The governor of the Bank of England has said that the UK economy is in such a state that whoever wins the next election will be condemned to electoral defeat for a generation – allegedly. The National Institute of Economic and Social Research (NIESR) has said that in order to grapple with the fiscal deficit, basic income tax rates will have to rise by 6p in the pound. But there is a way the UK can get out of economic jail.

The Good Doctor Mervyn King has not made it official. Rather, he uttered his words of dismay to a friend, the American economist David Hale, who, in the true spirit of international relations, repeated what the Bank of England governor said on Australian TV. He said: “I saw the Governor of the Bank of England last week when I was in London, and he told me whoever wins this election will be out of power for a whole generation because of how tough the fiscal austerity will have to be.”

It begs the question, of course, why are politicians trying so hard to win the election. Or maybe Gordon has a cunning plan, is playing to lose, a strategy he is carrying out brilliantly and is desperately hoping for a couple more opportunities to call someone a bigot while he ‘accidentally’ leaves his microphone on.

NIESR reckons that current plans will have the effect of halving the fiscal deficit within five years. But says the government needs to do more, and reduce the deficit to 3 per cent of GDP over that time frame. It said: “On the baseline we assume it is achieved through income taxes rising by an equivalent of six pence in the pound on the basic rate.”

We know what you are thinking – why not use VAT to raise money? Well, the snag here is that NIESR reckons “VAT receipts will be held back by weak consumption and higher saving.” Okay, then, you may retort, how about just cutting spending. Well, NIESR’s Ray Barrell said: “Efficiency savings are largely a myth. When you cut spending, people lose their jobs.”

It’s a theme touched on here before. Reducing inefficiency seems seductive. But even if someone is working in an office doing no more than moving paperclips from one drawer to another, then at least that person is helping to boost the economy by spending their earnings. In an environment in which there is a shortage or labour, and the private sector is being held back through its inability to recruit, then it would make sense for the government to slash jobs. But we are not in such an environment at the moment.

This argument does not totally hold true. Our paperclip shuffler could have talents that could enable him, or her, to work in an environment creating real wealth. But for as long as there is good money in paperclip movement, there is no incentive to try and change. But, then again, right now is a very bad time for career changes.

NIESR also said: “After 2020 the number of people of pensionable age will rise except in 2024-6 when state pension ages will rise from 65 to 66. Taxes will have to be ½ per cent of GDP higher, equivalent to 1½ pence in the pound on the basic rate, to pay for ageing by 2030.” They are dead right of course, the retirement of the baby boomers is a problem for the future that seems to have no obvious solution. But all three of the main political parties are terrified of trying to address this challenge.

Of course, what with Greece falling faster than Icarus from the sky, what we all want to know is whether the UK is vulnerable to a government funding crisis. On this front NIESR had both good and bad news.

The bad news: if investors decide that lending to the UK government is more risky, then “A 50 basis point rise in … [risk] premium would raise borrowing or taxes by half a per cent of GDP by 2016.”

But then it revealed the good news, saying: “We are not concerned about the emergence of further risk premia on UK government borrowing. The UK has never defaulted on its debts.”

Here are a couple of observations.

NIESR, along with just about all the other economic think tanks, failed to predict the credit crunch or banking crisis. Under normal circumstances, banks’ strategy of borrowing from the money markets was sound. What they failed to prepare for was the possibility that circumstances would cease to be normal. When markets panic, you can throw the rule book out. Right now there is a real danger of Greece defaulting. It may not happen this year, or next. But it may well happen in the next few years. Such a default would mean markets would turn their spotlight on the rest of the PIIGS, forcing the yield on bonds up. The higher the cost of government borrowing, the greater are the chances of default. How markets will react if other euro economies default is anyone’s guess. But to say the UK won’t suffer in such conditions is just not credible, any more than if the Met Office tried to predict what the weather will be like this time next year.

But there is something the UK could do to fix its fiscal hole, and that is to try and get people off benefit and into work, try to encourage those on the minimum wage to strive for pay rises, and encourage wealth creation via greater entrepreneurial activity. To achieve this the government should create much better incentives for people to work. At the moment, the cost of getting a job, in terms of loss of benefit, including housing allowances, is such that for many people getting a job makes no sense. All three parties agree that to get people off benefit and working there needs to be more stick. But there needs to be more carrot too. Once people who have been on benefit for years start working, a cultural shift in attitude can follow, real wealth is created, and eventually tax receipts can rise significantly.

And then there’s our paperclip shuffler. For some people who are unable to get the job they think they deserve, the answer can lie in a form of self employment, perhaps setting up a business of their own. For some people, the opportunity to set up a business when you have been unemployed or just made redundant, is like manna from heaven.

If the government was to make sweeping cuts, and purge the public sector of all jobs that aren’t highly productive, then such a policy would make sense if the money saved was then invested into schemes designed to help some of the people who lose their jobs to set up businesses, which in turn can employ others.

The problem with the UK and its fiscal mountain is cultural. The government has to change that culture, and encourage people to become wealth creators. That is the way the fiscal debt mountain can be reduced to a valley.

© Investment & Business News 2013