Inflation means bigger Budget cuts

Allister Heath
IT’S Budget time again. Tomorrow is George Osborne’s big day; he will be tasked with reinvigorating the coalition’s flagging support without giving up on austerity. There will be plenty of new policies, most of which have been heavily discussed already. But here are a few thoughts that you won’t have read elsewhere.

Total public spending in cash terms is due to rise from £696.8bn this year to £701.8bn in 2011-12, £713bn in 2012-13, £724.2bn in 2013-14, £739.8bn in 2014-15 and £757.5bn by 2015-16. In nominal terms, spending is going up every year. But such figures don’t adjust for the fact that the purchasing power of sterling keeps on declining. A pound in 2015-16 will be worth less than a pound today. So it makes sense to adjust for inflation. In real terms, total public spending will fall by around four per cent over the period, a smallish but significant and painful decline after years of massive growth.

But all of this begs a simple question: what if inflation turns out to be much higher than the Treasury is assuming? Such an outcome would reduce the real value of spending by more than the four per cent described above, thus accelerating the cuts – or it could allow Osborne to spend more in cash terms, thus partly appeasing his critics, while still reducing spending by the same amount in real terms and satisfying the markets.

The measure of inflation used to translate cash public spending into real spending is the GDP deflator. It reflects prices of domestically produced goods and services, including investment goods, government services and exports, but does not include the price of imports, unlike measures such as the CPI and RPI. At the moment, the Treasury is assuming inflation on the GDP deflator measure of just 1.9 per cent in 2011-11, down from 2.9 last year. This is a strange assumption to make at a time when all other measures of inflation are soaring. If it were revised up by just one per cent (to 2.9 per cent, like the previous year), an extra £7bn would be cut from real public spending at the stroke of a pen. So this is important.

There is another reason why inflation will matter tomorrow, whether Osborne admits it or not. Public sector wages are being frozen for two years for those earning £21,000 or above. The government claimed yesterday this will save £3.3bn a year by 2014-15, but this is based on dubious inflation forecasts. The real value of the cut could be larger than the government admits. Let’s see what Osborne has to say.

GIVING YOU A VOICE
London’s business and financial community needs to be heard. That’s why City A.M. – in partnership with top website PoliticsHome – is today relaunching its special panel to gauge our readers’ views. It made a splash during the election campaign; it will do so again this time. Each week, we will send a short smartphone friendly email with a couple of questions to members, and publish the results in the paper. Signing up is easy: if you work in business or finance, go to www.cityam.com/panel to answer a few short questions. The data is completely confidential and will not be shared with any other party – and neither will your responses. We’re giving successful applicants the chance to win a free luxury holiday for two to Paris. In September, we’ll put those panellists who have responded to at least 80 per cent of the surveys into a prize draw. Good luck.

allister.heath@cityam.com
Follow me on Twitter: @allisterheath