‘Painful Retrenchment’: What Will It Take to Get Britain’s Economy Back on Track?

When Gordon Brown announced his resignation and walked out of Downing Street with his wife and two young sons on May 11, he brought 13 years of Labour Party-led government in the United Kingdom — first under Tony Blair and then by himself since 2007 — to an end. The next morning, Britons woke up to a new political reality. David Cameron’s Conservatives, who had not convinced enough voters in the election on May 6 to grant them a controlling majority, and the Liberal Democrats — Britain’s perennial third party led by Nick Clegg — had forged a deal that gave the U.K. its first coalition government in more than six decades.

Under Cameron as prime minister, the new government faces many challenges, not the least of which is dealing with a massive budget deficit during a time of recession. The end of the Blair-Brown era finds Britain with an annual budget deficit of £156.1 billion ($225 billion) for 2009-10, or 11% of GDP. (In the United States, by comparison, the federal deficit is nearly $1.4 trillion, or 10% of GDP.) Consumer price inflation, at 3.7% in April, is well above the official 2% target rate.

Unemployment stands at 2.5 million — 8% of the workforce — with employers in the private sector preferring to spread existing workforces thinner rather than hire. The public sector will be hit by 30,000 to 50,000 job losses this year, according to estimates, and other cuts to public spending could affect contracts outsourced to the private sector. Although the increase in unemployment since the start of the recession has tapered off slightly, there are fears that it could approach the “politically sensitive” level of three million unemployed — the peak during the recession in the 1980s and 1990s — says Paul Wallace, Britain economics editor of The Economist.

Although credit-rating agencies Moody’s, Fitch and Standard & Poor’s have so far not downgraded Britain’s AAA credit rating on market jitters around the election results and the ongoing economic strife in Europe, the country is on watch. And while there have been signs of some recovery in real estate (in the buy-to-let rental market, for example), the housing market that underpinned so much of the good times remains a shadow of its former self. In early May, Jones Lang LaSalle, a global real estate firm, reported that bank lending on U.K. real estate for the first quarter of 2010 had improved only marginally year on year, growing at the second-lowest level recorded since March 1997, just before the election that brought the Labour Party to power.

According to Wallace, after presiding over a decade of non-stop growth and low inflation, the Labour Party “made the mistake of thinking that nothing could go wrong.” Despite warnings, for example, that the housing bubble was bound to burst eventually, Labour was “simply not cautious enough.”

Although Brown won international praise for his speedy and timely response to the economic crisis — a rescue package for British banks that brought Britain back from the brink — the recession, when it arrived in 2008, caught Labour off guard, according to Matthew Bidwell, a Wharton management professor and native of the U.K. The government was “too reliant on house prices and the financial sector for fiscal revenues, and overly optimistic about growth. They let public spending get away from them.”

A Degree of Freedom

The new government takes power at a time when the world’s attention is focused on troubles elsewhere in Europe, as the Continent’s economic powers mull the future of the euro on the back of Greece’s debt crisis and fret about contagion spreading to other vulnerable countries such as Spain and Portugal. Indeed, comparisons between those countries’ strife and Britain’s have been drawn. Philip Booth, professor of insurance and risk management at City University’s Cass Business School in London, notes, for example, a similar level of borrowing used by the U.K. to support its public finances.

But there are also crucial differences, notably Britain’s ability to devalue its currency — the trade-weighted value of which has fallen by about a quarter since mid-2007 — and to control its own interest rates because it is not part of the euro zone. Bidwell points out that this gives Britain a degree of freedom that other countries don’t have, allowing it to avoid the potentially catastrophic deflation prospects faced by the likes of Portugal.

With seven of Britain’s 10 main trading partners being euro members (the U.S. is the largest at 13% of trade, followed by Germany at 11%), a collapse of the euro would hit Britain hard in trade terms. But Brown’s decision to keep Britain out of the euro zone looks smart in hindsight. The situation in Britain, Booth says, is “less urgent,” but “no less chronic.”

Meanwhile, Europe’s proposed regulations targeting hedge funds are another source for concern, says Simon Walker, chief executive of the British Venture Capital Association (BVCA). These regulations could drive funds out of Britain, where venture capital is, according to Walker, an “area of great potential” for British enterprise development. Prime Minister Cameron has expressed his own reservations about the regulations, which are supported by Germany, and he has pledged to oppose them. But, like much about Europe, they may become a poison pill Britain has to swallow.

Tough Fiscal Measures

Much remains unclear about what the new coalition government needs to do, or even how damaged Britain’s economy really is. But there are clearly problems that need addressing — including the size of Britain’s public sector (consuming half of national income and especially bloated outside the economic hothouse of London and the southeast) and the resulting budget deficit.

Walker notes that unless government spending is brought under control, Britain could end up “like Portugal … a country with a glorious past, but a pretty B-grade economic power.” Bidwell adds that the deficit needs to be reduced drastically. This is not without risks, especially with signs of a fragile recovery emerging. “It is hard to know who will pick up the slack as government spending goes down.”

Selling spending cuts to the electorate will prove to be a particular challenge to the coalition. According to Wallace, “There is an overriding need for painful fiscal retrenchment in a country where many people still don’t really believe it is necessary.” Some blame for this expectation can be placed on the politicians themselves, who spent much of the campaign talking about simple “efficiency savings” in government spending. Britain’s deficit problems run far deeper, most experts agree.

It was the gap between the need for action and voter expectation that encouraged Cameron to enter a formal coalition with the Liberal Democrats. In doing so, he has made sure that the Liberal Democrats’ fingerprints will be alongside those of Conservatives on the weapon of spending cuts, with senior Liberal Democrats, including Clegg as deputy prime minister, in key economic policy positions. The coalition can also claim a mandate of sorts, despite the widely held view that the election results represent a “vote for nobody.” Bidwell says the coalition’s advent marks the first time since the Second World War that “[more than] 60% of the British electorate has voted for the government in one form or another.” Wallace notes that such a mandate may make hard decisions easier to sell politically.

On May 24, the government announced nearly £6.2 billion in spending cuts, including a freeze in civil-service recruitment. Business leaders have been cautiously welcoming such moves. Steps to mitigate Labour’s increase in contributions by employers to national insurance — Britain’s state pension fund — have been particularly well received.

Other possibilities are less welcome. BVCA’s Walker is concerned about the coalition’s plans to increase “non-business” capital gains tax (CGT) — on property and stock gains, for example — from the present rate of 18% to close to 40% beginning next April, in line with the top income tax rate. That could impact the venture capitalists and private equity firms the BCVA represents (around 20% of international private equity is located in Britain). Currently, he says, Britain sits about midway on the spectrum for these taxes internationally, but such a move would push it to the high end.

According to Walker, this move, combined with the possibility of coalition plans to raise taxes on “non-domiciles” — wealthy foreign residents in Britain — could drive wealth out of the country to places like Geneva, Hong Kong, Shanghai and New York. With the financial services sector a besieged but still important part of the economy, such a move “promotes uncertainty at a time when we need certainty.” (Currently, financial services accounts for around 8% of the economy, down from over 10% in 2008 before the recession hit, without taking related professional services into account.)

City University’s Booth also worries about the CGT rise possibility, which would amount to “double taxation on investment returns” and could potentially harm the business environment. Others expect the prospect of CGT changes to spark sales of shares and second homes. Yet cutting a huge deficit means raising money as well as building savings. With other coalition plans, including a rise in the basic tax allowance beginning next April — the threshold of income exempt from income tax — money will have to come from somewhere.

Booth is among those who suspect the likelihood of an increase in the value-added tax (VAT) from 17.5% to 20% to make up the difference. This could work against economic recovery, he warns. Walker, on the other hand, welcomes the idea of emphasizing indirect taxes rather than income taxes. Combined with a firm government program for cutting expenditures, “a rise in the VAT to 20%, with all exemptions removed, would be a good start” for the new government in its deficit-slaying mission.

According to Booth, the new order in government is an opportunity to deal with the deficit from the bottom up — not likely to be a quick process — rather than from the basis of reducing the existing deficit. It also offers the possibility of radical change, to “look at everything again.” One such area would be the “public-sector distortion of labor markets in poorer regions.” For Britain to fully reform, there must “be no distortion at all,” he says. Walker agrees, urging labor-market reform to encourage expansion of business to less well-off regions and to prevent businesses from relocating their operations in lower-wage economies in central and eastern Europe and Asia.

Hope for Recovery?

What are Britain’s prospects for economic recovery? Wallace is cautiously optimistic: Despite employment rates not growing in the near-term, the unemployment rate “is not likely to soar.” He also points to areas of strength beyond financial services, such as the business-services sector, and the openness of Britain’s economy in general.

In financial institutions, there may be some grounds for cheer. In mid-May, a report from Morgan McKinley, a recruitment consultancy, showed twice as many job vacancies in the sector in April 2010 than the same month a year earlier, with businesses focused on emerging markets as a particular growth area.

Wharton’s Bidwell also expects a recovery in cyclical terms, but he warns it will “not be easy or pretty.” In addition to the overwhelming need for the coalition to deal with the deficit, he says that the new government needs to grapple with the heavy role the financial-services sector has played in Britain in general. “A big financial services sector is risky. But who will take up the slack if it shrinks?”

Then there is the question of the survival of the government itself. According to Bidwell, despite the locked-in nature of the coalition agreement, and the safety nets Cameron has sought, “keeping the whole thing flying will be a challenge.” Over time, for example, the more left-leaning Liberal Democrats, or the right wing of the Conservative party could become uncomfortable and rebel, especially if public support tapers off as the pain of spending cuts is felt. And there are, of course, always unexpected events. Says Wallace: “It is the unexpected that tests in politics.”

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