U.K. Coalition Will Snap by End of Year: David G. Blanchflower

They sold their souls for a few pieces of silver. Well, actually for the chance to be in government, but probably not for long.

Liberal Democratic leader Nick Clegg is now the U.K.’s deputy prime minister and all three of his chief negotiators -- Vince Cable, Chris Huhne and Danny Alexander -- have Cabinet positions in a coalition government led by David Cameron of the Conservative Party.

Cameron and Clegg will have a major problem keeping the left wing of the Liberal Democrats and the right wing of the Tories in line. I suspect another election will be called before the year is out. The compromises that both parties have made are too great: What was unthinkable to the Liberal Democrats last week on issues such as atomic energy, euro membership and immigration was suddenly acceptable to them. They even acceded to Conservative demands for 6 billion pounds ($8.9 billion) in spending cuts, as part of an austerity budget.

For a short time, the markets responded favorably to the formation of a new government. The pound strengthened.

Then Bank of England Governor Mervyn King severely compromised his independence at a press conference to launch the Monetary Policy Committee’s inflation report. He entered the political arena by supporting the new government’s austerity package of cuts for 2010. This clearly isn’t the MPC’s view, but simply his own, as there would have been no time to consult his colleagues on the committee. As a former MPC member, I recall King’s strict dictum that we shouldn’t speak on fiscal matters, which weren’t part of our purview.

Downside Risks

More important for the markets was the MPC’s statement that the downside risks to economic growth had increased since their previous report in February. The latest labor-market figures, published on the same day, were also weak, with unemployment rising again. The pound fell about 2 cents against the U.S. dollar during the course of the day. The new government had a bounce in the markets that lasted for about 12 hours.

It is a concern that the scale of the fiscal deficit the new government is planning to cut is calculated on the basis of overly optimistic growth projections. The MPC’s forecast, only a little more bullish than the Treasury’s, implies a growth rate of about 2 percent in 2010, 3.5 percent in both 2011 and 2012, and 3 percent in 2013. This is considerably higher than other forecasters are predicting, as well as the European Union and the Organization for Economic Cooperation and Development.

MPC Did Nothing

Even with this bullish growth path, which omits more fiscal tightening proposed by the new government, the inflation outlook is well below the MPC’s 2 percent target after 2010. More budget cuts will move the central projection for inflation into deflationary territory. A forecast like this implies the economy needs a lot more stimulus, but the MPC did nothing.

When inflation was above target, interest rates were raised to take it back to target, and this was reflected in the forecast. This can be seen in August 2006 when borrowing costs were increased to 4.75 percent from 4.5 percent, and in November 2006 when they rose by 25 basis points to 5 percent. Policy action by the committee was forecast to move inflation back to target. Not this time. The MPC should have increased quantitative easing -- and by a lot. It’s unclear why it didn’t.

It isn’t that the MPC believes that quantitative easing isn’t working. “Asset purchases appear to be having a sizable downward effect on gilt yields,” it said in the latest inflation report. “Equity and corporate bond prices have increased significantly since early 2009. That is likely, in part, to reflect the exceptional monetary stimulus.”

The Cameron-Clegg government is inheriting an economy still in decline and a central bank that is doing nothing about it. This may well be an election that the Labour Party will be pleased it didn’t win.

(David G. Blanchflower, a former member of the Bank of England’s Monetary Policy Committee, is professor of economics at Dartmouth College and the University of Stirling. The opinions expressed are his own.)

To contact the writer of this column: David Blanchflower at david.g.blanchflower@dartmouth.edu

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