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Economics Weekly Will public sector spending cuts push the UK back into recession? Weekly economic data preview - UK inflation and China Q2 GDP in the spotlight

Economics Weekly 12 July 2010

 

Will public sector spending cuts push the UK back into recession?

 

The austerity package announced in the emergency Budget has raised concerns that the degree of public spending restraint could tip the UK back into recession. On the face of it, these concerns are understandable. With total spending cuts amounting to £99bn (or 5.2% of GDP) and tax increases of £29bn (2% of GDP) planned by 2015-2016, the fiscal squeeze is the most aggressive since the Geoffrey Howe Budget in 1981. In this weekly, we examine the size of the spending cuts put forward by the Chancellor and assess the implications for the economy as a whole.

 

How aggressive are the spending cuts?

Since 1997, the share of the economy accounted for by public spending has risen from 38% to 48% - its highest since 1984. Over the next five years, public spending is projected to fall in real terms by 4%. If realised, this would reduce the share of the economy devoted to the public sector to 40% over this period (given the anticipated growth in the economy).

 

This decline is far from insignificant, particularly when measured against previous assumptions. Moreover, the total cuts in department spending will be far higher than this, as a large proportion of public spending either falls outside the government’s control or is very difficult to change.m This includes, amongst other things, the costs of servicing public sector debt, social security payments and public sector pension obligations.

 

With limited headroom to cut these categories, It falls to government departments to bear the main burden of the structural spending cuts. Full details of where the departmental axe will fall will not be published until 20 October when the government publishes its next Spending Review. Nevertheless, the totals were set out in the emergency Budget. Based on these, the Institute for Fiscal Studies (IFS) concludes that real spending cuts averaging 14% across all departments would be required for the Chancellor to deliver his objective of a balanced cyclically-adjusted current budget over the next five years. This equates to a structural reduction in department spending of around 5% of GDP in the period.

 

For most departments, however, the cuts are set to prove far more severe. Since the government has committed to protecting spending on the NHS and overseas aid, the average cut faced by ‘unprotected’ departments is estimated at 25-33% over the next four years. Ahead of the Spending Review, the Treasury has asked departments to seek out potential cost savings of up to 40%.

 

The expectation is that efficiency savings will account for the bulk of the budget cuts although, given the scale, it seems possible that front-line services could be affected. Moreover, in its latest forecast, the Office of Budget Responsibility (OBR) estimates that as a result of the spending cuts, public sector job losses will total 600k by 2015- 2016.

 

Economic impact

The scale of the proposed spending squeeze has led to an intense debate about whether or not it will derail the nascent economic recovery. The cuts in public expenditure (both current and capital spending) will have a direct impact on GDP through reducing government consumption and public investment. There will also be a second order impact on consumer spending, savings, and investment as a result of the ensuing public sector job losses.

 

Balanced against this, however is that public sector borrowing will be lower than would otherwise be the case. This reduction could be expected to reduce the cost of capital in the private sector, and free up savings to finance business investment. This, in turn, could be expected to have positive benefits for employment and consumption and therefore GDP growth.

 

The net impact of a change in government spending on aggregate demand can assessed by looking at estimates of the fiscal multiplier. The OBR estimates that the fiscal multiplier applied to departmental spending is 0.6. – i.e. a cut in departmental expenditure equivalent to 1% of GDP would have the effect of reducing GDP by 0.6% in the short run. Over the long run, the implications for GDP are assumed to fade, as wages and prices ultimately adjust to bring the economy back to its long-run equilibrium.

 

Applying the fiscal multipliers to the timetable of proposed cuts in public spending show that the largest impact to GDP growth occurs in 2011- 2012 (see chart a). In that year, GDP growth is 1.5% lower than it would have been had the spending cuts not occurred. Thereafter, the impact of the fiscal multiplier on GDP growth steadily reduces

 

It should be stressed that estimates of fiscal multipliers are highly uncertain. They depend on numerous factors, including the marginal propensity of businesses to invest, household’s marginal propensity to consume, the resulting monetary policy response, and prevailing inflation and credit conditions. Our own forecasts of the impact of the fiscal multiplier are slightly more cautious than those of the OBR, largely because we believe prevailing credit constraints and a lack of desire by businesses to invest in the current environment will act as an impediment to growth. Moreover, with interest rates already close to zero and term rates at historically low levels, it is unlikely that monetary conditions will loosen further.

 

Nevertheless, we are cautiously optimistic that the UK economy will be able to continue to recover, despite the scale of the fiscal tightening. We expect GDP growth to rise by around 1% this year, by 2% in 2011, before peaking at 2.7% in 2012. That GDP growth can rise amid such a sharp tightening in fiscal policy is not without precedent. Following Geoffrey Howe’s Budget in 1981, the share of government spending in the economy fell from 48% to 42% over six years. Over the same period, annual real GDP growth averaged 2.7%. Similarly, in the early 1990s, a substantial fiscal tightening under the Major government failed to prevent a strong economic recovery (see chart b).

 

It must be stressed that given the scale of the structural credit shock, we doubt the improvement over the coming years will be nearly as strong as the recoveries of the early 1980s and early 1990s. Nevertheless, we are cautiously optimistic that even with the scale of fiscal consolidation planned, low interest rates and a pick up in private sector demand should enable the UK to avoid a double dip recession.

Adam Chester, Head of UK Macroeconomics

 

 

Weekly economic data preview 12 July 2010

 

UK inflation and China Q2 GDP in the spotlight

 

 

􀂄 The UK data calendar is particularly busy this week. The inflation numbers for June will receive the most market attention, particularly given the nature of the current debate on the MPC with a number of members stressing their unease with the persistently elevated level of consumer price inflation. A jump in petrol costs and the impact of the January 2010 VAT hike have meant that inflation has been above the 2% target every month since December 2009, rising to 3.7% in April, before falling back to 3.4% in May. We expect this disinflationary trend to continue, although on our own forecasts, CPI is expected to remain above 2% through the rest of 2010. If inflation does begin to come down, the debate over the appropriate level of interest rates is likely to become more focused on the uncertain nature of the economic recovery. Given this, we believe interest rates will remain unchanged this year. In June specifically, annual CPI inflation is expected to have declined to 3.1% with a slightly smaller decline in annual rates of both the RPI and the RPIX to 4.9%. In terms of other data, labour market statistics are set to continue to paint a fairly mixed picture with claimant count unemployment likely to fall further, and the more inclusive ILO measure continuing to show little, if any, growth in employment. Headline average earnings growth is forecast to slow as the positive bonus effect drops out of the calculation. Finally, the ONS is set to publish the final estimate of Q1 GDP. No change is expected to the 0.3% quarterly growth rate, but the release coincides with the publication of the annual Blue Book which adds to the uncertainty, given the likelihood of substantial revisions to past growth rates.

 

􀂄 Last week, ECB President Jean-Claude Trichet was at pains to highlight the good news coming out of the euro-zone economy at the moment. The sharp 2.6% m/m increase in German industrial production during May (and associated strength in exports) is a case in point. With global recovery still being propelled by emerging Asia, Far Eastern demand for Germany’s exports (notably from China) is lending crucial support to economic activity at the moment. But this demand cannot be relied upon indefinitely, particularly amid signs that growth in China is beginning to slow. Although still robust, Chinese Q2 GDP data this week are expected to show annual growth slowed to 10.3% from 11.9% in Q1. Also published this week, Chinese consumer prices are forecast to have risen 3.3% in June – the second consecutive month that inflation has been above the official target of 3%. Given rising inflationary pressures, combined with the recent pick up in wages, we expect the Chinese authorities to raise the prime lending rate to 5.85% by end-2010. This week’s eurozone data releases include EU-16 industrial production data and Germany’s ZEW economic sentiment index for July. For the latter, we look for a relatively modest dip to 26.0 from 28.7 after June’s sharp deterioration prompted by turbulence in euro area financial markets. Beyond this, final CPI data for June are published in a number of countries, including France and Italy.

 

􀂄 Data from the US this week will help to refine estimates of Q2 GDP growth, with June retail sales and industrial production along with external trade and business inventories for May, due for release. Despite the softer tone to indicators recently, we look for annualised GDP growth to near 3.5%-4% in Q2 from 2.7% in Q1. The latest price trends will also be in focus with June import prices, PPI and CPI all released this week. We look for further confirmation that price pressures remain subdued. In addition, there are a host of Fed speakers this week, including Chairman Bernanke, while the minutes of the 22/23 June FOMC meeting are published on Wednesday. The Treasury will sell $69bn of notes and bonds this week.

Marchel Alexandrovich, Mark Miller and Jeavon Lolay

 

Economic Research,
Lloyds TSB Corporate
Markets,
10 Gresham Street,
London EC2V 7AE
,
Switchboard:
0207 626 - 1500
www.lloydstsb.com/corporatemarkets

 

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