The UK chancellor, Philip Hammond, is due to deliver his postponed Mansion House speech on Tuesday, following a general election result that has caused, to put it mildly, great uncertainty about the medium-term outlook for the economy and the government finances. If the Conservatives had won the election with a sizeable majority, the government would have been mandated to proceed with its hard Brexit strategy, combined with further “austerity” budgets. As an aside, Mr Hammond would also have lost his job.
The hung parliament has thrown this into confusion. The 2016 referendum result no longer reigns quite so supreme in British politics. It is more difficult to see how a hard Brexit, and its associated large-scale legislation, can be piloted through the new parliament, either in the Commons or particularly in the Lords.
Furthermore, the election result has also dealt a big political blow to the “austerity” path that the Conservatives have pursued for the budget since 2010. With a Jeremy Corbyn government now a very real possibility in any early election, it can no longer be taken for granted that further austerity measures will be acceptable to Conservative MPs.
Brexit and austerity policies are clearly linked: the harder — or more chaotic — the Brexit, the higher will be the budget deficit. Therefore, the less room there will be to relax austerity policies while hitting the government’s targets for the budget deficit and public debt.
So the government may need to choose between the hard Brexit still apparently preferred by Theresa May (“no deal is better than a bad deal”) and the relaxation of austerity controls on public expenditure. They cannot have both.
In interviews at the weekend, Mr Hammond seems to have chosen the path of softer Brexit, though only in the form of a lengthy transition deal towards the ultimate goal of taking the UK out of the single market and, apparently, the customs union. This would prevent the “cliff edge” of no deal with the EU and give the chancellor a better chance of being able to relax austerity policies in coming budgets.
This transition period might be seen by Leavers as a way of putting Brexit into the “sometime, never” category. Nevertheless, most Tory MPs may be willing to accept that path, in preference to ushering in a Corbyn government.
Let us look at the fiscal arithmetic facing Mr Hammond. How sensitive are the government finances to the type of Brexit that the government pursues? Following last year’s referendum result, the Office for Budget Responsibility published the following assessment of the impact of Brexit on the economy and the public finances:
The OBR concluded that the budget deficit would be increased by around £15b (0.6 per cent of gross domestic product) in 2020/21 as a direct result of Brexit. It based its assessment on a very benign interpretation of the likely Brexit deal, guided by the prime minister’s Lancaster House speech. The OBR allowed for a relatively minor decline in the growth of imports and exports, and somewhat lower migration, but no major disruption on either front. This is clearly a fairly soft Brexit.
The chancellor reacted to these estimates simply by increasing his targets for the budget deficit and public debt in coming years. There was, therefore, no impact on tax or expenditure policies. Instead, public debt was used as a shock absorber. The date of achieving budget balance was delayed by several years, and the ratio of public debt to GDP was increased by about 8 percentage points, compared with pre-referendum estimates.
A more pessimistic view of the impact of Brexit on the public finances was propagated by the UK Treasury during the referendum debate. It estimated that the budget deficit would rise by £24-39bn within one year of a vote for Leave, roughly twice the recent estimates by the OBR. This seems to match better the likely consequences of a harder Brexit, which would have more disruptive effects on the economy in the near term .
In the event of a hard Brexit, the chancellor would need to react, either by raising taxation, cutting public spending, or delaying the date of achieving budget balance yet again. When faced with a problem of this type since 2010, the government has always decided to delay the date of budget balance, add more to public debt and extend the period of “austerity” in the public services. Mr Hammond’s first instincts would probably be to do the same again.
However, this reckons without the new anti-austerity mood that seems to have emerged in the latest election. Even on the current optimistic Brexit assumptions built into the March 2017 Budget, there will be a need for substantial further “austerity” public spending measures to hit the budget and debt targets.
According to the Institute for Fiscal Studies, the share of public spending in GDP would need to decline at around 2 percentage points in the next five years. This is only about half of the rate of decline that has been achieved since 2010, but it would still amount to a very difficult further squeeze, given that “austerity fatigue” seems to be emerging in large segments of the electorate.
In interviews at the weekend, Mr Hammond appeared to rule out any increase in public borrowing, except perhaps to cushion a temporary recession triggered by the Brexit process. However, he did seem to suggest that there may be some relaxation of public expenditure limits, because the government has listened to the message from the electorate on the need to ease austerity. This could require some increase in taxation to make the fiscal numbers add up, as the chancellor himself seemed to acknowledge.
So the Treasury seems ready to tread a fairly narrow path, involving a Brexit transition period to avoid the “cliff edge”, some relaxation of austerity in the public services and somewhat higher taxes. The right wing of the Conservative party may not like this very much, but it probably offers the best chance of progress.
 Note that these numbers take no account of the exit “dowry” that the UK might be forced to pay in order to retain temporary access to the single market in any transition deal. The latest demands from the EU Commission think this dowry should be E 100 billion gross, or E 60 billion net; the UK is currently thinking it should be only a small fraction of that amount.