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U.K. Chancellor George Osborne swung a heavy axe at Britain’s welfare state Tuesday. He also announced a raft of tax increases. The net result will be one of the biggest fiscal contractions in any developed country since at least the World War II.
The British public won’t know what hit them.
The budget aims to drag the U.K.’s public-sector deficit down by nine percentage points, from 10.1% of GDP in this financial year to 1.1% by the end of the current parliament due in five years’ time. This is as dramatic as Canada’s mid-1990s experience, when its government managed to trim its deficit from 9.1% in 1992 to a surplus of 0.2% by 1997.
But Canada had the benefit of a fast-growing U.S. economy to help it to an average annual GDP growth of 3.1% during those years of fiscal contraction. The U.K. isn’t so lucky. Its major trading partner, the euro zone, is also going through a major bout of fiscal austerity; the U.K. faces having to make its cuts at a time when its major trading partner, the euro zone, is doing the same.
The Treasury expects the euro zone to grow by an average of 1.9% over the coming four years. This, in turn, is expected to generate average U.K. GDP growth of 2.7% over the same period. Remember, the total fiscal tightening over this period is expected to be worth more than 6% of GDP, according to Capital Economics, three quarters of which will come in the form of spending cuts.
The risks for growth must be skewed to the downside.
Given that the last time the British went through such deep public-sector austerity was in the mid-1920s, it is safe to say few if any people can imagine quite how harsh these cuts will feel. Public rebellion could yet force the governing coalition–fundamentally a fragile beast–to water down these measures.
A combination of slower-than-projected growth and official backpedaling would ensure deficit targets won’t be met.
So far, British government bond yields have been well behaved thanks to confidence in the coalition government’s ability to deliver fiscal austerity. A failure to do so would almost certainly cause sterling weakness and flight from the bond market, forcing up domestic interest rates.
Rising interest rates would be the killer punch.
Not only is the U.K. government heavily indebted, but its private sector is the most over-borrowed of any in the developed world. The Bank of England has been trying to alleviate the burden of this debt by engineering inflation. Consumer prices have been running well more than a percentage point above its 2% target.
And it will continue with its program of extremely easy monetary policy for as long as it can reasonably argue the government is meeting its side of the bargain. But a run on sterling in the event of higher-than-expected budget deficits would put the central bank in a bind.
My expectation is of lower growth, higher inflation, bigger deficits and higher interest rates by the end of the current Parliament. It’s a mess with its own momentum.
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The Source is WSJ.com Europe’s home for rapid-fire analysis of the day’s big business and finance stories. It is edited by Lauren Mills, based in London.
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