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No Easy Way Out of U.K. Recession

U.K.’s slide back into recession defied expectations, and analysts now fear David Cameron’s government has no means of spurring recovery.

  • David Turner

The United Kingdom has confounded expectations by sliding back into recession, according to official figures revealing that even the painfully slow recovery eked out since the 2008-'09 economic crisis has disappeared. And analysts say Prime Minister David Cameron’s government has few good options available to spur recovery.

Wednesday’s numbers show the U.K. entering double-dip territory — where the economy suffers a new recession before output has recovered from the last one — for the first time since the crisis years of the 1970s.

“This is a worse performance for the economy than the Great Depression of the 1930s”, said George Buckley, chief U.K. economist at Deutsche Bank in London. “Fiscal austerity, private sector debt reduction, European sovereign uncertainty and sticky inflation all present challenges to the recovery.”

The 0.2 percent fall in output for the first quarter of this year, which followed a 0.3 percent decline in the previous three months, shocked many economists in the City of London — most of whom had predicted a small rise. Several responded by suggesting the precipitous 3 percent fall in construction activity — the main driver behind the overall decline for the economy as a whole — might be revised in future months to show a less severe slide.

Economists acknowledge, however, that regardless of later revisions that may or may not show a narrow escape from recession, the gross domestic product (GDP) figures confirm a distressing picture: The U.K.’s recovery from the severe downturn that ended three years ago has been extremely disappointing. In addition to the fall in construction, industrial production declined by 0.4 percent, and the huge service sector rose by only 0.1 percent.

Deutsche Bank noted that in the past, output has bounced back with a vengeance following recessions to grow at about 3 percent a year. This is above the long-run trend of growth of the U.K. economy, which is around 2 percent. However, Deutsche calculates that since the previous recession ended in mid-2009, growth has averaged only 1.1 percent.

This is partly because government departments and households are trying, at the same time as each other, to reduce high debts accumulated in earlier years.

The euro zone debt crisis has imposed an added burden — depressing demand in a 17-member currency bloc that accounts for about half of U.K. exports. Many economists think the euro zone also returned to recession in the first quarter.

The persistence of high inflation will constrain the Bank of England’s ability to respond to weak growth with further quantitative easing — last mandated by the bank’s Monetary Policy Committee in February.

Consumer price inflation rose by 0.1 percentage point to 3.5 percent in March — boosted by higher gas and electricity prices. It is far above the Bank of England’s target of 2 percent.

Inflation has also hit the economy by reducing Britons’ spending power. Inflation is rising faster than pay growth, which has been depressed by rising unemployment.

The freedom of maneuver for George Osborne, the U.K.’s Conservative finance minister, is even more limited. The U.K. has avoided the debt crises of euro zone neighbors, despite a gaping deficit which dwarfs Italy’s and Spain’s, in part because of Osborne’s unflinching insistence that there is “no plan B” to replace his unwavering commitment to reduce the deficit through spending cuts. This leaves virtually no room for government largess to pump-prime demand. Moreover, abandoning the fiscal tightening to give a fillip to the economy would mean discarding the Conservative-Liberal Democrat coalition government’s central policy — inflicting fatal political damage on the administration at a time when it is already performing dismally in opinion polls.

Economists worry, in addition, that the inherent structure of the U.K. economy has constrained its ability to recover vigorously.

The financial services sector, which has been at the very center of the downturn, is recovering only slowly across much of the world. This is particularly germane to the U.K., where the sector accounts for an unusually high 9 percent of GDP.

By contrast, global manufacturing has bounced back much faster from the downturn — as it tends to do following recessions. However, manufacturing accounts for a much lower share of U.K. output — about one tenth — than in Germany and several other advanced economies.

The U.K. stock market responded to Wednesday’s poor economic news by virtually missing out on the day’s global rise in equities. The FTSE 100 closed only 0.2 percent higher at 5,719.

The U.K.’s low economic growth will, by reducing tax revenue, make it harder for the U.K. to cut its high fiscal deficit — forecasted by the International Monetary Fund at 8 percent of GDP this year. Yet one of the most striking aspects of the U.K.’s economic sluggishness has been the absence of any significant reaction by the government bond market. Yields on 10-year gilts rose 5 basis points to 2.15 percent on Wednesday, but this still left inflation-adjusted interest rates for gilt investors at less than zero — meaning that investors are paying, in real terms, for the privilege of parking their money in U.K. government debt. Analysts attribute this to the Bank of England’s ability — in contrast with the euro zone central bank — to print as much money as it likes to prevent a run on gilts.

The pound remains strong largely because of the safe-haven attractions of sterling-denominated debt. As the Wednesday U.K. afternoon ended, sterling was at $1.61 — little changed on the day and up 6 cents since the beginning of the year.

Jim Leaviss, fixed-income fund manager at M&G Investments in London, worries that this safe-haven status could, ironically, hurt the U.K. economy further. In a note published on Monday, he calculated that sterling had risen by more than 7.25 percent since June, on a trade-weighted basis. Because of its “exceptionally strong” performance “there could be big headwinds for the U.K. economy over the next few months,” warned Leaviss.

Higher exchange rates dampen economic activity by reducing the competitiveness of exporters.

Economists also warn that the Queen may make her own contribution to the U.K. recession. Output is at risk of falling for a third straight quarter because of the June Diamond Jubilee holidays marking Elizabeth II’s 60 years on the throne. By keeping factories idle for more days than usual, the Golden Jubilee vacation time ten years ago slashed manufacturing output by 6 percent month on month.