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Tory turmoil raises risk in event of Brexit

by Hugo Dixon | 21.03.2016

The latest bout of civil war in the Tory party will make it harder to balance the budget whatever the result of the EU referendum. But if we vote to leave, the consequences could be especially worrying.

Iain Duncan Smith’s resignation as welfare and pensions secretary – blaming the government for a politically-motivated crackdown on disability benefits that would have saved £1.3 billion a year – has two main impacts on the referendum.

First, it has damaged George Osborne, the chancellor. He was expected to play a big role in arguing why Britain should stay in the EU. He may now be a less credible figure to make the case. His already receding chances of replacing David Cameron as prime minister have also taken a knock.

The second impact is on the Tories’ ability to balance the budget. Even before Duncan Smith’s explosive departure, the government was struggling to manage the public finances. Osborne revealed in last week’s budget that government debt isn’t going to fall this financial year as a proportion of national income – causing him to miss one of his fiscal targets. The row over saving the comparatively small amount of £1.3 billion shows the febrile state of the Conservative party at a time when Cameron has a slim majority in the House of Commons.

A Brexit vote would make the government’s task all the more challenging. If it leads to slower economic growth, as a range of economic forecasters including PwC for the CBI are predicting, taxes will be lower than previously envisaged. The deficit, which will still be £72 billion in the current financial year, according to the Office of Budget Responsibility, might then stop shrinking.

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Given that Cameron would by then probably have been forced out of office, it would be up to the new prime minister to decide how to react to such a deterioration in the budgetary outlook. One option would be to slash spending or increase taxes. But such a dose of austerity would further hurt the economy. It would not be popular. The required adjustment would make the current debate over how to save £1.3 billion look like a pin-prick.

The new premier, whoever that was, might therefore ignore the fiscal targets, even though they are set in law. But that would send a bad signal to those it borrows from, many of whom are international investors. Indeed, Britain as a whole borrows about £80 billion a year net from the rest of the world. That’s because we spend more on imports than we export, and in recent years have run down our foreign assets.

We are dependent on the “kindness of strangers”, as Mark Carney, governor of the Bank of England, put it in January. As a result, if the public finances got out of control, the pound would fall further and interest rates might have to rise. That would push up the government’s borrowing costs, worsening the budgetary pressure. The post-Brexit hangover could be quite painful.

Edited by Luke Lythgoe

Hugo Dixon is the author of The In/Out Question: Why Britain should stay in the EU and fight to make it better. Available here for £5 (paperback), £2.50 (e-book)