Evercore Pan Asset

Much of the commentary on the UK economy has been looking at the public sector squeeze, which has not yet started according to the numbers. It has ignored the private sector squeeze, which is long and deep. Public spending in the first nine months of the Coalition government has been running 7% higher in cash terms than the same period a year earlier. There has been much talk of cuts, but most of these have been delayed to future years. There has been little talk of spending increases, but there have been some significant ones in areas as diverse as overseas aid, health and the European budget including assistance to Ireland. Even an item which has been debated as big cuts, the imposition of higher tuition fees on students, will push up public sector borrowing substantially when it first comes in. The government has to lend the money to the students in the first place so they can pay the universities for their fees.
 
A recent piece of work commissioned by the BBC from the IFS has got closer to the truth about the state of the UK economy at budget time. Real incomes have fallen since 2008, and are going to remain under pressure as the Governor of the Bank of England recently pointed out in a gloomy speech. People on median earnings are worse off than in 2008. People on well above average earnings have taken a much bigger reduction. Pensioners have fared less well than younger people, because they tend to be savers without borrowings at a time of very low interest rates.
 
The main reason real earnings for the average earner have been falling is the high rate of inflation. The Governor was the right man to point it out, as it has been easy money and a weak exchange rate that have done most of the damage. On median earnings direct taxes and benefit changes have been slightly helpful to the individual.  VAT has been the only major cut in living standards from the government. Most of the reduction – and the usual growth in real earnings foregone – has come from the high rate of inflation at a time of modest wage increases. Bank of England forecasts point to further high inflation in the first part of this year, leaving people worse off again as pay remains under reasonable control. The public sector, which has enjoyed good pay rises up until now, wil enter a pay freeze at a time of 4% inflation. Higher earners have been hit by tax and benefit changes.
 
None of the changes in the budget are going to make much difference. We know the numbers on overall spending, borrowing and taxation in advance. These have been set out for a five year period, and the Chancellor does not want to deviate much from them. The better news, that borrowing is a bit below target, gives him a cushion ahead of the impact of slower growth. We read that official forecasts are being shifted down, in the light of the poor performance in the final quarter of 2010, and the more difficult global circumstances as the emerging markets cool their economies. It would be unwise to declare victory over the deficit this early and start to increase spending more rapidly and prematurely.
 
So what can the Chancellor do to ease the squeeze on the private sector? Tackling the deficit may help stabilise the currency, which in turn cuts one of the main sources of inflation. Offering reduced regulations and special schemes for enterprise may at the margins help create more jobs. The more the government can help transfer people from benefits to work, the more real incomes will benefit. It also helps greatly in bringing the deficit under control, by cutting the costs of unemployment on the benefit bills. Much of the government’s strategy rests for its success on their new welfare reforms designed to make it more worthwhile to work, and planned to help people back into employment by assisting them with training and other support. Early pilots are finding that a significant number of people on disability benefit could work and would like to work.
 
The future of the UK economy rests rather more on what happens to the banks than on the relatively minor changes in the budget. The government has to handle the Vickers Report into the structure of the banks. Somehow they need to keep the main banks resident in the UK, keep the tax revenues from the banks up, and at the same time encourage them to lend more. All this has to be done whilst allowing or requiring them to rebuild their capital bases. The biggest headwind to UK economic recovery is the state of the banks, and the biggest threat to deficit reduction is more loss of revenue from financial sector and other businesses deciding to go offshore. The Chancellor’s technical changes on business tax are important. His stance on the banks will be even more crucial. This year we cannot judge the future trajectory of the Uk economy on budget measures alone. Other matters will have a bigger impact.

As published in Investment Week