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.

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4 Comments

  1. Tony Makara
    Posted May 19, 2008 at 3:00 pm | Permalink

    “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.”

    This is very true. However it is going to be very difficult with such a reduced manufacturing and agricultural base. The more we can produce for ourselves, the less we need to be dependent on imports and with it the worry over currency depreciation leading to imported inflation whenever we cut interest rates. If we can produce goods in abundant supply we can keep prices low and fight off the lure of cheap foreign imports. This is particularly important as far as food production goes. What we need to import through necessity we should import, but where possible we should try to supply our own domestic market, especially with foodstuffs. We need to give manufacturing and agriculture special tax status and allow those that produce to operate at a lower level of taxation. After the years of neglect by the Labour government in favour of imports, British producers now need a business friendly Conservative government.

  2. Neil Craig
    Posted May 19, 2008 at 4:07 pm | Permalink

    You are right about government living beyond its means. I don't think individuals are as much. After all real, after tax, income has been static or falling for the last couple of years. The world economy is growing at 5% & despite all the claims about an international recession causing our troubles, it looks likely to continue doing so.

    What we are seeing is, as you point out, commodity prices, rising, at least in terms of our own currency. However the world is continuing to produce more goods & human wealth will increase. What this suggests is that we are falling from being a country which produced things using cheap commodities to one rather lower down the technological food chain.

    Paddy Ashdown on Question Time recently put the current fashionable political view that we are facing the end of cheap power, food & travel & must get used to it & regulate accordingly. This illiberal view was entirely wrong on all 3.

    Food production is increasing & this will only accelerate with GM foods. Unlimited cheap power is available if we just let the market build as much of it as we want. Technologically airflight is getting cheaper (also safer & quieter) & it is only politics which could let Britain lose the position of having the world's #1 airport & all the economic benefits that go with it.

    In all 3 cases & several others the brake on prosperity is Britain & the EU's government enforced Luditism often on the basis of government funded propaganda (the EU is the overwhelming funder of Friends of the Earth Europe who use their money to lobby for more restrictions as Mr Porrit of the Sustainable Development Commision, the BBC, the Carbon Trust etc etc use UK tax money to sell the same line).

    If we were seriously to make growth rather than Ludditism our objective we could certainly match the BRIC countries (Brazil, Russia, India, China)

  3. mikestallard
    Posted May 19, 2008 at 5:32 pm | Permalink

    You make several important points:
    1. Production of food: Here, in the Fens, mile upon mile of verdant greenery signals the demand (EU?) for biofuel. Hardly any other food can be seen. There is absolutely no chance of a reduction of the CAP ("Open Europe" this morning).
    2. Production of manufactured goods/energy: why are 1/4 people out of productive work? What is being done about them?
    3. Central Government is losing power fast to Brussels. We all know this. So why are the MPs getting more and more questioned about their expenses? Could the two things be connected?
    4. And the bureaucracy, even down at Parish level, is stultifying. I am even told what textbooks to use to teach out of!
    5. Taxation is at about the same as at the end of the Roman Empire or just before the French Revolution: dangerously high.
    Meanwhile, we hear today of a mere couple of million pounds being squandered on teaching adults how to drink alcohol. (Sentence removed)

  4. Derek
    Posted May 20, 2008 at 1:42 am | Permalink

    I have just returned from a buying trip to China. They are most definitely not immune to the credit crunch and US slowdown. Factories there are closing down left, right and centre. It's possible that China's commodity demand may subside, but it's unlikely the Chinese government will publicise any setbacks their economy experiences.

    Even having witnessed this I'm still pessimistic about inflation in the short to medium term, too many cost increases are already in the pipeline, literally and metaphorically. It's not entirely clear that demand from high-growth economies is a complete explanation for soaring prices.

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    John Redwood won a free place at Kent College, Canterbury, and graduated from Magdalen College Oxford. He is a Distinguished fellow of All Souls, Oxford. A businessman by background, he has set up an investment management business, was both executive and non executive chairman of a quoted industrial PLC, and chaired a manufacturing company with factories in Birmingham, Chicago, India and China. He is the MP for Wokingham, first elected in 1987.

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