Evercore Pan Asset

It is quite difficult having a sensible discussion about UK public spending and borrowing. Most people know that spending has been cut and are busily discussing whether the pace of the cuts is too fast and total spending now too low. The problem is, the figures the Treasury publish show an entirely different story.

The June 2010 Budget clearly set out the plan to increase public spending for the first two years of the strategy. The government decided to increase current public spending by £37.3 billion in the first year, and by £51.1billion for the second year compared to 2009-10. These were real increases, assuming they held the line on public sector costs and wages as planned. They abated some of the planned cuts in capital spending. Overall, taking capital and current combined, they planned to increase total spending by £27.5 billion in the first year.

All of the increase was to be borrowed. They planned to borrow £149 billion in 2010-11, or 10.1% of GDP, and then borrow another additional £116 billion in 2011-12. The March 2011 budget revised the borrowing figure upwards for the present year.

By any standards this is a huge fiscal stimulus. In past cycles people have discussed boosting the economy by an increase of one or two percentage points of GDP through additional public borrowing and spending. No-one has seriously believed you can sustain additional borrowing at the rate of around one tenth of your output year after year. The discussion we now need is not should we have additional fiscal stimulus, but why has such a massive injection of borrowed public sector money had so little impact on output?

It appears that large fiscal stimuli produce diminishing returns. Every pound borrowed is a pound the private sector can no longer spend, because it has to lend the money to the private sector. The bigger the state sector becomes, the more worried people in the private sector grow about future tax increases. The public sector has a habit of assuming the large increases in spending it undertakes to “boost” things in hard times should be built into its base budgets and spent in perpetuity. As you cannot go on increasing borrowing at current rates indefinitely, that means higher tax bills in the future to pay for all the increased spending. If a government over-expands public spending, borrowing to do so, it can undermine confidence in the private sector. It hits spending and demand, which in turn depresses the private sector.

The biggest problem the current policy has created is rapid inflation. The combination of money printing through the QE programme, and the surge in public spending and borrowing, has pushed up public sector costs and pushed down the exchange rate. This has cut real incomes in the private sector, fuelling the economic slowdown. The substantial cash increases in public spending have in part been lost in inflation of public sector costs.

Pan thinks the UK strategy faces problems. The possibility of another round of QE is already hitting the exchange rate and points to further inflation. The slowdown in activity means less tax revenue than the Budget plans, which means in turn less success in cutting the deficit than forecast. The deficit reductions always depended on increased revenues, given the decision to increase cash spending every year. We continue to think recovery in the UK and successful deficit reduction is going to take time. The risks do not seem to be fully recognised in the markets.