U.K. Pre-Budget Report Likely to Deliver Significant Stimulus to Struggling Economy

Desperate times call for desperate measures. Ordinarily with the public finances in the very poor state that they are, the government would be highly unlikely to be enacting fiscal stimulus. Indeed, data released this week showed that the current budget deficit more than doubled to £23.3 billion in the first seven months of fiscal 2008/09 (April-October) from £9.5 billion in the corresponding period in 2007/08. Current government receipts were up just 1.9% year-on-year in April-October, which was way below target and reflected a deteriorating tax take. In contrast, current government expenditure was up 6.0% year-on-year. Meanwhile, the Public Sector Net Borrowing Requirement (PSNBR) surged to £37.0 billion in April-October from £20.1 billion a year earlier.

At the current rate of deterioration, the PSNBR is on course to hit £67.5 billion in 2008/09 compared to the Chancellor's target of £43.0 billion in last March's budget—without taking into account any immediate stimulus actions that may be unveiled by Darling on Monday. Indeed, in normal circumstances, there would be much more focus on how the public finances have got to be in such a poor state after GDP growth averaged 2.9% a year over the period 1997 (when Labour came to power) through to 2007.

But these are very, very far from ordinary times and the key issue is trying to ensure that a potentially long and deep recession does not develop into something even nastier.  The very real risk of something extremely nasty happening to the economy warrants substantial fiscal stimulus being enacted at this stage in addition to the monetary stimulus now increasingly coming from the Bank of England.

Forecasts

 The government's GDP forecasts in last year's Pre Budget Report for 2008/09 were far too optimistic. This was evident to many people at the time, but the government needed to put as positive a spin as possible on the outlook to support its forecasts for the public borrowing requirement and to meet its "Golden Rule." Under the "Golden Rule," the current budget (when expressed as a percentage of GDP) must be balanced during the economic cycle, with borrowing only allowed to finance capital investment; it is not allowed to fund current expenditures. In addition, public debt must not exceed 40% of GDP.

The Golden Rule has now been consigned to history. In addition, there is little point in the government trying to underplay the weakness of the economy, when it is stressing the need for significant fiscal stimulus to limit the length and depth of the downturn. Consequently, we expect the government to forecast that GDP is likely to contract by around 1.0-2.0% in 2009, which would be in line with IHS Global Insight's current projection of 1.5% GDP contraction in 2009.

Nevertheless, we suspect that the government may put a positive spin on the likely pick up in economic activity in 2010, to try to boost optimism, encourage the impression that its planned fiscal measures will have a major impact, and limit the size of the uncomfortably large Public Sector Net Borrowing Requirement (PSNBR) that it will have to forecast for 2010/11. We forecast GDP growth at 0.8% in 2010, but would not be surprised if the government projects it to be 1.0-2.0% or even 1.5-2.5%.  Meanwhile, we currently forecast the PSNBR to amount to £62 billion (4.2% of GDP) in 2008/9, £94 billion (6.3% of GDP) in 2009/10 and £97 billion (6.3% of GDP) in 2010/11. However, these forecasts could well be revised up significantly, depending upon the size of the fiscal stimulus that the government announces and how quickly the measures take effect.  

Long-term Sustainability of Public Finances

While there is a strong and justifiable case to loosen the already slack purse strings now—and the relatively low level that public debt facilitates—it is of vital importance for the credibility of economic policy that the government gives clear indications as to how public finances will be restored to a sustainable state over the long term, and then kept there.

Stressing that the government remains committed to long-term fiscal discipline and sustainability will not be enough. With its frequently maligned and long-discredited Golden Rule now blown out of the water, the government needs to be open about the extent of the fiscal tightening that will be needed to rein in the public finances over the longer term once the economy is on a sounder footing. This includes acknowledging that the fiscal stimulus will be temporary and that tax hikes and/or tight controls on public spending cuts will be necessary further out.

The Chancellor has indicated that the government can reduce the budget deficit by several billion of pounds from making extra efficiency savings and getting better value for money from public spending from 2010-11. This, in itself, will clearly be insufficient to return the public finances to a sustainable state, particularly as there is always considerable skepticism over potential claimed efficiency savings.

There have been calls for an independent body to be set up to monitor the public finances. This seems unlikely to happen, but it could well bolster confidence in the government's commitment to longer term fiscal discipline and sustainability.

Potential Main Measures

Reports suggest that the fiscal stimulus is likely to amount to at least £15 billion (around 1% of nominal GDP) and could be as much as £30 billion (around 2% of nominal GDP). The indications are that Chancellor Alistair Darling favors a smaller stimulus due to concern about the state of the public finances, while Gordon Brown believes a larger stimulus is warranted and possible.

The fiscal stimulus measures that the government announces need to feed through as quickly as possible to boost the economy. In addition, while savings rates need to rise in the United Kingdom over the long term, in the near term, it is important that most of the extra money given to consumers is spent. This heightens the case for any tax breaks and hand outs to be heavily directed towards the lower paid and less well off who have a greater propensity to spend. In contrast, the better off tend to save more of any extra money they get, especially at times of uncertainty.

It is also necessary that any extra or advanced public spending and investment can be utilized quickly.

Given these requirements, it seems highly probable that the measures to be announced by the government will include:

• Increase in tax credits for poorer families
• Increase in child benefit 
• Increase in winter fuel payments
• The bringing forward of capital spending on transport projects, infrastructure, schools, and hospitals. The Financial Times reported that this element of the stimulus package is likely to be less than £5 billion.
• Increase in the funds available to small businesses. The Financial Times has reported that the small firms' loan guarantee scheme is likely to be extended.
• Measures aimed at temporarily easing the tax burden on small companies.

Possible measures include:

• A temporary cut in value-added tax
• A 1p cut in the basic rate of income tax
• An income tax rebate
• Raising the lower income tax rate threshold 
• Cutting corporation tax
• Extending and deepening the stamp duty suspension. This is currently for one year from September for homes costing up to £175,000

Extent of Fiscal Stimulus Will Influence Bank of England's Interest Rate Plans

The minutes of the November meeting of the Bank of England's Monetary Policy Committee meeting revealed that the MPC considered cutting interest rates by even more than the 150-basis-point reduction from the 4.50% to 3.00% that was actually enacted. One of the factor's deterring the MPC from making an even larger interest rate reduction in November was a desire to see the government's fiscal plans in the Pre-Budget Report.

This suggests that the size of what seems a highly probable Bank of England interest rate cut in December could be influenced significantly by just how much fiscal stimulus the government announces in the Pre-Budget Report. If the government's planned stimulus is at the top end of the £15-30 billion range being bandied about, then the Bank of England may well be reluctant to cut interest rates by more than 50 basis points from 3.00% to 2.50% in December. A smaller fiscal stimulus could well see the bank cut interest rates by another 100 basis points to 2.00% next month, given the sharper-than-expected drop in consumer price inflation in October and rising fears that deflation could occur next year. Further out, interest rates seem ever more likely to fall as low as 1.00% in 2009.