Darling’s Christmas present conceals a debt trap

Simon Ward, economist and strategist at New Star: Alistair Darling's emergency budget is pregnant with dangers. His package will not achieve his objectives of shortening the recession and hastening recovery while the borrowing the UK will have to undertake will impose major costs on future taxpayers, endangering the long-term health of the economy.

On the face of it, Darling is delivering a significant economic stimulus in 2009-10 through his temporary VAT cut and other measures. The Treasury reckons cyclically-adjusted net borrowing will rise by 1.9 percentage points of gross domestic product (GDP), the largest increase since 1992-93. This package will contribute to record headline borrowing of £118 billion in 2009-10 or 8% of GDP.

The form of the package and its temporary nature, however, imply a much smaller positive impact on demand.

Most consumers base their spending on their long-term income expectations, not current earnings. Current income is a key factor only for families with no savings or unable to obtain credit.

It follows that a temporary tax cut applied across all families paid for by higher future taxes may not have a significant impact on consumption. Measures targeted at savings-short, credit-constrained people would have a greater chance of success but the rise in spending of those benefiting would be partly offset by cutbacks by other consumers anticipating lower future post-tax incomes.

Fiscal actions financed by higher borrowing can deliver a short-term stimulus. Policies must, however, be designed to enhance the economy's supply potential, thereby raising long-term income expectations. Examples include marginal tax rate cuts, which stimulate entrepreneurship and effort, and public investment in projects promising high returns such as transport infrastructure.

A temporary VAT cut is not targeted at people more likely to spend any windfall gain and has no positive impact on the economy's long-term supply potential. Consumption will rise in the months before the lower rate is withdrawn but fall by roughly same extent afterwards. The temporarily higher demand will be met either from imports or a rundown of stocks, with no impact on domestic production.

Higher borrowing can have monetary effects - a rising deficit financed by bank borrowing rather than bond sales to long-term institutions would boost the money supply, thereby representing a "net injection of cash to the economy". The same positive monetary impact, however, could be achieved simply by "underfunding" the existing deficit, without further fiscal largesse. In any case, the authorities appear to have rejected underfunding as an option.

Regardless of whether the effect of Darling's package is large or small, it will be fully reversed in 2010-11 and beyond as the VAT cut is reversed and higher national insurance and income taxes kick in. Cyclically-adjusted net borrowing is projected to fall by a combined 2.9 percentage points of GDP in 2010-11 and 2011-12. This could undercut the Treasury's hopes of GDP growth of 2% and 3% respectively in these two years.

So it is possible that by 2011 the economy will be no stronger than in the absence of Darling's measures yet the public finances will be worse, with the net debt/GDP ratio on the Treasury's own optimistic projections reaching 53% by March 2011, even excluding the impact of recent financial sector rescues.

Servicing this growing debt will eat significantly into the nation's resources. The Treasury projects a rise in debt interest from 1.7 percentage points of GDP in 2008-09 to 2.4 percentage points by 2013-14. This increase is the equivalent of £10 billion in today's prices. Put another way, the increased cost equals a 2.5p rise in basic rate income tax.

Even this, however, could prove to be too optimistic. The Treasury assumes the interest rate paid on debt averages 0.9 percentage points less than the annual GDP growth rate in nominal terms between 2010-11 and 2013-14. Investors may, however, demand higher yields to induce them to hold more gilts in their portfolios. If the average interest rate were to equal nominal GDP growth, debt interest would soar to more than 3% of GDP by 2013-14.

The danger is of a debt trap - a vicious circle in which the debt/GDP ratio explodes as rising debt interest causes ever-widening budget deficits.

A debt trap develops if two conditions are fulfilled - the primary budget balance, which excludes debt interest, is in deficit, and the debt interest rate is greater than money GDP growth. The Treasury's forecasts show an average primary deficit of 3.3% of GDP over the next five fiscal years. Even a modest rise in gilt yields would cause the debt/GDP ratio to explode.