UK Budget: Strong and stable, the search is now on for sustainability

Strong and stable. But is it sustainable? This is the key issue facing the UK economy after UK Finance Minister, Chancellor Gordon Brown delivered his eight annual Budget in mid-March. It was a significant event in a number of ways.

First, it highlighted how well the UK economy is doing. Indeed, The UK is growing at a rapid pace and has been one of the star performers of the world economy in recent years, outperforming other industrialised countries. Sterling is strong and UK assets are seen as attractive. A positive feature for the UK has been its macro-economic stability, helped by a credible policy setting framework. One needs only make a comparison with the European Union to see how well the UK is doing.

Second, the Budget effectively signaled the start of the next general election campaign. Even though the election need not be held for two years, it is widely expected to occur in May or June next year.

Third, the Budget showed that the fiscal numbers on government spending and tax are credible, but only if the economy continues to grow at a strong pace. That is certainly likely this year, but in future years it is far from clear.

The immediate market impact of this Budget was limited. There were few surprises, with the overall fiscal stance broadly neutral. The Chancellor added a relatively small 725 million GBP to the economy this fiscal year, and is taking out an even smaller 65 million GBP next year. These are tiny sums for a Chancellor who previously has shown a strong desire to interfere, with countless tax measures.

A fiscally neutral Budget points to the Bank of England having to fine tune the economy with further, albeit small, interest rate increases. This makes life tough for the Bank of England, as inflation is low but asset prices and borrowing continue to rise strongly. Any rises in interest rates could push sterling even stronger, despite the problems this is already causing for UK exporters.

The Chancellor's first four Budgets, from 1997 to 2000, were dominated by prudence. The Chancellor then played to the markets, keeping public spending under control. In this Budget the focus was on securing long-term stability, with fairness in tax and attempts to encourage enterprises. Yet, by his previous standards, the Chancellor did little, keeping financial markets content. Perhaps more importantly from a political perspective, he avoided alienating business, whilst he kept voters content by avoiding tax increases and pointing to further significant spending rises.

The UK's present economic picture appears good. After 2.3% growth last year, as expected the Chancellor retained his growth forecasts of between 3% and 3.5% for both this year and next. "A Britain of stability and strength" was the message. Yet, for strong growth to be sustained requires growth to become more balanced. And that, in turn, requires, a better mix with higher investment and an improved trade performance. In recent years, the two areas of the economy that have been growing strongly have been driven by debt: consumer debt and government debt. Yet financing such debt is not proving a problem for either consumers or the government.

Strong jobs and steady income growth has given people the confidence to take on more debt. And low inflation leading to low interest rates has made it cheap to service such debt. The ideal situation would be a gentle slowdown in consumer spending, matched by both a rise in investment and a trade improvement. Yet, despite the Chancellor's upbeat assessment of the economy, businesses seem more cautious. As has often been the case in the UK, investment is low. The latest trend in trade also demonstrates a dramatic deterioration. The Treasury projects a huge current account deficit this year. Although such a trade deficit is not presently a problem it could become so for sterling once the overall pace of economic growth slows in the future. Sustainable growth requires more balanced growth.

Sustainability is also the key word when analysing the Chancellor's fiscal sums. This year government borrowing is set to reach 37.5 billion GBP. Although only slightly higher than his previous forecast in December, this is a borrowing figure 10.2 billion GBP higher than forecast only a year ago. Whilst the Chancellor's economic forecasts may have proved correct, his borrowing projections have proved poor. Perhaps this should not be a surprise. The margin of error in such budget forecasts is high, and averages about 11 billion GBP for predictions made just one year ahead. Whilst spending trends higher, tax revenues have disappointed. If this continued, it would be a big problem.

Yet, as one might expect, the Chancellor expects it all to be good news in the future. As is often the case, the government expects the future pace of public spending growth to slow whilst higher taxes boost revenues, allowing the deficit to stabilise and then improve dramatically. So in time, government borrowing is expected to fall sharply. But with the borrowing numbers so high, the margin for error is small.

The forecasts may be credible, but are dependent on a strong economy. If growth disappoints then either spending will have to slow even further, or taxes rise. This is unlikely to become an issue this year, but it could in the future. And it signals the battleground for the next general election.

Dr Gerard Lyons is Chief Economist at Standard Chartered