Time for the Chancellor to loosen the purse string?

BRITAIN’S economy will fall into recession in the first half of the year and the Government needs to ease up on its tough package of spending cuts, the National Institute of Economic and Social Research (Niesr) has warned.

The UK economy will shrink 0.1% in 2012, Niesr said, as cash-strapped households tighten their purse-strings and nervous businesses hold back on investment.

Chancellor George Osborne’s austerity measures are contributing to low demand in the UK, which in turn is damaging the broader economy, Niesr said, so a temporary softening of his fiscal stance would give the country a much-needed boost.

In addition, Niesr said an increase in Government investment would not derail the Chancellor’s long term goals or prevent him hitting his fiscal targets.

Elsewhere, Niesr said the UK economy would rebound in 2013 with 2.3% growth, but only if a successful resolution to the ongoing eurozone debt crisis is found.

Meanwhile, the group forecast global growth of 3.5% for 2012, led by Asian powerhouses China and India, while the US should see 2% growth.

The UK is already close to another recession – defined as two consecutive quarters of economic decline – after official figures revealed the economy shrank by 0.2% in the final three months of 2011.

In its UK and World Economy Forecast, Niesr said: “We forecast a return to technical recession in the first half of this year, as households continue to retrench, credit conditions remain tight, and businesses are reluctant to invest given uncertainty about both domestic and foreign demand.”

The forecaster said economic conditions will not improve in the short term, with flat output this year, as both the private and public sectors clear off debts.

Unemployment will rise to about 9% this year, from 8.4% in the three months to November and will remain above 7% in 2014.

A jobless figure at this elevated level for a long period is likely to do “permanent damage” to the supply side of the economy, with large long-run economic costs, Niesr warned.

The thinktank added: “The UK economy currently suffers from deficient demand; the current stance of fiscal policy is contributing to this deficiency. A temporary easing of fiscal policy in the near term would boost the economy.”

The Niesr report came came a day after the Institute of Fiscal Studies (IFS) said Mr Osborne had scope for temporary tax cuts of up to �20billion in the Budget to boost growth.

The IFS said the case for cuts to VAT or employers’ National Insurance contributions, as well as increased investment, was “stronger now than a year ago”.

Expectations of a fall in inflation later this year meant that the Government could increase borrowing by around 1% of GDP to fund a short-term fiscal stimulus without triggering an increase in interest rates, said the IFS.

But it warned that any stimulus package must be “timely, targeted and temporary”. There was a “strong case” against permanent tax cuts at this stage, and any larger package would risk unsettling the bond markets and forcing up the cost of Government borrowing.

Labour, which has been calling for a five-point plan to boost jobs and growth, including cuts in VAT and National Insurance contributions, as well as infrastructure investment, welcomed the IFS judgment, contained in its Green Budget.

Shadow chief secretary to the Treasury Rachel Reeves said: “The independent IFS is right to say that the case for short-term action on jobs and growth – for example through the temporary tax cuts Labour has been calling for – is now stronger and will get stronger still if the eurozone crisis deepens.

“But rather than waiting for things to get even worse, George Osborne should take urgent action in next month’s Budget. Years of slow growth and high unemployment are not just bad for families and for the deficit, but also risk permanent damage to our economy.”

The IFS report predicted that Mr Osborne will beat his deficit reduction target by �3billion in the current financial year but it said that prospects for 2012 remained bleak, with predicted growth of just 0.3% – significantly lower than the 0.7% predicted by the Office for Budget Responsibility, which produces the Government’s official forecasts.

John Walker, of Oxford Economics, which worked with the IFS on the report, said he was “certainly” expecting a double-dip recession, with negative growth in the current quarter to follow the recently-announced contraction in the last three months of 2011.

The report also warned that a break-up of the eurozone could plunge the UK back into “deep recession”, with GDP falling both this year and next and unemployment soaring to a 20-year high.

Mr Osborne should use his Budget statement on March 21 to spell out how he would react if the debt crisis in the single currency deteriorates further, said IFS economist Gemma Tetlow.

The fragile state of the euro meant that the risk of an unexpected development in the economy was “heavily skewed to the downside”, and the Government needed to reassure investors that it has the flexibility to respond, she said.

Modelling by Oxford Economics suggests that the departure of up to five countries from the eurozone would result in British GDP shrinking by 1.7% in 2012 and a further 0.9% in 2013, while unemployment would soar to 10.7% – the worst level since 1993.

In the case of a collapse in the euro, Mr Osborne would have to impose further tax increases and spending cuts unless he was willing to abandon his own “fiscal mandate” of balancing the books over a five-year period.

“If the eurozone does break up, pretty much all our forecasts are blown out of the window, as is the Government’s fiscal strategy,” said IFS director Paul Johnson.

The report said the size of austerity measures planned for the UK were “almost without historical or international precedent” and represent the biggest sustained cuts since the Second World War.

It pointed out that, by the end of the current financial year, just 6% of the cuts will have been implemented, and added: “How deliverable the remainder will prove to be remains to be seen.”

But the pressures of an ageing population on health and pensions budgets mean that “further hard choices over tax and spending are likely to be needed”.

Mr Johnson said: “The Chancellor faces his third Budget with the economy and public finances in considerably weaker shape than he had hoped a year ago.

“While it looks as though central Government is going to underspend against tight spending plans, this neither leaves much space for any permanent fiscal loosening nor avoids the fact that the vast majority of the planned – and unprecedentedly big – public service cuts are still to come.”