Austerity won’t lead to a double-dip


The pivotal question in the run-up to yesterday’s emergency Budget was whether it would knock the economy into a double-dip recession. This debate had been raging for months – indeed, the Labour Party campaigned hard on the assertion that too much austerity too soon could tip the economy back into recession. Even yesterday, its message was still that such measures should wait until the recovery is on firmer ground.

But chancellor George Osborne defended the need for severe measures. Already the UK government is borrowing £1 for every £4 it spends and the message yesterday was clearly that without action now, the cost for future generations will be untenably large. Osborne is not alone in prioritising the job of repairing the public finances – the tone of the most recent G20 meeting made clear that most governments are thinking along the same lines.

The reason is clear, investors are no longer attributing zero (or close to zero) default risk to sovereign debt and, as investors demand higher risk premiums, governments fear that debt maintenance costs could rise to very painful levels

It is on this pretext that the Liberal-Conservative coalition has been defending the need for budget austerity. Prime Minister David Cameron warned earlier this month that without action, the cost of debt maintenance would more than double to £70bn by 2015 – this would be greater than the combined budgets for transport, running schools in England and climate change.

While some economists do fear that a double-dip recession will be a consequence of budget austerity, both the CBI and the National Institute for Economic and Social Research (Niesr) think that this is avoidable. But whether or not the UK economy will fall back into recession depends in part on the economic performance of the country’s trading partners, most of which are entering their own periods of repair.

On the whole, international data suggests that the global economic recovery remains in place, indicating that the industrialised world has entered a phase of growth, albeit at a relatively low levels. Recent UK economic data has brought mixed results. Industrial production data was disappointing but retail sales and labour data were brighter – the claimant count fell by a greater-than-expected 30,900 in May. This was not the first time since the financial crisis began that UK unemployment figures have brought a positive surprise; the peak in the jobless rate is likely to be significantly lower than the double-digit peaks experienced in both the 1982 and 1992 recessions. That said, while unemployment apparently improved this spring, the employment numbers remain sour. Only a net 5,000 new jobs were created in the three months to April, and all part time.

The increase in VAT to 20 per cent, combined with the reduction in the welfare budget, will be punishing for some out-of-work consumers. But the Budget did include some incentives to cheapen the costs of hiring low paid workers that should help to negate some of this pain. Market estimates centre around a growth forecast for the UK economy around 1.2-1.3 per cent this year, in line with those of the Office for Budget Responsibility (OBR).

While changes to the tax and welfare system are broad-based in nature, it is the reaction of public sector workers to the changes in their pay and pension provisions which threaten to create the biggest backlash. All public sector workers earning over £21,000 will have their wages frozen for two years. But perhaps more emotive are the proposals to cut the £10bn gap between the assets and liabilities of public pensions, which threatens to significantly reduce the attractiveness of public pension schemes which is unlikely to go down well with trade unions. The markets will not react well to any labour unrest.

Disappointingly, the absolute level of public debt is likely to carry on rising through the term of this government. This statistic is softened by the projection that the debt/GDP ratio should fall as should the deficit/GDP numbers. Borrowing as a share of GDP should fall to just 1.1 per cent of GDP by 2015, down from 10.1 per cent of GDP this year. Furthermore, the government aims to reduce the structural deficit a year earlier than previously expected. While the markets tend to remain sceptical of budget projections until firmer evidence is seen, these estimates should stave off risk of a credit ratings downgrade and these projections should therefore support sterling assets. The firmer tone of gilts in recent weeks has already translated into lower fixed mortgage rate costs (rates on a two-year fixed mortgage have reached a seven-year low). Lower borrowing interest rates should translate into a better environment for economic growth, offsetting some of the impact of fiscal austerity.

At the end of the speech, euro-sterling was very little changed from its level at the start. That said, both sterling and the FTSE 100 did rally in the aftermath. The fact that the chancellor stated that Germany and France were also announcing a bank levy diluted the impact of that measure on the UK financial sector. The Budget may give sterling sufficient incentive to recapture more ground against the euro but scope for an aggressive move appears rather limited.