As Cameron Wields the Ax, Britain Cringes

On June 5, the British paper the Observer ran a letter from 52 economists begging Prime Minister David Cameron and Chancellor of the Exchequer George Osborne to rethink their radical plan to lower government spending. "Recent economic figures have shown that the government urgently needs to adopt a Plan B for the economy," said the letter. Then came a rare bit of good news for the Prime Minister: an International Monetary Fund report urging Cameron and Osborne to stick to their guns. "Strong fiscal consolidation," wrote the IMF, "remains essential to achieve a more sustainable budgetary position."

The arguments over Cameron's plan are getting heated as the Conservative-Liberal Democrat government presses on with the grim task of executing the deepest budget cuts since World War II. The government envisions about £80 billion ($130 billion) of spending cuts plus £30 billion of tax increases over the next four years. Last year, when the cuts began, was the easiest to bear: Some £6 billion in efficiencies were realized by the government in its various departments. Few layoffs occurred.

This year the pain has intensified. Britons have already felt the pinch of a sales tax boost to 20 percent, from 17.5 percent, which the Office for National Statistics says has added three-quarters of a point to the inflation rate, now at 4.5 percent. A two-year pay freeze for public-sector employees started in April, and cuts on welfare spending, including a three-year freeze in child benefit payments, are under way. A total of 310,000 government-funded jobs are to be wiped out by 2015; about 20,000 of those will be gone by the end of this year.

The psychological effect of the Cameron plan is significant. As the budget cuts unfolded, Sally Wheatman figured her days as a communications officer for the local government in Manchester, 163 miles north of the capital, were numbered. She volunteered to be laid off in April and started a public-relations company with her payout. Though she says she's optimistic about her prospects, Wheatman thinks "very carefully" before making big purchases, and all around her she sees people reflecting "long and hard" about their spending. "I don't get the sense that there's a light at the end of the tunnel," says Wheatman, 45. "When we saw how severe the cuts were, it started to dawn on us that things were going to change."

There are already 2.5 million Britons out of work. As of March, the unemployment rate had held above 7.6 percent for 22 months. The possibility of a worsening job market weighs on consumers, who have seen their incomes squeezed by rising prices for everything from food to car insurance. VocaLink, which processes 90 percent of British salaries paid directly to bank accounts, says annual wage growth in the three months through May was 1.8 percent, not even half the inflation rate. "Income isn't keeping pace with inflation, which is making people nervous," says Nick Moon, a managing director at GfK NOP, a research company that conducts national surveys on consumer confidence. "People aren't going to be rushing out to spend."

If consumers keep a death grip on their wallets, they could kill any chance of a strong recovery and deprive the Treasury of the tax receipts it needs to get the deficit under control. As it is, the economy stagnated over the last two quarters. The IMF lowered its 2011 growth forecast for Britain to 1.5 percent, from a 1.7 percent projection in April. While the weak pound should help manufacturing exports, it will do nothing to encourage consumers to start spending.

Adding to the uncertainty is concern about the next move by the Bank of England, Britain's central bank. "Consumer-spending growth is going to be sluggish at best," says John Bason, finance director of London-based Associated British Foods, which owns the Primark chain of discount clothing stores. "If the authorities were to start tightening interest rates, that has to be negative for the U.K. consumer."

So far the BOE has left the key interest rate at a record-low 0.5 percent. "They're frightened that weak demand growth isn't just a soft patch but something more sustained," says Richard Barwell, an economist at Royal Bank of Scotland Group (RBS) in London and a former BOE official. "It's become a really big deal." Yet the central bank also has to check rising inflation caused by high commodity prices, the increased sales tax, and a weak pound, which makes imports more expensive. Andrew Sentance, who just stepped down from the BOE's Monetary Policy Committee, has been campaigning to increase the benchmark rate to control inflation. Martin Weale, another committee member, and Spencer Dale, the bank's chief economist, both sided with Sentance this year.

Cameron and Osborne have said they're counting on the BOE to keep policy loose as they push government spending down to 40 percent of gross domestic product from 47 percent. Their plan calls for six consecutive years of spending cuts, a feat that eluded even former Tory Prime Minister Margaret Thatcher. The government's Office for Budget Responsibility forecasts that the deficit, which reached a record 11 percent of GDP in the aftermath of the recession, will narrow to 7.9 percent of GDP by March 2012. So far, though, the efforts of Cameron and Osborne have not gained traction. Britain posted a £10 billion budget deficit in April, the largest for the month since at least 1993, as tax income fell and government spending rose.

That's keeping pressure on Osborne, who only has to look 1,500 miles east to see how Greece is being punished by the bond market because of the perception that it's wavering in its budget commitments. The British government could find itself in similar circumstances if it starts to backpedal. "It's very possible that U.K. growth will disappoint and tax revenue may be less than forecast and they may miss their fiscal targets," says David Tinsley, an economist at National Australia Bank in London and a former central bank official. "The market will take a harsher view on signs they aren't committed to meeting the cuts."

A wild card is organized labor's reaction to austerity. So far the unions have made plenty of noise about staging a showdown with Cameron. Little has come of it. Now the Public & Commercial Services Union, the largest civil service trade union, which represents about 300,000 workers, is balloting its members on a possible strike to protest the job cuts. At a conference of the GMB, another major public-sector union, in Brighton on June 6, Vince Cable, Cameron's business minister, was heckled when he raised the possibility of government action to curtail strikes.

"Confidence is quite easy to lose but hard to get back," GfK's Moon says. For now, "people see themselves getting poorer."

The bottom line: While Cameron pushes ahead with deep budget cuts, consumers are refusing to spend and inflation is headed toward 5 percent.

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