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A Crisis at Home and Abroad

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The chancellor of the exchequer, George Osborne, has staked the British government's reputation on reducing the country's record-high peacetime fiscal deficit (11.4% of GDP in 2009). He has succeeded in making modest inroads since mid-2010, albeit by front-loading less politically contentious measures.

But the question remains as to whether the pace of deficit reduction is so ambitious - at a time of deep crisis in Europe and following the collapse in 2008 of a huge debt-financed asset bubble - that the policy is doing more harm than good, strangling the economic recovery and contributing to a more protracted and more painful adjustment process than would otherwise be the case.

Although fairly resilient labour market data may suggest otherwise, the UK statistical office confirmed last week that the economy fell back into recession in the first quarter of 2012. A decline in national output of 0.3% followed a 0.4% fall in the final three months of 2011. Official data may be revised up slightly over time, but there is no denying the underlying fragility of the economy. Unemployment is set to rise further, real disposable incomes are continuing to fall, there is no indication that firms are stepping up investment plans, and export orders appear under increasing pressure.

Since the beginning of the year Mr Osborne has attempted on several occasions to lay the blame for much of the weakness in the UK on the continuing turmoil in the eurozone, insisting that he has no intention of changing course from his 'Plan A' programme of deficit reduction.

The protracted nature of the eurozone crisis, and the continued absence in the minds of investors of a realistic strategy and timetable towards a resolution (some useful steps were taken at last weekend's EU summit, but the currency bloc remains a very long way from a 'game-changing' announcement), is undoubtedly contributing to the depressed level of business sentiment, investment spending and export growth in the UK.

However, one problem with the chancellor's account is that the eurozone itself avoided slipping back into recession in the first quarter of 2012 (albeit narrowly, thanks to Germany) and that the region as a whole - despite all the apocalyptic headlines, political upheaval, sovereign bailouts and endless 'crisis' summits - actually fared slightly better in terms of headline growth than the UK over the past year.

The uncomfortable truth for the UK is that the economy is suffering on dual fronts. On the one hand it remains mired in a severe (and rare) domestic balance-sheet recession, a consequence of its earlier reliance on debt-driven consumption and leveraged expansion of financial services and property. Irrespective of events elsewhere, the UK faces a long slog ahead against a backdrop of fiscal retrenchment (the planned squeeze on public spending has still barely begun), private-sector deleveraging and an alarmingly dysfunctional banking system.

But as the UK is also the largest country outside the eurozone with the deepest trading and financial linkages with the 17-member bloc, the euro crisis is also very much a UK problem. Almost half of all British goods exported in 2011 flowed to the eurozone, while the latest data from the Bank of International Settlements show the combined exposure of UK banks to Greece, Ireland, Italy, Portugal and Spain totalling some US$300bn.

Add in the banks' exposure to financial institutions in Germany and France, who weren't shy in lending heavily to private-sector borrowers in the periphery during the boom years, and the scale of potential cascading losses in the event of a disorderly eurozone default and likely severe contagion across the region climbs rapidly towards an alarmingly high number. Cue the prospect of a repeat of the unprecedented policy interventions of 2009 - taxpayer-funded bank bailouts, money printing and emergency liquidity support - and then some.

The Bank of England governor, Mervyn King, stated last week that the UK is not yet halfway through the financial and economic crisis that erupted in 2007-08. This is certainly the case. Household balance sheets remain under pressure and underlying weaknesses will persist across the financial sector, given banks' undisclosed losses, tighter global regulatory demands and huge counterparty risk arising from the interconnectivity of the undercapitalised European banking system.

Meanwhile, the government's fiscal austerity programme is entering a new, far more challenging phase. Tax rises and capital investment cuts have so far borne most of the adjustment burden (above-target inflation has helped too), with the level of current spending little changed from two years ago. Whatever the rhetoric, the government is relying heavily on the 'confidence fairy' to spur economic growth that will bring down the deficit. As in the eurozone periphery, it is likely to prove a forlorn hope.

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