Economic update – July 2010

George Osborne delivered his first budget on June 22nd, describing it as ‘unavoidable’, ‘fair’ and ‘progressive’. In fact, it was none of these. An ‘emergency’ budget was not needed, whether to calm financial markets or for any other reason.

George Osborne delivered his first budget on June 22nd, describing it as ‘unavoidable’, ‘fair’ and ‘progressive’. In fact, it was none of these. An ‘emergency’ budget was not needed, whether to calm financial markets or for any other reason.

The new independent Office for Budget Responsibility cleared the Labour Government of ‘fiddling the figures’ when it concluded that cyclically adjusted government borrowing would be just 0.3 per cent of GDP higher in 2014/15 than projected in the March budget. This hardly amounts to a statement that the fiscal position was much worse than previously thought.

There is nothing fair about swingeing cuts in public services. After the Chancellor’s announcement, 77 per cent of planned deficit reduction will be achieved by spending cuts, including £11bn from the welfare bill, and 23 per cent through higher taxes. This will mean real cuts of more than 25 per cent in the spending of some government departments.

The poorest and most vulnerable in society, those who rely on public services, will be hit hardest by a package that is tilted so much towards spending cuts. The budget deficit is not progressive, even on the Chancellor’s own numbers, which are for 2012/13 (why not 2014/15?) and so include all of his tax measures but only some of the benefit cuts.

Earners in the top income decile are the biggest losers from overall fiscal consolidation, but only because of tax increases previously announced by the Labour Government. This first coalition budget is regressive; the biggest losers from it, in proportionate terms, are those on the lowest incomes.

The UK economy was out of recession – just – around the turn of the year. There has been a delay in the release of full national accounts data for the first quarter of the year, but provisional figures show real GDP increased by 0.3 per cent in the first quarter of 2010 following growth of 0.4 per cent in the final quarter of 2009. The new Office for Budget Responsibility thinks that the economy will grow by 1.2 per cent in 2010 and by 2.3 per cent in 2011. It is betting on a surge in private business investment and an unprecedented contribution to growth from net exports over the next five years.

Retail sales could be faltering. Official figures suggest the volume of retail sales continues to increase at a modest pace. Sales in May were up 2 per cent over the last year and by 1 per cent comparing the last three months with the previous three. But anecdotal evidence suggests the picture is weaker, with the CBI reporting high street sales fell for a second consecutive month in June. High inflation is restricting households’ spending power and consumers may also be worried about a renewed increase in unemployment following the budget.

The labour market was stabilising in the early part of the year. There was a small increase of 5,000 in the number of people in employment in the three months to April, compared to the previous quarter. This was only the second increase in employment since the recession began two years ago. Although the number of full-time jobs is still declining, the labour market looks to have been stabilising in the first few months of 2010.


Unemployment has also stopped rising. According to the Labour Force Survey, unemployment remained close to its peak for this cycle, at 2.47 million, in the three months to April 2010. Meanwhile, the claimant count – the number of people claiming Jobseeker’s Allowance – has fallen in six of the last seven months and it dipped below 1½ million in May for the first time since March 2009. However, following the coalition budget, the Office for Budget Responsibility expects it to increase again in the second half of 2010.

Wage growth remains subdued. Official figures show that regular pay is only 2 per cent higher than it was a year ago, though total pay is up by more than 4 per cent – in large part due to a recovery in bonus payments in the financial sector. The forthcoming squeeze on pay in the public sector – pay will be frozen for anyone earning more than £21,000 – means that aggregate wage growth is likely to remain subdued. In such circumstances, there is little prospect of a strong revival in consumer spending.

Price inflation remains well above its target rate. Consumer price inflation dropped a little in May – to 3.4 per cent from 3.7 per cent – but it is still well above its 2 per cent target rate. Although high petrol prices and January’s increase in VAT have pushed inflation up, core inflation pressures are far higher than the Bank of England expected. Its underlying assumption that a large amount of spare capacity in the economy would put significant downward pressure on inflation is looking increasingly questionable.

The coalition’s first budget implemented £40 billion of deficit reduction measures. George Osborne has bet the future of the UK economy on one particular economic philosophy: that private spending is being held back by worries about the scale of government borrowing. He believes that a promise to eliminate the structural current budget deficit over the next four years will encourage households to spend and companies to invest and that this extra activity will offset contraction in the public sector. But with confidence still fragile after the recent recession, the risk is that households react to the increase in VAT and the prospect of hundreds of thousands of jobs being lost in the public sector with more caution, not less. And if households are not spending and the UK’s main export market, the euro zone, is also struggling to emerge from recession, companies will remain reluctant to invest.

The Monetary Policy Committee splits. The minutes of the MPC’s June meeting show that one member, Andrew Sentance, voted for an increase in the bank rate from 0.5 per cent to 0.75 per cent, the first vote for an increase in interest rates since the economy fell into recession. Given the MPC’s sole focus on inflation, other members of the MPC may choose to follow his lead in coming months. This could be very bad for the UK’s growth prospects, at a time when the government is implementing an aggressive tightening of fiscal policy.

UK government bond yields have fallen. Since the middle of February, the benchmark 10-year bond yield in the UK has fallen from around 4¼ per cent to 3½ per cent. In his budget statement, the Chancellor attributed this decline to the prospect of an accelerated reduction in government borrowing under the new coalition government. In fact, the decline began well before the election was called and yields did not increase during the election campaign and the period of uncertainty immediately after the election (when there would have been some doubt about the prospect of more spending cuts and tax increases). It is more likely yields have fallen because investors are worried about the UK economy falling back into recession – or at best experiencing an extended period of very sluggish growth – and that the odds on such an outcome have narrowed as a result of the measures announced by the Chancellor.


Sterling has reversed half of its decline against the euro. The Bank of England argues that high inflation is the result, in large part, of the weakness of sterling. Meanwhile, proponents of early cuts in government borrowing suggest that fiscal stimulus can be replaced, in part, by strong export growth thanks to the boost to UK competitiveness that results from sterling’s fall. However, sterling has now reversed almost half of its decline against the euro. It was already difficult to see how UK exports to the euro zone – our main export market – would boom, given the weakness of demand across the region. As sterling climbs against the euro it is becoming even harder.


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