Government's Pre-Budget Report: Too Bullish, Too Risky,

UNCLAS SECTION 01 OF 02 LONDON 003097

SENSITIVE
SIPDIS

E.O. 12958: N/A
TAGS: ECON EFIN ETRD EINV UK
SUBJECT: Government's Pre-Budget Report: Too Bullish, Too Risky,
Say Critics

REF: LONDON 02970

LONDON 00003097 001.2 OF 002



1. (SBU) Summary: The Pre-Budget Report (PBR),announced on
November 24, has been widely criticized, from the size and nature of
HM Treasury's fiscal stimulus package to HMT's perceived overly
optimistic macroeconomic forecasts. On December 10, the Chancellor
of the Exchequer Darling defended the PBR before MPs on the Treasury
Select Committee. He explained the necessity of the fiscal package,
dismissed concerns of deflation, and defended HMT's claim that the
economy will start to recover in the second half of 2009. Prior to
the Chancellor's appearance in front of the Committee, HMT officials
met with MPs to explain the assumptions used to determine the
macroeconomic forecast, the importance of the fiscal stimulus
package and the reasoning behind abandoning HMG's fiscal rules.
Independent economists told the Committee that HMT's forecast was
optimistic and cautioned that any recovery would be contingent on
increased bank lending. They expressed concern that public finances
will not rebound as quickly as HMT expects. End Summary.

Chancellor Defends Pre-Budget Report
--------------


2. (U) Chancellor Alistair Darling defended his Pre-budget Report
(PBR) before MPs on the Treasury Select Committee December 10. He
maintained support for the macroeconomic forecasts made in the
November 24 PBR (see reftel) - particularly that UK economic
recovery will start in the second half of 2009. He said the
forecast was consistent with the Bank of England's independent
forecast and said the recovery will be aided by a low interest rate,
the fiscal stimulus package, lower inflation and a flexible economy.
He acknowledged that any recovery will be influenced by bank
lending and said he will meet with his new lending panel and the
chief executives of major banks December 11 to discuss strategies to
increase lending. The Chancellor dismissed concerns of sustained
deflation, saying that as the economy recovers, the summer's
inflationary pressures will likely return. He welcomed
President-elect Obama's calls for further U.S. fiscal stimulus. He
said the UK's fiscal stimulus package was "absolutely necessary" and
that if HMG had allowed the recession to become deeper and longer,
the cost of doing nothing might have outweighed the cost of doing
something.

HMT's Macroeconomic Forecast: The Verdict
--------------


2. (U) Dave Ramsden, HM Treasury's Chief Economic Adviser, defended
the government's macroeconomic forecast before Treasury Select
Committee MPs on December 9. Under heavy questioning from
Conservative members of the Committee, Ramsden said the forecast for
an economic recovery beginning July 2009 was underpinned by four
factors: a sharp fall-back in commodity prices that will support
household incomes; a large fall in interest rates; the fiscal
stimulus package; and a significant depreciation in sterling. While
HMT expects output to fall at the beginning of next year, these
forces, he argued, will lead to a recovery gathering pace in 2010.
He assured the Committee that HMT has not underplayed the risks to
growth but acknowledged that the Treasury's view was not shared by
all independent forecasters.


3. (U) Independent experts who appeared before the Committee
December 4 were less optimistic about the UK's outlook. Robert
Chote, Director of the Institute for Fiscal Studies, said the PBR
assumption that the stimulus package would reduce the depth of the
downturn by about 0.5 percent was reliant on international action.
If the UK's package was not accompanied by similar measures
internationally, other countries, and not the UK, might reap the
benefits of the UK's package. The economists criticized the
Chancellor's statement that the UK was more resilient than other
economies, saying the UK's high levels of household debt, massive
housing bubble, and large financial sector left the UK badly placed
to cope with a banking crisis. Roger Bootle, of Capital Economics,
told MPs that getting banks lending again was critical to any
recovery. A self-proclaimed free-marketer, he shocked MPs by
calling on HMT to adopt the post World War II monetary policy of
directed bank lending. He said HMG can't continue "encouraging"
banks to lend. If banks continued to resist the stern warnings from
the Chancellor, HMG would have to force lending. Bootle added that
banks will be cautious to the point of reckless and will not act in
the collective interest unless forced.

The Fiscal Stimulus: Temporary, Timely, Targeted
-------------- --


4. (SBU) HMT officials told MPs that the fiscal stimulus package
was designed to be temporary, timely, and targeted. They said the
package introduced in the PBR met all three criteria. However, the
Committee's independent witnesses were critical of HMT's use of a

LONDON 00003097 002.2 OF 002


VAT reduction. Simon Kirby, of the National Institute of Economic
and Social Research, told MPs that trying to stimulate spending in a
credit crunch without addressing the problem of credit constraints
will have minimal impact. Professor Colin Talbot, of the University
of Manchester, was worried that the VAT reduction could prove
deflationary. If there is any stimulus effect, he said, it will be
loaded towards the end of the VAT reduction period (end of 2009).
(Comment: These views are in line with comments made to econoff by
bank economists about the potential impact of the VAT reduction.)

Farewell To The Fiscal Rules
--------------


5. (U) HMT officials said the fiscal rules on debt were used to
meet three objectives: achieve sustainable public finances in the
medium term, protect investment, and support monetary policy in
stabilizing the economy. (Note: HMG's two self-imposed fiscal rules
were: the 'golden rule' that HMG will only borrow to invest and the
'sustainable investment rule' that public sector net debt will
remain below 40 percent of GDP. End note.) Ramsden said against
the background of a credit crunch it would be perverse to stick to
these rules. Therefore, the Chancellor's PBR announced that HMT has
"temporarily departed" from the rules and now abides by a temporary
operating rule that requires HMG to "set policies to improve the
cyclically-adjusted budget each year...so it reaches balance and
debt is falling as a proportion of GDP once the global shocks have
worked their way through the economy." Ramsden said HMT has not
established a definite end date for the temporary rule. He could
not say whether HMT will ever return to the previous fiscal rules.



6. (U) During the Treasury Committee's session with independent
experts, Chote told MPs that the new temporary operating rule fails
to act as a constraint on government actions. The economists were
also skeptical of the Chancellor's forecasts for the public
finances. According to the PBR, HMT expects tax receipts, as a
proportion of GDP, to return to 2007-2008 levels by 2013-2014. The
economists said that in normal circumstances, tax receipts do not
return so quickly after a recession. They also warned that the
extent of the government debt will become an increasingly important
factor in the cost of the debt. Eventually, borrowing will become
significantly more expensive and its cost will begin to pose a
considerable constraint on future borrowing.

TUTTLE