George Osborne is back as Chancellor of the Exchequer. But he’s inherited something of an economic mess from the last government. Here are the top six reasons he faces a tough task ahead:
1- Spending cuts didn’t work last time. For two years after the 2010 election, Osborne tried diligently to stick to the harsh austerity plans laid out in his June 2010 Emergency Budget. Britain suffered the third worst spending cuts in Europe, behind only Greece and Luxemburg. But, predictably, the economy was forced back into a slump and recession. As the failure of the original plan became evident, the Treasury took the decision to ease off. By 2014, the pace of deficit reduction had been reduced to a crawl. The failure of austerity meant Osborne missed his original deficit target, and will continue to cut for another five years.
2- They won’t work this time, either. But the Conservatives are committed to accelerating the cuts. Despite the rhetoric, the Coalition eased right off on austerity towards the end of its time in office. The Conservatives are now committed to achieving a fiscal surplus (getting more taxes than they spend) by the end of their current term of office. This implies a further £33bn of cuts. However, if they squeeze harder on public spending now, as in 2010-2012, they’re like to drive the economy back into stagnation.
3 - The low-hanging fruit have been picked. Despite its rhetoric, the Coalition was careful to cut what it considered to be easy targets. In the first few years this meant extraordinary cuts in capital spending on things like buildings and equipment. Expenditure here fell for some departments by more than 50%, but the effects of these cutting were not immediately felt. The Coalition was careful to apply very deep cuts to local authority funding, effectively sub-contracting austerity to local councils who could then take the flack. It targeted certain parts of social security spending, such as disability benefits, demonising claimants. For Conservatives, these were low-hanging fruit, in that the political costs of cuts were minimal. Now, particularly if the government intends to make £12bn in welfare cuts, meet its deficit goal, and continue to protect certain parts of spending, it will be very hard to avoid hitting politically damaging targets. Unprotected departments could be facing cuts of nearly 18% over the next few years.
4 - Household debt is rising again. The only factor likely to dampen the economic impact of a return to full-throttle austerity is rising household debt. Over 2010-2012, British households were still, in the aggregate, repaying the debts they had built over the boom years of the 2000s. But this switched in early 2013, as “unsecured” borrowing (that is, borrowing not on mortgages but things like credit cards, car financing deals, and payday loans) began to rise. By the end of last year, it was rising at its fastest rate since 2006. With real incomes falling, rising borrowing fuelled rising consumer spending. By 2013, households had become net borrowers from the rest of the economy, just as they were in the early 2000s. If households carry on borrowing to spend, this will compensate for the impact of cuts. But this also means household debt will continue to rise, as the official forecasts show (Chart 3.31) – a crisis waiting to happen. This household borrowing is, of course, heavily dependent on rising house prices: although quantitative easing and other political interventions have helped sustain the bubble, it’s not clear how long this might last for.
5 - We’re becoming less productive. All of the above problems would matter less if the underlying economy was in a better shape. But since 2007, UK productivity, output per hour worked, has not risen. This is exceptional: productivity has grown consistently since the Industrial Revolution and most other major developed economies have seen a return to productivity growth since the crisis. On average, every hour worked in the UK produces 29% less than every hour worked in Germany. The result is that scope for real pay increases is very limited; it is easier for firms to increase pay when productivity is rising, since they can make the payment out of the productivity gain. Investment should secure productivity gains, but investment fell at the end of last year. Last summer falling oil prices translated into low inflation and, finally, some rises in real incomes. But this was extraordinarily lucky, and it’s going to be very hard to sustain real wage rises on the basis of very low inflation.
6 - We’re not paying our way in the world. The deficit that dominated the election campaign is the government’s fiscal deficit: its spending minus tax receipts. But this is the least important of the three large deficits the UK economy is now running. More worrying is the sharply rising household deficit (see point 4), and the current account deficit – at around its highest level since modern records began, nearly 6% of GDP. This deficit is the gap between what we earn from the rest of the world, through exports and investments, and what we pay to the rest of the world, through imports, overseas investments and lending. It matters because, like any other deficit, it needs financing. Britain has run a persistent current account deficit for decades, which it has paid for by selling off assets (think Eurostar or London property) and borrowing. As a result, we have the highest external debts of any major economy, at over 400% of GDP. The need to finance this makes the whole economy hugely vulnerable, since it makes us all highly dependent on the ability to find financing. If the rest of the world no longer wishes to finance us, due to an external shock such as US interest rate rises or the collapse of the Chinese credit bubble, the pound could fall sharply and a crisis could quickly emerge.
Put all this all together, add a slowdown in growth that hints at a peak in our debt-fuelled recovery, and despite winning the election it’s clear that the new government isn’t in for an easy ride.