Fiscal tightening to dampen, not derail, recovery – comment by Rupert Watson, head of asset allocation at Skandia Investment Group

The Chancellor has just announced details of the Comprehensive Spending Review (CSR). The overall spending plans were the same as those announced in the emergency budget in June, although today’s announcement set out departmental spending and hence where the cuts will be made. Unsurprisingly, it has received a mixed reception with some saying that the cuts risk pushing the economy back into recession. We think that the cuts will slow the economy somewhat although are unlikely to push the economy back into recession. Furthermore, it could lead to stronger growth rates in 2012 and beyond.
Highlights of the spending review:

• The bulk of the overall deficit to be eliminated by 2015/16, with the structural deficit eliminated by 2014/15. Fiscal policy to be tightening each year until 2015/16
• After a modest tightening in 2010/11, mostly by the previous administration (e.g. VAT hike in January 2010), the next 2 years will see a more than 4% cumulative tightening in fiscal policy, the sharpest such tightening in decades
• The tax increases are front loaded (e.g. VAT hike in January 2011), while the spending cuts are more evenly spread across the parliamentary term
• The bulk of the 490,000 public sector job losses occur towards the end of the parliamentary term. This is largely because public sector pay restraint over the next two years is achieved through the public sector pay freeze. In his statement today, the Chancellor said that most job losses will be achieved through natural turnover.
• Overall government spending to slow to just 0.4% in nominal terms in 2011-12, before rising slightly more rapidly thereafter.
• Spending on health, international development and a few other items are protected, while spending on ‘annually managed items’ such as debt interest and public sector pensions are projected to grow.
• Elsewhere, average departmental spending is cut by 19%, less than expected. The previously planned rise in the state pension age is brought forward. Whitehall savings of £6bn is more than the £3bn initially targeted. There will be a permanent bank levy. Welfare savings of £7bn are sought.

Impact on GDP
The fiscal cutbacks are likely to dampen the economic recovery in 2011, although we do not expect the cuts to push the economy back into recession. Monetary policy is set to remain at exceptionally loose levels over the course of 2011, with the Bank of England indicating that it would provide further monetary stimulus if that was required – today’s MPC minutes showed that Adam Posen voted for more Quantitative Easing (QE). An improving trend in the UK public finances could also lead to greater confidence and hence greater spending by the corporate sector, which is currently generating huge amounts of cash.
In terms of the labour market, the government’s plans imply job losses equating to 0.5% of total private sector employment each year. In the past, the private sector, which employs four times more people than the public sector, has created that amount of jobs on many occasions, including 1993-1997 when fiscal policy was tightened (1.6%) and over the last year (1.4%).
Over the medium term, the measures could lead to improved economic performance. Periods of fiscal restraint have often been associated to improved economic performance as inefficient government spending is replaced by more efficient private sector spending. Furthermore, if the government is successful at reducing the number of people stuck on benefits this could further improve the overall economy’s performance and government finances as well.
Summary and Conclusion
The government’s fiscal plans should lead to a substantially lower deficit over time and may dampen, although not derail the recovery. While some will argue that the cuts could lead to weaker growth, the new government had little choice, given the size of the deficit. The difference between the plans laid out in the CSR and those of the opposition are not as substantial as some have suggested, while less pain now would have implied more pain later. In addition, the government has scope to adjust the plans if economic conditions follow a different path to those assumed, while there also remains flexibility on the monetary policy side as well. Over time, the government’s plans should lead to a leaner more efficient public sector to the benefit of the economy as a whole.
The opinions expressed in this document are those of Skandia Investment Group and are subject to change without notice and may differ or be contrary to opinions expressed by other business areas or groups of Skandia as a result of using different assumptions and criteria.  Such opinions are also not necessarily reflected in Skandia funds.