biggest peacetime explosion of government liabilities.

In cash terms, the government expects to borrow more in 2009 and 2010 than the entire borrowing of centuries of British governments between 1692 and 1997.

The pressure mounted this week when Mervyn King, the Bank of England governor, reiterated his view that official plans to reduce the deficit by half over the next four years were insufficient and not credible.

Instead, he called for “something where a really significant reduction in deficits to eliminate a large part of the structural deficit should take place over the lifetime of a parliament”.

Plans for deficit reduction are central to the domestic political debate, but neither main UK party has come close to providing a detailed programme for public expenditure curbs of the scale needed to cut the deficit and control debt.

The scale of the cuts is, however, already clear. Under the government’s existing Budget, it is planning to halve the annual level of capital expenditure between 2009-10 and 2013-14. Road, hospital and school building will bear the brunt. Day-to-day expenditure will also be hit hard.

Over the three years from April 2011 government departments will face cuts of 1.9 per cent a year in real terms, compared with the annual rises of more than 4 per cent they were used to in the previous decade.

“This would be the tightest squeeze in spending on public services since the UK was negotiating its spending plans with the IMF in the late 1970s,” says Robert Chote, director of the independent Institute for Fiscal Studies.

The main difference between the parties is that Labour believes that doing too much deficit reduction too soon might threaten the anaemic recovery, while the Conservatives claim that doing too little might lead to higher borrowing costs.

But the big issue confronting Britain and governments in all advanced economies is that the current level of public borrowing is too high but few know when to start consolidation, or how fast it should be.

Whatever happens, people in Britain will have to get used to paying much more for their public services and receiving much less.