Counting the fiscal cost of the current crisis: A glimpse from the UK?

Posted by Richard Hughes

The unremmitting flow of bad economic and financial news over the past few weeks and ongoing discussions of fiscal stimulus packages and expanded financial rescue plans suggest that it is too early to start counting the overall cost to the public purse of the latest economic crisis.  However, the UK's latest Pre-Budget Report which was published on 24 November provided an initial glipse of the potential fiscal repercussions of the current financial and economic turmoil.

The UK has been something of a "leading indicator" throughout the current financial crisis.  It was one of the first countries to see one if its major financial institutions succumb to the credit crunch when Northern Rock, the country's fifth largest mortgage lender, was forced into public ownership following a loss of access to short-term financing and a run on deposits in the autumn of 2007.  And the UK Government has played a lead role in defining the policy response to the crisis.  This autumn, the UK Treasury was the architect of the combination of direct injections of government equity into troubled banks coupled with government guarantees of deposits and wholesale interbank lending that has been adopted by more and more advanced countires in an effort to kick-start bank lending.  In recent weeks, the UK Prime Minister Gordon Brown has been one of the most ardent advocates of a concerted global fiscal expansion as a means of circumventing frozen credit markets and delivering a direct stimulus to the global economy.

So what will be the impact on the public finances of a typical advanced country of the financial crisis, economic slowdown and governments' efforts to combat both?  Well it is certainly too soon to give any definitive answer.  But once again, the UK provides and early and striking glimpse of what might be in store.

On 24 November, the UK published its 2008 Pre-Budget Report (PBR) which included an updated set of macroeconomic and fiscal forecasts which were the first to take account of the direct and indirect costs of the current financial crisis and economic slowdown.  What it revealed was a sharp downward revision in the UK's forecast of economic growth in 2009 as a result of the crisis, from 2.5% at the time of the Budget in March to -1% now.  While this was the first time the Treasury has ever forecast a recession (though obviously not the first time the UK has experienced one), it was hardly surprising given the UK's dependence on financial services as an engine of growth and the sensitivity private consumption in the UK to changes in house and other asset prices.

More surprising, perhaps, was the impact that the financial and economic crisis is having on the UK's public finances.  Back in March of 2008, the Treasury was forecasting public sector net borrowing to fall from a high of 2.9% of GDP in the current financial year to 1.3% by 2012-13 and for public sector net debt to remain just under the government's self-imposed ceiling of 40% of GDP over the forecast horizon.  Nine months later this latest PBR showed that the combined direct and indirect costs of the crisis had pushed the Treasury's forecast of borrowing up to 8% of GDP next year.  Rather than peaking at 39.8% of GDP in 2010-11, public sector net debt was now expected to rise in every year of the forecast period to 57.4% in 2013-14.

While the overall deterioration in the UK's public finances was striking enough, what is most interesting are the reasons behind the sudden and sustained fiscal deterioration.  The UK has announced one of the most extensive financial sector inteventions in the G7 in which the government nationalizing 3 major financial institutions and taking large equity stakes in 3 others.  The fiscal impact of these various direct financial interventions, which are are catalogued in a box at in Annex B of the PBR, sum to total of around GBP 77bn in additional borrowing most of which is forecast to fall in the 2008-09 financial year.  These figures may overstate or understate the net cost of these financial interventions as they exclude any future benefits that may come in the form of fees paid on government loan guarantees, interest and dividends paid on the government's equity stakes and any capital gain from the evenual sale of equities themselves.  At the same time, these costs exclude the contingent liabilities associated with government guarantees extended to deposits and interbank lending.

Nonetheless, at around 5% of GDP in 2008-09, this first estimate of the one-off direct costs of the financial crisis to the UK Government is a fraction of the Treasury's estimate of the ongoing indirect cost of the crisis as manifested in the form of lower tax receipts, higher spending on unemployment and other benefits, and the cost of the various fiscal stimulus measures which were also announced in the PBR.  In 2009-10 alone, the combined effect of these indirect non-discretionary and discretionary measures is expected to increase borrowing by 5.5% of GDP, of which:

• 4.4% is non-discretionary fiscal deterioration most of which occurs on the receipts side and is spread across income, consumption, corporate and housing taxes; and
• 1.1% is attributable to the discretionary fiscal stimulus measures announced in the PBR which included a temporary reduction in VAT from 17.5 to 15%, the acceleration of GBP 2.5bn of planned investments and an additional GBP 400m to help the unemployed find work.

While the Government proposes to take steps to restore the public finances to sustainablility from 2010-11 onwards, the long-term repercussions of the crisis on the UK public finances are such that borrowing doesn't return to the level initially envisaged for this year until 2013-14, debt doesn't begin falling again until 2015-16, and the Government has set aside both its long-standing fiscal rules (the Golden Rule and Sustainable Investment Rule) for the duration of the crisis and its aftermath.

Comments

[Jeff]

Good article.
thanks for sharing this post.