Reducing the deficit is getting harder

The Duncan Weldon Economics Matters Column

It’s been a terrible week for the chancellor, the government and the economy’s prospects – the Project Merlin lending targets don’t seem to be going well, the ONS has confirmed the economy’s 6 month stagnation and public borrowing increased in April. And all that before the OECD downgraded is UK growth forecast and said that spending cuts might have to be slowed down, endorsing the need the need for ‘Plan B’.

But the problem goes far deeper than a week of bad headlines and data points. In the political debate over the economy participants often get side tracked into focussing too much on the day to day. In reality none of the events this week are really that surprising, steeping back and looking at 2011 so far, the economic picture has been becoming increasing gloomy.

GDP growth can come from four sources – consumption, investment, government spending or net trade. We learned this week, in the GDP data, that household spending has now been contracting for two quarters.

The prospects for consumption growth look very weak indeed – household income is being squeezed by a combination of slow wage growth, rising prices and tax and benefit changes. The OBR forecast that household spending would rise at a faster pace than household income as families increased their debt levels to maintain their consumption. This doesn’t seem to be happening. The real concern for the economy now, is that cautious households actually increase their savings and spend even less.

Investment was one of the Chancellor’s great hopes. The news this week was terrible. Business investment fell by a 7.1% in the first quarter of 2011 and is now 3.2% lower than at the same time in 2010. Business confidence, like consumer confidence, is low and so firms are unlikely to increase their capacity.

Government spending is now starting to be cut as the real austerity measures outlined in June last year start to take effect.

In other words two of the four economic drivers are moving in reverse and they are about to be joined by a third.

George Osborne is now pinning all his hopes of growth, and hence deficit reduction, on the final driver – exports. Although the UK’s net trade position is improving, it remains highly doubtful that exports alone can offset contracting consumer spending, falling investment and the impact of the government’s fiscal tightening.

As stockbrokers Tullet Perbon noted this week:

“Over the past decade, the British economy has been critically dependent on private borrowing and public spending. Now that these drivers have disappeared – private borrowing has evaporated, and the era of massive public spending expansion is over – the outlook for growth is exceptionally bleak.

The mathematical implausibility of growth poses major problems given that the government’s fiscal rebalancing plan is entirely dependant upon growth reaching at least 2.8% in less than two years from now.

If this doesn’t happen – and we are convinced that it can’t – the deficit reduction plan will come apart at the seams.”

To get a sense of the longer term picture, it is useful to look at the economic forecasts collated by the Treasury and published monthly. Comparing the most recent set, to those of December when Cameron boosted about the UK economy being ‘out of the dangerzone’, we see a stark picture.

Back in December the average forecast for 2011 growth was 1.9%, by the middle of this month that had fallen to 1.6%. The CBI forecast is down from 2.0% to 1.7%, as is that of the IMF. The OECD has cut its forecast this week from 1.7% in December to 1.4% (it’s third downgrade). Two weeks ago the Bank of England cut its own forecast and the OBR has lowered its forecast on every occasion it has revised them.

It’s important not to get carried away by a week of bad economic news – but it’s now looking like nearly six months of bad news and downgrades. All of which makes the task of reducing the deficit that much harder.