UK economy's shock contraction: are government cuts to blame, and will there be a double dip?

The City expected the UK economy to grow by 0.3% - 0.7%, having grown by 0.7% in 2010's third quarter. The stark reversal of fortunes has knocked both the FTSE (down 0.6% this morning) and Sterling (down 1.3% against the Dollar) - to give some indication of how the markets are taking the news.

How much can we logically fear being plunged back into recession? The Office of National Statistics, which measured the country's gross domestic product (GDP), said its estimate 'was significantly affected by the bad weather in December'. Chancellor George Osborne, not that surprisingly, is towing this line. And to some extents the weather looks like a fair scapegoat.

The ONS explained 'the decline in the fourth quarter is due to decreases in two of the component aggregate series, namely services and construction'. Construction decreased by a whopping 3.3% in the fourth quarter, compared with 0.6% growth in the third. Construction is, obviously, an industry that's particularly vulnerable to bad weather.

Critics, however, are calling Osborne's convenient weather excuse ridiculous, not least because the ONS said (rather ambiguously) growth would have been 'flattish' had it not been for the weather anyway. Many commentators are blaming the contraction on the government's £81bn cuts (an average 19% trim for each department), which have been pushed into force faster than non-reformers would have liked.

The outgoing director-general of the CBI, Sir Richard Lambert, chimed in with some such criticisms yesterday (and is consequently being heavily cited in cuts-condemning articles today).

"It's not enough just to slam on the spending brakes," Lambert warned. "Measures that cut spending but killed demand would actually make matters worse."

Lambert wasn't entirely criticising cuts though - he actually said the cuts are 'strongly supported by business' and necessary, but they aren't being sufficiently counterbalanced by initiatives to help protect jobs and stimulate growth. He accused the government of taking 'a series of policy initiatives for political reason, apparently careless of the damage that they might do business and job creation'. (He also lampooned Labour for making a 'mess' of public finances.)

And, let's not forget, the full force of the cuts are yet to be felt. Many have been announced, but they are being rolled out over the couple of years, not condensed into the past three or four months. So their full impact on growth is still to be decided.

Unfortunately, therein lies another log on the furnace threatening to burn up into a double dip. The first quarter of 2011 is crucial, since it will decree whether the economy is really receding (if GDP contracts again) or if the fourth quarter was just a climate-impacted blip we bounce back from instantly. Yet the economy will face the new bite of the VAT hike in this first quarter, and will have to withstand the next round of governmental cuts. And January is always a more stagnant month than December, seeing as everyone's keeping their purse strings tight post-Christmas.

Is an economy that has suddenly contracted robust enough to withstand these pressures?

It's impossible to say, and economists' opinions vary. (Click the link for fuller analysis.) There are, however, some glimmers of hope among all this. The UK's total production output rose 0.9% in the fourth quarter of 2010. Manufacturing, which the government has been so keen to rebalance the economy towards, grew an impressive 1.4% compared with a more modest 1.1% in the third quarter.

This isn't itself isn't necessarily enough for us to all breathe a sigh of relief, but it is something. As Chris Williamson, chief economist at Markit, surmises: "Strong demand from overseas markets such as Germany, China and the Middle East raises our hopes that UK exporters will have continued to help offset domestic weakness and revive the recovery, but the chances of a double-dip recession have surely increased."

Should the government change its cuts policies? Osborne has resolved not to, anyway: "There is no question of changing a fiscal plan that has established international credibility on the back of one very cold month," he said. "That would plunge Britain into a financial crisis. We will not be blown off course by bad weather."

While this author cannot pretend to the expertise of economists who are concerned a double dip is plausible, nor of those who speculate it's unlikely, I do there is some solace to be taken from Osborne's unwavering.

Governments need to inspire confidence in their people and in markets, and while this economic contraction has wobbled both, a U-turn on policy would surely create even more inflammatory uncertainty. (And that's not to mention any of the arguments in favour of sticking with the deficit-shrinking cuts, the most compelling of which is to secure faith in the banks, and, therefore, investment in the UK and trade with it and the country's stability as a whole.)

The greatest economic minds in the country cannot agree on what the best fiscal direction is. We'll just have to hope the government's self-certainty and determination to ride out the storm pays off.

We use cookies to create the most secure and effective website possible for our customers. Full details can be found here