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Fiscal boost won't stop deflation

Created:
18 November 2008
Written by:
Chris Dillow

The huge rise in government borrowing which Alistair Darling will announce in Monday's Pre-Budget Report will not stop recession or deflation, economists say.

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Michael Saunders of Citigroup expects the Chancellor to forecast that public sector net borrowing will hit £90bn in 2009-10. That's £52bn more than he predicted as recently as March. But, says Mr Saunders, this "will not be enough to prevent the near-term recession".

Nor will it stop deflation. David Owen of Dresdner Kleinwort expects the retail price index to fall by 2.5 per cent in the 12 months to next September - the biggest drop since 1932. Markets share these concerns. Futures markets are pricing in a 1.4 percentage point fall in three-month Libor - to 2.7 per cent - by next September. Traders do not believe higher government borrowing will prevent the need for more interest rate cuts.

One reason for this is that most of the rise in borrowing is due merely to the recession cutting tax revenues, rather than a deliberate injection by the Chancellor. Mr Saunders says that the poor state of government finances will limit any discretionary tax cuts or spending increases to little more than £5bn. Which is not much in a £1.5 trillion economy. And even this might be saved by consumers rather than spent, as households worry about rising unemployment, high debt and the fact that taxes will rise once the economy recovers.

The challenge for the Chancellor is to find a form of stimulus that won't, or can't, simply be saved. One possibility lies with business taxes. Bill Dodwell, tax partner at Deloitte, says Mr Darling could allow smaller businesses to defer their tax payments. This would, in effect, be a government loan which would plug some of the gap created by the banks' reluctance to lend. In relieving the credit squeeze on some companies which might otherwise go bust, this could ameliorate some of the recession.

Another hope is that fiscal policy would loosen around the world. This would help the UK - insofar as it boosts activity overseas - not only by raising imports, but because any global economic recovery might encourage banks worldwide to resume lending.

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