Tax and spending squeeze will keep Bank rate low

David Smith: Economic Outlook

So what, now the party conferences are over, do we know about how the budget deficit will be tackled? The answer is not enough, but we are slowly getting there.
Who is making the running? On tax, Labour is still out there, including its 50% tax rate kicking in at £150,000 in April, higher National Insurance contributions from 2011, and the squeeze on tax allowances and the tax relief on pensions.

A strong theme of last week’s Conservative conference in Manchester was that Gordon Brown and his ministers are in denial about the need to tackle the public finances. That is unfair on the chancellor, though perhaps not the prime minister.

There was also an element of denial from the Tories, however. Listening to them, you got the impression that the only tax changes they are contemplating are cuts. They are committed to raising the inheritance-tax ceiling to £1m during the next parliament, and want to reverse the rises in NI and higher-rate income tax.

Before that, we may get the rise in Vat to 20% I wrote about in July, though the Conservatives are not encouraging that speculation. Things are different, they say, to when Sir Geoffrey Howe raised Vat in 1979 and Norman Lamont did so again in 1991.

On spending, while the Tories have much left to announce, George Osborne managed to leapfrog Alistair Darling and, even with a fairly modest set of proposals, turn himself into a credible cutter.

The chancellor, having seen Osborne’s hand, will get a chance to raise him in his pre-budget report in a few weeks’ time. Despite an attempt to get in on the act by announcing a freeze on salaries of higher-paid public-sector employees, Darling had the initiative snatched away from him.

I have left the Liberal Democrats out, though Vince Cable has the most comprehensive plan to cut public spending and described Tory proposals as “Lib Dem lite”.

Even so, they were proposals from a party that expects to be in government soon. They included a public-sector pay freeze in 2011 for anybody earning over £18,000; a reduction in tax credits for the better off (household incomes above £50,000); a £3 billion annual cut in the cost of running Whitehall and quangos; and ending child trust funds for all but the poor and disabled. Together these will save £7 billion a year by the end of the parliament, 2014-15.

Longer-term savings will be achieved by raising the state pension age to 66, beginning with men in about 2016. The burden of unfunded public-sector pensions will be tackled by limiting them to £50,000 (those whose rights already exceed this figure will have their entitlements frozen).

As always with politicians, it is wise to count your fingers after shaking hands. Osborne’s one-year freeze on public-sector pay was presented as necessary to preserve 100,000 “frontline” public-sector jobs. But public-sector employment will have to be cut, even with the wage freeze.

Both Osborne and David Cameron presented their proposal for raising the state pension age as a trade-off for restoring the link between pensions and earnings.

That link, raising state pensions in line with earnings rather than prices, is due in any case to be restored in 2012, at least four years before any increase in retirement age. The Tory argument is that only this will make restoring the link sustainable.

The proposed increase in the pension age, politically very significant, was not handled astutely. The Tory leader got into a muddle over the calculations, an estimated £13 billion reduction in the budget deficit. The shadow chancellor’s team relied on research by Martin Weale of the National Institute of Economic and Social Research (NIESR). He calculated it needed a one-year increase in the retirement age to generate that £13 billion. But because many people retire early and because not everyone’s decision to retire depends on the state pension age, this requires it to increase by at least 18 months and possibly two years.

The Tories got to their figure by basing it, not on today’s prices, but those that will prevail by the time the policy is in place many years from now, which is not the usual way of measuring these things.

This decision will help, and is the right thing to do. By my rough calculation, a state pension age of 66 for men in 2016 and women in 2020 will cut the budget deficit by £7-8 billion (in today’s prices), though not until the 2020s.

To be fair to Osborne, he has not pretended his £7 billion of annual cuts are the last word. Treasury plans imply a £35 billion real cut in departmental spending by 2014, so his proposals represent about a fifth. If the Tories want to cut the deficit faster, as they say, the party will need to identify, not only a further £28 billion, but more.

One interesting question is what a big tightening of fiscal policy means for monetary policy. Will it constrain the Bank of England from raising interest rates? The answer, according to research to be published this week from the Centre for Economics and Business Research (CEBR), is a firm yes. The CEBR, run by Doug McWilliams, assumes a new government will seek to get the budget deficit down more quickly than implied in the Treasury’s current projections, reducing it to below 2.5% of gross domestic product by 2014-15.

The CEBR calculates this will require £100 billion of fiscal tightening, split between £20 billion of tax hikes and £80 billion of spending cuts. If, at the same time, the Bank was raising interest rates, the economy could be squeezed too much.

The Bank likes to distinguish between putting on the brakes and easing off the accelerator. When Bank rate is below, say, 5% that accelerator is being pressed. The CEBR says it will have to be kept close to the floor for some time to compensate for the fiscal squeeze. It predicts another £75 billion of quantitative easing, taking it to £250 billion, and that no assets purchased under the programme will be sold back into the market before 2014. It also thinks Bank rate will remain at 0.5% until at least 2011 and stay below 2% until 2014.

What is good for borrowers is not great news for savers. Policy announcements mean older workers can anticipate being forced into later retirement. Those who are already retired will have to get by on low income from savings for quite a few years.

PS: The only time most of us notice the gold price is when it hits a record, as last week. What does a gold price of more than $1,050 an ounce tell us? The answer, as always, is a mix of sensible argument and daft rumour.

One sensible argument for buying gold for investment is that when interest rates are near zero, the cost of doing so is very low. But when the Reserve Bank of Australia raised interest rates last week, the first in the G20 to do so, the price of gold surged.

This is because of the other big argument about gold, that it is a great hedge against inflation. Gold’s usefulness as an inflation hedge has been exaggerated, as anybody buying it in 1980 (until recently the peak) found to their cost. With many countries suffering deflation, inflation worries look misplaced. World recessions are not followed by galloping inflation.

That leaves the dollar. A report by journalist and Middle East expert Robert Fisk suggested it could be abandoned as the currency for pricing oil. He pointed out, however, that talks on this subject had been taking place for a couple of years and, if there is a shift, the target date is 2018. Gold will rise and fall. The dollar is going to be around as the world’s reserve currency for a long time. (David Smith, The Sunday Times)

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