HAMISH MCRAE: Budget deficit axe is no-brainer for new Prime Minister

The budget deficit is going up, not down, and that is not good. It is not good for the next Prime Minister, for it makes all this stuff about tax cuts and more spending look tricky. 

But more important, it is not good for us as citizens because it means that the slog of getting on top of the current stresses will take even longer. The bill for rebuilding the economy after the pandemic was always going to be big. It has got bigger. 

Up to now, the country’s fiscal deficit has generally been coming in lower than expected. Ever since the pandemic struck, the Office for Budget Responsibility would give its eye-wateringly huge forecasts of borrowing, but then, hey presto, the deficit would turn out to be quite a bit less. 

That was thanks partly to slightly lower-than-expected spending but more because of strong tax revenues. Revenues are still more or less OK, but one really important item of spending is not. It is the interest on the national debt. Not only are interest rates going up everywhere, but thanks to the fact that a quarter of our £2.5trillion of debt is index-linked, the cost of servicing it is adding disproportionately to the burden. 

It gets worse. Debt interest payments are linked to the Retail Price Index, which is higher than the Consumer Prices Index, and the RPI was up 12.3 per cent last month. Who knows where it might go in the autumn – 15 per cent? Imagine paying 15 per cent on a quarter of your mortgage. 

Some numbers. The fiscal deficit in the last financial year was £142billion. This spring, the OBR forecast it would come down to £99billion this year, but warned it might be up to £150billion if the economy slowed and spending climbed. There is not much point in trying to second-guess the detail of what the new Government might do but the respected forecasters Pantheon Macroeconomics are warning the deficit is likely to rise to £170billion. So quite probably up on last year, not down. 

If you are going to borrow on that scale you have to be credible to the markets. If you are not, not only will the interest rate on new debt climb even higher; sterling will be clobbered too, adding to import costs and hence further inflation. 

The markets are not stupid but at the moment they are deeply risk-averse and they will not be inclined to cut the new PM much slack. So the new Government will have to move fast to reassure them. How? First, it has to have a long-term plan to get the running deficit down to a manageable number, say £50billion a year. The Office for Budget Responsibility was created to persuade the global financial community of just that: the UK government of the day would be financially responsible. 

It is needed now more than ever, for the new PM has to build credibility and there is not much time to do so. Next, the Government has to support the Bank of England. Markets do not like governments that try to beat up the central bank. Look what happened in Turkey, where they sacked the central bank governor last year: the lira plunged and the country now has 80 per cent inflation. 

It is perfectly reasonable for people outside of government to criticise the central bankers and part of the current surge in inflation is the result of their collective failures. In the medium-term there are changes that might be made, including to the mandate of its monetary policy committee. 

But the Government has to rebuild its own credibility first. It is on trial too, and if push comes to shove the markets will trust the central bankers more than the politicians. The new Government must also create a credible medium-term plan to lift UK productivity. The problem is extraordinarily complicated and this is not the place to go into detail. 

What is worth saying is that the Government should benchmark every aspect of its policies against global best practice and ask whether what it is doing is likely to help companies deliver their goods and services more effectively, or whether it is making life more difficult and more expensive, rather than easier and cheaper. 

Finally, it has to lift its own game. There are some services that it provides over which it has direct control. If these are not being well-managed, then it should ask itself what it is doing wrong. The world of finance will always pursue its own special interests, notably making profits. But the harsh truth is that the new UK Government needs to show it is competent. By doing so, it will win the support from the people who will lend it the money. Simple as that.