Tory Britain: Grim, Then Grimmer

The government planned for the pain to stop by 2015. It won’t

George Osborne, Britain’s Finance Minister, had a plan: First, use brutal austerity measures to rid Britain of its record budget deficit before the next election in May 2015. The hard part done, Osborne would then cut taxes, boosting the economy and opening the way for the Conservatives led by Prime Minister David Cameron to sweep into a second term.

Now that strategy is in doubt. Spending cuts will have to continue for two years beyond the election to meet the government’s deficit targets, Osborne announced in his Autumn Statement to Parliament on Nov. 29. That day, after the speech, the Office for Budget Responsibility (OBR), a nonpartisan body of economists set up after the Conservative-led coalition took office, released its prediction for gross domestic product. GDP, it said, will grow just under 1 percent this year, not the 1.7 percent expected in its March forecast, and by 0.7 percent in 2012, instead of 2.5 percent. The deficit in the five years through March 2016 will be £112 billion ($175 billion) higher than planned. The next day some 1 million state workers staged a 24-hour strike over plans to make them retire later and pay more for pensions. That raised the specter of years of labor strife as Osborne attempts the deepest budget reductions in British peacetime history.

Crucially for Osborne, the OBR reckons the 2008 financial crisis and the ensuing recession inflicted far more permanent damage on the economy than previously thought. Manufacturing capacity is shrinking as factories close and the financial services industry—10 percent of the economy—is smaller. Potential economic output in 2016 will likely be 13 percent lower than forecast.

A smaller economy means lower tax revenue. As a result, Osborne will have to pursue an extra £15 billion in austerity measures to meet his deficit goals, the watchdog says. Government workers face pay cuts until at least 2015 and more than 700,000, or 13 percent of public-sector employees, may lose their jobs. “Growth until 2016 will be similar to, or worse than Japan’s lost decade and the U.K.’s worst recession/recovery cycle of the last 100 years,” says Michael Saunders, chief European economist at Citigroup. “It may be even worse than we expect. There is no accepted definition of depression, but this may qualify.”

Osborne argues Britain is a victim of the euro crisis and that the country would lose its top credit rating if he bowed to Labour demands to ease up on the cutting. Interest rates of 2.3 percent on 10-year U.K. government debt, compared with 5.8 percent in Italy, support his case, he says. It’s not all pain: The Conservatives plan to underwrite billions of pounds of loans to small and medium-size companies and allocate extra funds for infrastructure projects.

Osborne and Cameron appear to be winning the argument with voters, who have only to look at the Continent to see the havoc that deficits can wreak. A BPIX poll published on Dec. 4 found that on the question of the economy, the Conservatives led Labour by 31 percent to 28 percent. A separate ICM Research survey showed the Conservatives gaining two percentage points in overall support, to 38 percent, with Labour dropping to 36 percent. Both polls were taken following Osborne’s speech. Still, the squeeze under way may test that support as living standards decline at the fastest pace since the 1970s.

Before it's here, it's on the Bloomberg Terminal.