UK-Style Austerity Trap

The chanting may be louder and the protests more violent but like Greece, the UK is suffering through its own austerity program. However, unlike Greece which is having restraint forced upon it in exchange for emergency funding from the European Union, the UK is engaging in a self-imposed program of spending cuts and tax hikes in an attempt to balance its budget.

In the three years prior to the 2010 British election, government spending and total debt ballooned to levels not seen since the Second World War. In the final few years of the previous government’s 13-year reign, spending had become so out of control that Britain found itself in violation of the debt and deficit limits imposed by the 1992 Maastricht Treaty.

Under the terms of the treaty, all European Union members must ensure yearly deficits do not exceed 3 percent of GDP while total debt must not exceed 60 percent of GDP. By the end of 2009, Britain’s deficit was more than 11 percent of GDP and the country’s accumulated debt stood at nearly 70 percent.

During the campaign period leading up to the election early last year, the Conservative party led by David Cameron made economic reform the center plank of the party’s election platform. While Cameron ultimately won the election to become Prime Minister, he needed the support of the third-place Social Democrats to form a coalition and gain the majority necessary to pass legislation. More on that later.

Coalition Delivers an “Austerity” Budget

Less than two months after forming the government the newly-minted Chancellor of the Exchequer, George Osborne, released a budget that Osborne described to the media as “tough but fair”. The main objective of the budget was to begin the process of balancing the books that the government claims will be accomplished primarily through spending cuts rather than tax increases. The government estimates it can accomplish the task within five years.

Despite the pledge to rely more on reduced spending as opposed to raising taxes, one of the leading elements in the budget released last June was to increase the Value Added Tax (VAT) to 20 percent from 17.5 percent. The budget also contained wide-ranging spending cuts starting with a cap on public sector wages and other programs designed to reduce overall spending.

The government has been forthright in admitting that these moves – while necessary to restore confidence in the economy – will be difficult in the short-term. An understatement perhaps for any of the 300,000 or so public sector workers who are expected to lose their job in the coming months. Private sector rolls could also suffer as the government reduces or even withdraws funds set aside for large-scale infrastructure projects.

To date, the employment outlook has actually improved in the months following the budget. Last May unemployment was pegged at 8 percent climbing to 8.1 percent by October – by the end of the first quarter of 2012 unemployment had fallen to 7.9 percent with the most recent reading for May placing unemployment at 7.7 percent.

Time will tell if the economy can continue to add jobs as the austerity measures take greater effect. Still, while employment has performed better than expected so far, wages themselves continue to be depressed. Wage increases are on-hold across the spectrum and while workers are certainly not enthusiastic about this reality, there is comfort in continuing to receive a regular pay cheque.

The impact of wage stagnation is further amplified, however, by rapidly rising price inflation. This past May higher energy and food costs, coupled with the government’s increase in the Value Added Tax, helped pushed inflation to more than twice the Bank of England’s 2 percent inflation target.

Despite the increase in price inflation, overall economic growth remains constrained. The latest projection by the National Institute for Economic and Social Research has Britain’s economy expanding by a mere 0.1 percent during the second quarter of the year. This has caused a dilemma for the Bank of England – should interest rates go up to deal with inflation at the risk of overall growth, or should interest rates remain low to promote growth while possibly driving inflation even higher?

Not surprisingly, the Bank of England’s Monetary Policy Committee (MPC) remains divided on the question but at this point at least, those arguing against rate hikes are in the majority. On Thursday, even as the European Central Bank was raising interest rates in the Eurozone by a quarter point, the Bank of England announced it would maintain the current 0.5 percent benchmark rate.

Can the Coalition Hold Itself Together?

As consumers feel the pinch from stagnant wages and rising inflation the government comes under greater pressure to ease up on the pace of change. The two parties forming the coalition are at opposite ends of the political spectrum making it difficult to imagine sufficient common ground can be found to maintain the arrangement for the duration of the current mandate. Indeed, it is a marvel that a full year has already passed with relatively little acrimony between the two parties.

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