UK: Spend, Tax and Borrow (page 3 of 3)

As the Governor of the Bank of England suggested in a speech this week, longer-dated borrowing would meet the desire of many pension funds who are keen to buy longer dated debt to match their future liabilities. Overall, with UK borrowing low and inflation low, the cost of such increased borrowing should not be too high.

Of course, the main desire should be some greater control over public spending. Yet, with spending plans already outlined in the summer Comprehensive Spending Review, the UK looks set for increased government expenditure. This points to a number of potential problems and should be linked in to the last part of the Chancellor's Pre-Budget Report, when he focused on the need for the UK to face up to the challenge from Asia.

Time to Change the Terms of the Debate

The whole framework of the debate on public finances needs to change. Up to now, it is spending that trends higher and has to be funded by taxes or borrowing. However, if the UK is to be truly competitive, facing up to the challenge from Asia, then this should set a limit to tax increases. Approaching this way, would then force a slower pace of spending growth.

Also, the full consequences of increased public spending have yet to be seen. Since 1997, around 0.5mln workers in the public sector have been added. Many are on final salary pensions that are unfunded. The Chancellor did not address the pensions' issue in his Statement, but this is a further future liability that needs to be funded.

There is a view that increased public spending will allow a more regionally balanced economy, helping the output-inflation trade off, but given the skill shortages in the economy, it could if anything force a regional inflation problem. Already there are regional employment hot spots and the likelihood is that the private sector may need to bid up wages to attract staff. There is a data vacuum that prevents the full consequences from being seen. Also, the further one moves from London, the more local housing markets are underpinned by public sector employment. This may of course allow the housing market to be more resilient on the downside, particularly when combined with the shortage of properties in the south-east of England. However, the housing market is already off its peak and its vulnerability is one of the domestic risks that must still concern the Chancellor.

At least, interest rates at 4.75% look unlikely to rise further for now. Yet, with public spending continuing to grow above trend, the Bank of England may decide to keep rates high, relative to the current 1.2% targeted rate of inflation, in order to ensure the private sector grows below trend, thus maintaining balance in the economy.

An increasing share of the public sector is not the best way to ensure that the UK faces up to the challenges from Asia that the Chancellor alluded to. We have spoken and written on this issue many times before. There are a number of issues. There clearly is a need for the UK to become more competitive, particularly in higher value added areas. This points to the need for the UK to break out of its longer-term trend of under-investment. However, the UK must also see Asia as an opportunity, not just a threat; as the Chancellor said in his speech, a region to export to and invest in.

Overall, the market impact from the PBR was limited. Although there is undoubtedly scepticism about the Chancellor's economic and fiscal forecasts, the markets were relieved that there were no shocks in his projections. For now, the view will be that UK interest rates are unlikely to fall. Even though sterling already looks too strong for its own good against the dollar, it may rise further near term. It may not yet be boom and bust for the UK economy, but it will undoubtedly be a rise and fall for sterling as we move into 2005.

Dr Gerard Lyons
Chief Economist and Head of Global Research
Standard Chartered