Beware the big, black hole

Full employment, low interest rates, low inflation, no more boom and bust - Gordon Brown's proud list of successes has been at the top of Labour's agenda for the past few weeks. But Thursday could be Labour's last chance to fight an election campaign on its impeccable economic record. Booming property prices and low unemployment have helped to create the unbroken period of growth of which the government is so proud - but the housing market has already slowed sharply, and a growing chorus of experts believes the feelgood factor is about to disappear.

'I think Tony Blair's choice of 5 May was apposite,' says Roger Bootle, economic adviser to Deloitte and Touche. 'If he had delayed it until the autumn, he could have been in serious trouble.'

The clues have begun to appear: home repossession orders hit a 10-year high in the first quarter of the year; B&Q owner Kingfisher warned of a 'sticky consumer market' when it issued a profit warning last week; and the Institute of Directors said a fall in business confidence among its members suggested the current economic climate was 'as good as it gets'.

Bootle believes these are the first signs of a sharp consumer slowdown, which could force the Bank of England to slash interest rates to keep the economy on the move. The Bank's policymakers have been relaxed about the impact of the housing market slowdown on consumer spending and economic growth; but there is mounting evidence that heavily indebted homeowners who have become used to seeing the value of their biggest asset shoot up by 20 per cent a year have reacted to the slowdown by cutting back their spending.

'The obsession with whether house prices will "crash" misses a key point, which is that even a slowing housing market removes a major support to, and source of finance, for consumer spending,' says John Butler, chief UK economist at HSBC, who is also expecting a downturn. 'The housing market is still overvalued and a correction will come.'

The global economy is also giving cause for concern, with oil prices still well above $40 a barrel, signs of a renewed 'soft spot' in the US, and Germany, the engine of the eurozone, close to recession.

That is why the row between the parties about the size of the 'black hole' isn't just a mathematical quibble. The tight fiscal situation will severely restrict how much action the government can take to counteract a slowdown.

Both the UK and the US increased government spending rapidly after 2001, helping to cushion their economies from the worst of the global downturn (George Bush threw in a lavish package of tax cuts for good measure).

'That's very important,' says Bootle. 'If you ask why the UK economy has done quite well over the past few years, since the bursting of the dotcom bubble, one of the answers is: we have had a significant fiscal relaxation. It's been a big help.' With the budget now much tighter, Britain will not be able to pull off that trick a second time. After an unprecedented surge in public spending, which has only partly been paid for by increased taxes, the government's room for manoeuvre is slim.

When the economy slows, government deficits tend to get larger, as tax receipts tail off and social payments increase. These 'automatic stabilisers', help to soften the slowdown. Brown's 'golden rule' - part of his self-imposed framework for controlling public spending - is meant to force him to be frugal enough when the economy is growing strongly, to offset the deficits when the automatic stabilisers kick in.

However, most experts believe the margin for error in meeting the golden rule over the next economic cycle, beginning next year, is tight, even if growth is strong over the next couple of years, as the Treasury expects.

Estimates vary as to the size of the problem: the IFS says £11 billion a year, the Ernst and Young Item Club £10bn; the IMF thinks it could be up to £12bn. But there is agreement among almost everyone bar Brown himself that either spending will have to be reined in, or tax rates increased, if the rule is to be met.

If Bootle is right, and the economy is likely to slow sharply, that predicament looks far, far worse. 'If you're starting with deficits of more than £30bn, once the automatic stabilisers work you could be in the mid-50s and beyond,' he says. 'There's got to be a limit to how much you can do.'

In the worst scenario, Brown or his successor could exacerbate a slowdown, by cutting spending or raising taxes just as the economy slows, to meet the golden rule. At best, the Bank of England will have to cut rates faster and further than it otherwise would have done, without extra support from public spending.

Brown is dismissive of such gloom. He believes there was good reason for dipping so far into the red: delivering a necessary injection of funding for schools and hospitals. And, as he argued at the International Monetary Fund in Washington last month, his forecasts have been right in the past, and those who have dared question them (including the IMF itself), will be proved 'wrong again'. He is correct that economic growth has proved stronger than many predicted: few believed the Treasury's forecasts that GDP would expand by between 2.5 per cent and 3 per cent last year, but Brown's predictions proved spot on.

However, the point the black hole-spotters are making is not about economic growth, but the state of the public finances. On that score, the Treasury's forecasting record is more shaky. In each Budget since 2001, as tax revenues have disappointed and public spending steamed ahead, Brown has been forced to postpone the recovery of his finances, and predict a deeper slide into the red.

If Brown's Budget promises prove to be out of kilter with reality, he may eventually be accused of taking the economy into an election on a false prospectus. But if he is about to be sucked into a black hole, then so are the opposition parties. Both Oliver Letwin and Vincent Cable have used the Treasury's tax and spending forecasts as the baseline for their own plans. The Lib Dems intend to raise a little extra through a tax rise on those earning over £100,000. The Conservatives would implement £4bn-worth of tax cuts, and fill in £8bn of the black hole, paid for by a public sector efficiency drive. By 2011, they expect to be spending £35bn a year less than Labour has pencilled in. But if the IFS is right, £8bn will be too little to fill the black hole - and that will be available only if the Tories' cost-cutting plans work, which precedents suggest is doubtful.

And as Robert Chote of the IFS has pointed out, even if the Tories succeeded, it would still leave spending in six years' time higher than it was under Labour in 2002-3. 'The similarities between the parties are as striking as the differences,' he says. And if growth comes in sharply lower than Brown expects, all the parties' plans would go out of the window.

It's not clear that any party would have more tricks than Brown up their sleeve if there was a slowdown. In fact, the consensus about the basic macroeconomic framework Labour has set up since 1997 is striking. No one would seize back power to set interest rates from the Bank of England. Everyone would accept Brown's fiscal framework: both the golden rule, and the sustainable investment rule, which promises to keep government borrowing below 40 per cent of GDP. In fact, the Tories and Lib Dems would enforce the rules more strongly.

With hindsight, this election could have similarities with 1992. By the end of that year, when sterling had plunged out of the European Exchange Rate Mechanism in the most serious financial crisis since the 1970s, it was clear that Labour had been fortunate not to win the General Election. Labour - including Gordon Brown - had strongly backed the ERM project, and would have been just as powerless in the face of the markets as John Major and Norman Lamont.

No one is predicting such a financial apocalypse today. The economy was already deep in recession in 1992. Now, as Brown constantly reminds us, we have tame inflation, low interest rates and low unemployment. But as the knock-on of the housing market slowdown begins to ripple through the economy, and the public coffers are too empty to pay for a government rescue package, whoever is not in charge after next week may breathe a sigh of relief.