Time to stop living beyond our means – and that means the government too

Under Labour, the UK has been living beyond its means. The government sector has been especially profligate, spending ever-larger sums on quangos, spin doctors, regulations, banking support, railway support, welfare, bureaucrats and politicians. Gordon Brown has racked up huge debts for the taxpayer during the good times, over the “NICE” years, when a little more restraint would have seen good growth in public spending, paid for by the natural buoyancy of revenues in years of strong global economic performance.

Consumers overall have also been living beyond their means, building up huge mortgage debts, withdrawing some of the money to spend on consumption, and borrowing on credit cards.

As a result, we have run a large balance-of-payments deficit, so the country as a whole has had to borrow from abroad, or sell assets to foreigners (companies, football clubs, a slug of our gold reserves) to pay the bills.

Now it is pay-back time. All of a sudden, the consumer and house buyer find they cannot borrow as much as they want to on the terms they find acceptable. Some, dubbed sub-prime because their incomes are low and their past credit history not so hot, cannot borrow at all. The government ploughs on borrowing and taxing like there’s no tomorrow, seemingly oblivious of the damage this is doing and the extra pressure it places on everyone else. Government borrowing is now crowding out other forms of borrowing in the market. It’s Them, not Us, that takes the cash.

Meanwhile, there is a huge change underway in the world economy. The remorseless rise of both India and China is bringing another 2.5 billion people to the party who, until now, have lived in poor, low-income countries, making relatively few demands on world resources. All of a sudden, the explosion of domestic demand in India and China, coupled with their brilliance at producing lower-priced goods that can be exported to the first world, is placing unprecedented demands on oil, wheat, rice, metals and other vital commodities. When the western economies face a sharp slowdown, they are used to commodity prices naturally deflating, as their excess demand is removed from the system. That has not happened immediately this time, as the demand from Asia continues upwards, and the main commodity markets are largely short of stock, anticipating yet more demand. It is causing Central Banker paranoia about stagflation and, in the UK, uncertain and muddled policy responses.

Some in the west are now worried that these large price increases, which we see in input prices for UK business and, to a lesser extent, in the Consumer Price Index and the RPI, will bring yet more inflation on top of the obvious first-round effects. Not necessarily. This will happen only if the government prints too much money, and encourages inflationary wage demands, letting people believe they can get a big enough wage rise to cover these cost increases. This is unlikely in Credit Crunch conditions.

What has to happen is that the west must adjust quickly to much higher prices of energy and other basics, putting through the price increases and adjusting consumption of those and less essential items downwards. We have to accept that India and China’s success – and the oil producers’ good luck – means we have to tighten our belts. Higher commodity prices are the main way we pay for our excessive borrowing, and we have to recognise we are living beyond our means and need to cut back. China and the Middle Eastern oil states are earning much more than they spend, and now have the option of spending more from their massive reserves. The UK (and the US) has to shift some output into exports and import substitution. This will start to happen because of the weakness of both the dollar and the pound. China and the Middle East can shift some money from saving into spending.

There is no choice over whether we have to cut living standards or not. The game is up. We cannot keep borrowing at past rates to sustain so much more consumption by government and consumers than we can afford out of earnings. Gordon’s game of easy money and heavy borrowing is coming to an end. The issues are how quickly this adjustment will take place, and whether there will be a second-round domestic inflation as a result.

The best outcome is a rapid pass-through of these price increases, with no follow-up inflation owing to the tightened credit conditions we are experiencing. The danger is the Credit Crunch will overdo the tightening, adding to the fall in living standards which the commodity boom is creating. That is why we need sensible money policy to offset the worst of the collapse in credit, while allowing the adjustment to be made to a less borrowed world. The government would help greatly if, instead of increasing its borrowing, it took action to cut its own demands on a fragile economy by eliminating waste and too much bureaucracy. So far, all the strain of cutting borrowing has fallen on individuals and families, as we see in the collapsed mortgage market, while the government debt market carries on booming.

In the meantime, there are things the government can do about the longer-term position. We need to accept continuous adjustment to dearer commodities over the longer term, on the assumption that Asia will continue to improve its economy and want to buy more – and maybe Africa and Latin America will come to the party as well. Even if there are some commodity price falls ahead, as there has been a fall in the gold price from its high of earlier this year, the long-term trend is likely to be dearer commodities from the pressure of demand and from the needs of so many more people in the world.

Western governments should be making it easier for the private sector to respond to these changes. Here in the UK we need a faster move into new electricity capacity based on something other than imported gas. We need to create a favourable business climate where more progress is made in energy conservation, recycling and the development of substitute technologies. In due course, cars and lorries will be powered by something other than fractions of crude oil, more plastics will be used alongside metals, and more use may be made of renewable materials like wood. The UK public sector should take more of a lead in using its huge buying power to encourage these moves.

It also shows how crucial Common Agricultural Policy Reform now is. We do need to put more land under the plough. World market prices give plenty of encouragement to do that. Let’s make sure EU regulation does not stand in the way, as there is a hungry world to feed. The CAP has been a major impediment to developing countries, and a major extra tax on UK consumers. It is not needed now.