Poor old Mr Darling; with only months left before he faces the wrath of the electorate, he is certain to earn the title “Britain’s worst Chancellor”. During his short tenure at the Treasury, he has been responsible for the largest fiscal deficit in history, coupled with the deepest financial crisis in a century.
The Chancellor is now stuck between a rock and a hard place. The financial arguments in favour of expenditure retrenchment are overwhelming. Both the Treasury and the Debt Management office have pressed the red button. They have told the chancellor that the current policy framework runs the risk of an outright fiscal crisis.
However, Brown's electoral strategy has painted the Chancellor into a corner. The Prime Minister will not countenance any public expenditure cuts until after the election.
Meanwhile, the Bank of England's wild experimentation with quantitative easing has only added to the Chancellor's problems. The BoE is printing money, offering mortgage guarantees and generally building up a huge repository of problems for the future.
Darling is in a deep dark hole and there is no way he can dig himself out.
The Treasury reality check
Every day, Darling has to face his senior Treasury officials, who arrive in his office with ever more alarming numbers about the deterioration in public finances. This year, the deficit could be as high as ₤200 billion.
The numbers will be packaged in memos pleading for expenditure restraint. However, Darling knows his capacity to rein in spending departments is close to zero. The best he can do is to ensure that he can come up with the cash to cover the deficit.
The UK debt blow-out
The message from UK's debt management office is also dire. It has warned Darling about the increasing difficulties in meeting the mounting financing demands from the government. With each passing week, its capacity to sell government paper is being tested to the limit. Although it has a few remaining tricks in its box, such as syndicated commercial bank debt issuance, there remains a serious doubt whether the UK government securities market can absorb such a huge increase in supply.
An increase in government bond yields offers the only hope for satisfying the financing demands of the government. Nevertheless, higher yields undermine the government's stated aim of increasing credit flows to the private sector, especially the housing market.
The Bank of England - Whatever happened to interest rate management?
The Bank of England has deeply disappointed Mr Darling. The monetary policy committee had promised that quantitative easing would bring interest rates down. Last autumn, the committee had, for all practical purposes, lost control of interest rates when it began to cut its policy rate below the rate of inflation. All other interest rates in the economy obdurately refused to decline, most notably mortgage and corporate lending rates.
The MPC thought that wall of money would do the trick, allowing it to re-establish control over liquidity conditions. Instead, quantitative easing has provoked an increasing fear of rising inflation that has pushed up long-term interest rates. In short, the BoE and its wacky ideas about monetary policy only have created more problems for Darling. Despite the unambiguous evidence that quantitative easing has failed, the BoE are likely to persistent in this yield-raising foolishness.
The chief won't listen
Darling understands that the sensible thing would be to cut back on public expenditures. At this stage, the magnitude of cuts wouldn't have to be too dramatic. All he needs is a sustainable and convincing deficit reduction plan, with a modest expression of commitment in this fiscal year. Once markets understand that this year's huge deficit is a temporary event, the government will be able to sell debt at lower yields.
Although the Chancellor has undoubtedly presented the case for fiscal prudence, Mr Brown has countered with his electoral strategy. The Prime Minister wants to paint the Conservatives as the party of draconian public expenditure cuts. This theme would look rather weak if Brown were to start the expenditure retrenchment before the election. Brown wants New Labour to be the party of the public sector, and Darling's desire to establish a modicum of macroeconomic stability conflicts with the strategy.
A 12 percent of GDP deficit is a post election problem.
This “ignore the deficit" game plan runs the risk of a catastrophic fiscal crisis, where investors are unwilling to provide the financing to cover the deficit. However, for the Prime Minister, it is a risk worth taking. If the crisis happens, the election is lost anyway.
If the crisis can be avoided, and some modest economic growth could be restored, coupled with stabilising house prices, then the chances of a new Labour victory increase. If Labour wins, it has five years to clean up the mess. If it loses, it is someone else's problem.