Gilts as we have been saying for 6-12 months.

THURSDAY, APRIL 23, 2009

Strategic Void

Into the unknown

Yesterday's budget was way beyond depressing - it was downright alarming.

It wasn't just the dire state of the public finances, with government debt stillforecast to double in next five years, despite preposterously Panglossian growth assumptions, and despite ignoring the costs of the bank bailouts.

Even more alarming was the complete absence of any coherent strategy for gripping the crisis. Just like so many Labour budgets before, it's an unconvincing mix of fudge, half-truths, and wishful thinking.

Look, I know we've droned on about fiscal strategy many times, but it is now absolutely critical that we have one.

Why?

Because otherwise, sooner or later, the markets are going to lose confidence in the government's financial probity. And the costs of that will make our current predicament look like a Sunday afternoon picnic.

Remember the 70s, when the markets last lost confidence. The government found great difficulty issuing its bonds, because investors went on strike. They demandedmuch higher returns, and gilt yields (roughly, the interest rate on government bonds) reached an eye-watering 17%. To re-establish credibility, the Callaghan government eventually had to go crawling to the IMF.

Right now, the average interest rate on government debt is just over 4%. So with outstanding debt of £620bn, the cost of annual debt interest is £28bn.

But supposing the interest rate doubled to 8-9% - still much lower than the 70s. Then, with debt itself set to double, the annual cost of debt interest would go upfourfold, to well over £100bn pa. And to pay the extra, taxes would have to rise massively - equivalent to say, a doubling of VAT*.

So it is essential to maintain market confidence.

Now, nobody would start from here, and none of the options look good. But what we need is a fiscal strategy addressing two main issues - affordability and value for money.

On affordability, we need to acknowledge that much of the collapse in UK tax revenues is permanent, reflecting the collapse of our financial bubble - it's gone. And that means we can no longer afford the same level of public spending. Spending has to be cut, and our strategy has to set explicit targets for doing so. No more fudging - we need that Third Fiscal Rule spelling out limits for spending as a percentage of GDP (see many previous posts eg here).

On value for money, everyone now agrees that the public sector is riddled with waste - the TaxPayers' Alliance estimates it's costing around £100bn pa. But simply telling spending departments they've got to be more efficient just doesn't cut it. We've had government efficiency programmes as long as I can remember - Heath's government certainly had them - and none of them have really got on top of the problem.

The real key to more efficiency in the public sector is choice and competition - just like it is in the private sector. And instead of nibbling round the edges, we need an explicit overarching strategy to spread choice and competition across the public services. We've blogged many of the ideas before - school vouchers, social health insurance, fiscal decentralisation, directly elected officials, etc. It would be much clearer and easier to implement if we connected up the pieces into a stated strategy.

If we had both of these strategies in place, it would not only comfort the financial markets that HMG was committed to living within its means, it would also comfort taxpayers that that HMG was actually serious about delivering value for all that money.

*Footnote Yes, OK, the full impact of higher gilt yields would take some time to move through into debt interest costs, because existing gilts have lower yields fixed for years to come. But trust me, within just five years the pain would be more intense than you'd want to bear.