CRISIS IMPACT: Britain braces for era of austerity

Published: 14 Jun 2009 17:26:40 PST

* Taxes set to rise, spending faces axe

* Political scandal to complicate policy-making

* Unlike 1970s, Britain faces no wage-price spiral

* But long-term inflation worries may grow

LONDON, June 12 - When Labour swept to power in Britain in 1997, it used the pop anthem "Things Can Only Get Better" as its soundtrack. The next government will face a lot more doubt.

The winner of an election due in the next year will need to launch an era of austerity, with spending curbs and tax rises required to close a record budget gap of 175 billion pounds ($287 billion).

The global credit crisis has left governments around the world facing similar challenges. But what makes Britain's plight unique is a simultaneous crisis of confidence in the political system, triggered by a scandal over expenses claimed by members of parliament.

That second crisis will bring a host of new faces into parliament as tainted MPs stand down. High-profile independent candidates are preparing to run for election, and the main parties are suddenly discovering a latent zeal for institutional reform of parliament and the electoral system.

The turmoil has not changed the basic political arithmetic.

Opinion polls say the centre-right Conservatives are heading for victory, possibly a landslide, in the general election which must be held by June 2010.

But while investors are looking to the heirs of Margaret Thatcher to balance Britain's books, the Conservatives have been careful not to commit to any radical fiscal policy changes this far out.

The orthodoxy would be for Labour to raise taxes and the Conservatives to cut spending once the economy is recovering and fiscal stimulus is no longer needed. A recovery may well be underway by the end of this year.

But the delicate economic situation will demand a mixture of the two approaches. And getting the timing right -- early enough to limit the debt-build up, but not so early that the economy is hurt -- will be difficult, with the ratio of government debt to gross domestic product set to rise above 90 percent under Europe's Maastricht treaty definition by 2013/14.

"The debt is a fact of life. It's there now. It's best to deal with it as slowly as possible within the constraint of pleasing the markets," said Professor Campbell Leith, a macroeconomics academic at the University of Glasgow.

"Our work suggests that it is optimal to only adjust the debt to GDP ratio very slowly...as slowly as the markets can bear. The Conservatives are proposing to drag it down more quickly than Labour plans, and that would be quite costly."

HARD TIMES AHEAD

Budget cuts will likely prove hard to sell in a country that has grown accustomed to high levels of social spending.

But reductions in inflation-adjusted spending on health, education and law and order are inevitable, according to research for the Institute for Fiscal Studies and ESRC think tanks.

Managers said this week that the National Health Service faced a funding crisis and that action was needed to ensure the 60-year-old service, Europe's biggest employer, remained free at the point of delivery. An ageing British population will add to the burden on the state in coming years.

The upshot will probably be harder times for the average Briton, as government debt accumulated over a few years takes many years to pay down.

"UK households on average face a potential fiscal squeeze building up to around 4,600-5,300 pounds per annum from 2018 onwards if the government is to get public debt back under control and meet the potential long-term costs to the taxpayer of an ageing population," consultancy PricewaterhouseCoopers said in a report.

The crunch is expected to come with a Comprehensive Spending Review after the next election that will settle how funds are divided between government departments.

RETURN TO THE 1970S?

The IFS/ESRC study noted that the spending cuts and tax rises brought in by a Labour government three decades ago were dictated by the conditions attached to an emergency International Monetary Fund loan agreed in 1976.

Thatcher's Conservative government, which took office in 1979, was then able to get Britain's finances under control by holding down public spending, and also because it enjoyed windfall benefits from taxing North Sea oil.

There is nothing resembling an oil windfall this time around.

The upside is that inflation remains under control and that Britain does not face the wage-price spiral which it suffered in the 1970s.

But the aftermath of the scandal over MPs' expenses could produce a more populist, unstable parliament in which the next government finds it more difficult to push through sensitive spending cuts.

Concern about the impact of politics on fiscal policy was one reason behind the decision of Standard & Poor's last month to cut its outlook for Britain's sovereign debt rating. [ID:nLL627240]

It also helps to explain the underperformance of British debt over the last several months; the 10-year gilt yield <GB10YT=RR> has climbed 104 basis points from its March low, compared to 71 bps for the yield on 10-year German Bunds <EU10YT=RR>.

Since high inflation would be one way of quickly bringing down the value of Britain's debt mountain, the markets could in the worst case start to question the British government's commitment to fighting inflation.

Although the Bank of England sets interest rates independently, the government of the day still defines the price stability for which the central bank works by setting an inflation target. The target is currently 2 percent.

To head off potential fears over the risk of a politically inspired change to this policy, "all the main parties should make a manifesto commitment to stick to the current inflation target," said John Hawksworth, head of macroeconomics at PwC. ($1=.6096 Pound)