Ruth Lea: Battered economy leaves new team at the top holding a poisoned chalice

WHEN Gordon Brown became the Chancellor in 1997, he inherited from the outgoing Conservative Government a "golden legacy". The public finances were returning to surplus, growth was well-established after the ERM debacle of the early 1990s, inflation was under control, unemployment was falling and the current account of the balance of payments was in balance.

Alas, for George Osborne, the new Conservative Chancellor, and David Laws, the new Lib Dem Chief Secretary, their legacy is anything but golden.

In the wake of profligate public spending, a financial crisis and a steep economic recession, their legacy is more of a poisoned chalice. Bank of England Governor Mervyn King's alleged pre-election remark that the election victor would be out of power for a generation rings all too true.

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The most lamentable feature of the coalition's legacy is, of course, the horrendous public sector deficit which amounted to 11 per cent of GDP in 2009 – the worst of any major economy.

Suffice to say, the new Government's first priority must be to convince the financial markets that they are serious in tackling the public deficit.

I have heard people say that no government should be so beholden to the "markets". But when a country borrows as much as this one is doing, one in four pounds that it spends, borrowers cannot be choosers. And the financial markets will be analysing the Government's public borrowing performance and judging its ability to pay back its debts as any lender would look at any borrower, especially a profligate one. If there are any doubts then they will charge more.

Interest rates will go up, adding to the Government's financing costs and dampening growth. In the worst cast scenario, the markets may even stop lending to Britain at any price as happened in the mid-1970s. The IMF would then have to be called in and administer some very nasty medicine indeed. This is not an enticing prospect.

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William Shakespeare had a sharp insight into the relationship between borrowing, lending and financial management – as he had sharp insight into most matters. The wise Polonius said in Hamlet: "Neither a borrower nor a lender be; For loan oft loses both itself and friend;

And borrowing dulls the edge of husbandry."

The coalition Government does, however, seem to have got off to a promising start. As part of the coalition arrangements, it was agreed to implement the Conservatives' policy of 6bn of cuts for this financial year.

This is less than one per cent of total public spending and should be easy enough to achieve. The notion that these cuts would derail the economic recovery, as argued by both of the other two parties prior to the election, was not only economically implausible but also rather mischievous. The markets reacted quite favourably to this policy – though it is only fair to add they were much more concerned with the eurozone crisis last week and had only half an eye on Britain.

The next step will be an emergency Budget on June 22. Speculation is already rife as to what it will contain, but progress towards the aspiration of a rise in personal allowances to 10,000 and details on Capital Gains Tax hikes for non-business assets look almost certain to be included. Despite denials prior to the election of any increases in VAT rates, a higher standard rate – from 17 to 20 per cent – looks very possible. This move would raise about 12bn of revenue and is arguably the "least worst" tax to increase.

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Speculation is also rife about the strong possibility that Alistair Darling's Budget forecasts for the economy and government borrowing were too optimistic. Certainly his GDP forecasts looked over-buoyant and have been widely questioned.

Chancellor Osborne hopes to improve confidence by tasking his new Office of Budget Responsibility to oversee and work with the Treasury to produce the forecasts. City analysts will also be crawling over the implied cuts in public spending, the details of which will be released in the autumn when the next Comprehensive Spending Review is due.

So far so good. And let us fervently hope that this coalition can work together to implement the painful tax increases and spending cuts to come.

While the first priority of the new Government has to be sorting out the public finances, there is another crisis looming on the horizon relating to energy supplies. During this decade, many of our coal-fired power stations are due to close because of the requirements of the EU's Large Combustion Plant Directive.

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In 15 years' time, all but one of the nuclear power stations will have been decommissioned. In addition, Britain's reserves of natural gas are being steadily depleted making us ever more dependent on imported

supplies. The previous government's energy policy was remiss in the extreme, placing far too much reliance on costly and intermittent wind power. It accepted the need for nuclear power rather late in the day.

The coalition Government, though there are fundamental differences in approach between the anti-nuclear Lib Dems and the pro-nuclear Conservatives, must be prepared to bury their differences in order to press ahead rapidly with new nuclear power stations – or risk the lights going out.

Ruth Lea is economic adviser to the Arbuthnot Banking Group.

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