Brown balancing on a thin red line

BARELY has Britain's economic downturn begun – let's set aside the scary 'R' word for now – than the latest figures for the Government's finances show an alarming deterioration. 'Worrying trend' doesn't tell the half of it. They are, in a word, awful.

And they set up the biggest policy crisis yet for the Government and the Gordon Brown premiership. Does he stick to the fiscal rules which he introduced and on which he staked his claim to prudence? Or are we in a new terrain where the economic environment is deteriorating so far and so fast that the rules have to be broken to avoid making the downturn worse?

That is the biggest dilemma the Government now faces. It will be an enormous test of its credibility and leadership and its ability to sustain market confidence. It is not just the Chancellor's job that is on the line, but that of his Prime Minister and, more importantly, confidence in the UK currency. For if the pound's weakness turns into a slide on overseas investor concerns about the credibility of the Government's finances, we will have both a deepening pace of slowdown and rising inflation. Such sterling crises have been the classic death-knell of Labour Governments.

The picture, in brief, is this. After ten years of reasonably prudent management of public finances – let's set aside the constant postponement of lower borrowing – the figures now point to an ominous buckling of the Treasury's fiscal framework. Tax revenues are falling short of Treasury plans, while spending is powering on.

Public sector net borrowing in June hit £9.2bn, up 46% on a year earlier and a record for June. Net borrowing in the financial year to date now stands at £25.4bn. This is two thirds higher than over the same period last year, and another record.

A deterioration at this rate repeated over the rest of the year would result in net borrowing totalling £72.6bn – almost £30bn more than the forecast set out by Alistair Darling in the Budget earlier this year, and sweeping the budget deficit to the equivalent of 4.9% of GDP. This would be the highest level since 1994–95, when taxes were raised. But back then, we were coming out of a recession. Today we are just going into one.

So what's going wrong? As I set out here two weeks ago, tax revenues are stalling, with the oil price-fuelled gain in North Sea oil receipts being swallowed up by tax shortfalls elsewhere. For the latest three-month period, central tax receipts grew 2.5% on the year, while the Budget report had been looking for growth closer to 4.5% for 2008/09 as a whole.

VAT receipts have been especially subdued, reflecting lower than expected spending. Income tax revenues are holding up, but they are expected to stall, while stamp duty receipts could be slashed by half over the year due to the housing market slump. Company profits are also contracting, lowering the proceeds from corporation tax over the year.

The raising of the basic income tax-free allowance to help those left worse off by the scrapping of the 10p tax rate is expected to cost £2.7bn, while the scrapping of the 2p rise in fuel duty that was planned for October will also adversely affect revenues.

As for spending, the Budget projected growth in this financial year of about 5%. The latest data show that, in the first quarter of 2008/09, it was growing at almost 7%. The sharpest rates of increase are being recorded, not in planned departmental spending, but in those elements of public expenditure not subject to multi-year planning constraints. Net social benefits were more than 7% higher in April-June 2008 than in the corresponding months of 2007. And Government interest payments are also rising sharply. In the early years of the Brown Chancellorship, Government finances benefited from falling interest payments. This has now gone into reverse, with central Government debt rising and interest growing between April to June 2007 and April to June 2008 by £1.1bn. For the year as a whole an increase of £4bn is expected against the negligible rise the Treasury projected.

Another big problem is budget forecasts were based on the economy growing by 2% this year and 2.5% next. But most independent economists believe growth will be much lower, with the median forecast for 2009 at 1.5%. Meanwhile, the outlook worsens. We now have the highest inflation since 1992, the biggest rise in unemployment since 1992 and the sharpest drop in house prices for 70 years. This vile combination will lop billions off the Treasury's tax revenue forecasts.

At this stage in the cycle little room is left for any conclusion other than that public finances are effectively out of control. One of the 'golden rules' stipulated that net debt would be held to no more than 40% of GDP. It has already leapt from around 30% six years ago to 38.3%. Add in Northern Rock and other Bank of England liabilities and that figure hits 44.2% for 2008–09, and that's assuming things get no worse from here.

Little wonder there is a flood of speculation about an easing of Brown's famous 'golden rules' or 'borrowing only to invest' and limiting net Government debt. What is the wisdom of sticking to 'golden rules' conceived in an earlier and altogether different era, one that could not have envisaged the scale of the problems we face now?

The pragmatist would argue it makes better sense for the Government's fiscal policy to roll with the punches rather than defend targets and rules that would oblige it either to raise taxes or slash public expenditure, risking a sharp rise in unemployment and stiff trade union resistance. Such a response would make the downturn significantly worse. Indeed, easing the rule would allow the Government to provide much needed short term stimulus to the slowing economy.

So it is policy flexibility that is needed, not adherence to rules that were ambiguous and lacking in credibility. The stated objective was to control borrowing over the lifetime of the economic cycle – leaving the definition of the cycle and its length conveniently at the Chancellor's discretion.

And there is now a precedent for rule-breaking. Had we enforced the 2% inflation 'rule', interest rates would have been raised and homeowners and industry would be in even greater pain. Most believe it would be wrong in today's conditions to enforce the inflation rule. On that logic, would it not be equally wrong to enforce the budget 'golden rules' in the face of a sharp downturn in Government tax revenues?

Rewriting the rules now will be immensely tricky. Rule relaxation would be seen as another retreat by the Government, encouraging public sector unions to try their hand. That steps up the inflation risk.

And overseas confidence would be shaken by any perception that the UK has now broken all the key rules on monetary and fiscal policy by which it said it would abide. What faith can be placed in any subsequent rule regime? And relaxing the fiscal rules now would store up problems in the future. It would require tough corrective fiscal action once the economy is on a firmer footing to get public finances back in a healthy condition.

Thus, if the rules are a problem, scrapping them threatens to create even bigger ones, not least the debt pile that will have to be paid down in future years. This was a Government that set great store by adherence to its fiscal rules. But these rules never did give an assurance that its stance would be fiscally prudent. That is why we are in this mess. Brown was always able to defer calling an end to the economic cycle, and hence a return to budgetary restraint.

The danger now is that replacement by even more relaxed and ambiguous rules will put the skids under the pound and end with rules being imposed by the EU or the IMF. Thus, we may well end up coming full circle – back to the 1970s. It is Labour's worst nightmare, and a measure of the stakes with which the Government is now playing.