Britain now faces one of the most serious fiscal crises in its peacetime history. One reason is that the UK is now caught up in a sudden and severe international recession. However, the government has also recklessly increased its discretionary spending since 2000, and is trying to fight the present recession with costly Keynesian pump-priming measures of doubtful effectiveness.
The question is whether it is possible to fund such high levels of expenditure. The government’s Budget constraint means that all public spending has to be financed either by taxes, borrowing in the financial markets or borrowing from the central bank.
But taxes on income and wealth, indirect taxes plus local authority levies, and social security taxes have all reached their effective upper limits in relation to national output over the past two-to-four decades.
Raising the tax burden on the private sector of the UK economy is therefore not a realistic option. The next question that arises is therefore whether the government’s borrowing projections are sustainable.
The Budget forecasts imply that the ratio of the current budget deficit to factor-cost GDP will rise from 2.6% in 2008, to 9.1% this year, and 10.8% in 2010. This is a far larger current deficit than that recorded in the slump of the inter-war period, let alone the post-1945 experience.
The HM Treasury projections are noticeably smaller than the deficits recorded during the two world wars, however. On both occasions the UK was largely kept afloat by loans from the USA. It seems unlikely that Britain will be so lucky this time round, particularly now that Chinese officials have stated that they are not interested in adding further British government liabilities to their foreign exchange reserves.
There must be serious doubt whether deficits on this scale can be financed in a non-inflationary manner, at a reasonable real rate of interest, without very large capital inflows from abroad. In turn, it is hard to see why such inflows should be forthcoming. Rising taxes and stifling regulations have gradually undermined the productive potential of the UK, making it an increasingly unattractive destination for overseas investment.
Professor David B. Smith is the author of the report, How Should Britain’s Government Spending and Tax Burdens be Measured? A Historic Perspective on the 2009 Budget Forecasts, released by the IEA today.