With the pre-Budget report due on December 9th and further trouble brewing in the financial markets, it is vital to be clear about what sort of crisis we're in. The tabloids have turned the worst economic slump since the 1930s into a ‘budget deficit crisis.

Britain plc is going broke, overwhelmed by its national debt; Cameron, Osborne and their financial cronies peddle the line that it's all the fault of the State, so we need to cut back state spending drastically. Moreover, unless we balance the budget soon, the UK will lose its AAA credit rating and nobody will lend us money.

This sort of deficit hysteria is economic nonsense. But it strikes home with the public because Thatcher's handbag economics still has resonance. Despite all that's happened, neo-liberalism retains its credibility in the City, and big money has long known how to influence public opinion.

Automatic stabilisers
It is quite true that the UK government is running a large budget deficit, but that is exactly what happens in a recession. The deficit---and the need for government to borrow---merely reflects the fact that tax revenue has plunged while income transfers to the 2.5mn unemployed have risen. Were it not for the cushioning provided by this response---what economists call ‘automatic stabilisers'---the recession would be far deeper and the economic and social costs correspondingly greater. The long and the short of it is that we don't have a budgetary crisis. Yes, the government is borrowing a lot, but that's precisely what it should be doing at this stage in the cycle.

At the same time, it is important to recognise that Britain is unlikely to return to its 2007 level of GDP until 2013 or later---this is no ordinary cyclical downturn. What is more, even if and when it does, the UK's potential output path will be lower than it was; ie, we shall not be able to afford the same lifestyle as before. This fact has long-term implications for future budgets; inter alia, it places tax reform high on the political agenda.

The UK's credit rating
At the moment we should not worry excessively if Moody's and S&P decide to downgrade the UK's credit rating (which is unlikely). In 2009, Ireland and Greece were both downgraded; the spread between German bunds and their own bonds is around 130 basis points (100 basis points = 1%). Were Britain to be downgraded from triple A to AA+, the expected change in spread would be far less. This is in part because most UK government debt is held by its own nationals---the UK borrows far more at home than abroad---and in part because Quantitative Easing (QE) can be used to force down any serious spread.

Equally, the stock of UK public debt expressed as a percentage of GDP is not that great---just over 60% in net terms---and the flow of public borrowing as a percentage of GDP will start to decrease after 2010. The real fly in the ointment is that foreigners may be more reluctant to hold sterling denominated IOUs if currency risk rises, a point repeatedly stressed by economists like Willem Buiter at the LSE.

Public Investment is the key
Let's return to the ‘crisis' argument for a moment. It's important to understand that we don't need to ‘save more' (ie, balance the budget) in order to fund investment, what Keynesian economists call the ‘prior savings' approach to investment. Rather, the opposite is true. Savings will grow only if income grows, and income growth is driven by investment.

Although automatic stabilisers may be invaluable in smoothing the downswing of a business cycle, are they strong enough to lift us out of our current slump? The answer is ‘no' for two reasons. First, as Keynes rightly argued, when the economic outlook looks bleak, private businesses tend not to invest, and this results in the outlook looking even worse. Secondly, there are plenty of signs that we are in either for a second round of recession or, even barring a double dip, for a prolonged period of economic stagnation much like Japan's ‘lost decade'.

The way to break this vicious circle is for government to invest. And although government has spent a nearly a vast amount on bailing out the banks---the indirect result of which has been a boom in share prices which delights the City---it has done little by way of real investment in bricks and mortar. Gross Fixed Capital Formation (GFCF) has fallen from over 18% of GDP in 2007 to 14.3% at present, barely enough to maintain the existing capital stock, much less drive growth.

A modern green economy
Here's the rub. We need a large public investment programme not just to break out of prolonged stagnation, but to change the structure of the economy. We can face this challenge by building a modern, greener infrastructure, promoting renewable energy sources, new transport, properly insulated houses and the like. The more the public sector invests, the more private investment will be ‘crowded in.' How do we finance such investment? That's where a fairer tax system comes in---higher taxes on those who can afford them and lower taxes for those in poverty.

Funding Investment
In our Compass report In place of Cuts, we argue that nearly £50bn could be raised by tax reforms which affect the top decile group of income earners---indeed, by the richest percentiles within the top decile group. Tax reform is essential: the richest 10 percent of income earners in the UK (average income £95,000) pay a smaller proportion of their annual income in direct and indirect tax than the poorest decile group (average income £9,000).

A combination of other measures or even a Tobin tax would double this figure to £100bn; in short, the measures we suggest raise a great deal of revenue from the super-rich while avoiding extra tax for 90% of the population. Our measures taken together reduce income inequality by 3 points on the Gini scale, nearly a third of the 10 points lost during the Thatcher years. Moreover, tax reform is inevitable if fiscal policy is to be sustainable in the long term.

Will the ‘wealth creators' flee the country? A few may go, but most will stay. After all, work permits are available and taxation is lower only in a few EU countries, and life in Riga hardly compares to that in London.

Can Labour offer a progressive vision?
In short, an imaginative pre-budget report by the Chancellor could point the way not just to emerging far more quickly to a sustainable growth pattern, but doing so while promoting a fairer tax system. If the Chancellor seizes the opportunity, Labour could go to the country with a genuinely progressive vision, of a Britain which has rejected neo-liberal dogma and chosen to rebuild a truly sustainable economy. Will Labour seize the day, or will we have more of the same deferential ‘financial prudence' which places the interest of the financial services sector before that of the majority of citizens?

George Irvin