25/01/2012 07:14 GMT

UK Economy Contracts - Is It Time To Change Course On Austerity?

Blaming the eurozone and the world economy for the UK's economic woes might be wearing thin, as more bad news about the country's growth emerges. Austerity is having an impact. Is it time for a Plan B?

The UK's gross domestic product (GDP) fell by 0.2% in the fourth quarter of 2011, the Office of National Statistics (ONS) said on Wednesday.

The contraction was worse than economists' estimates of 0.1%, and serves to highlight the weakness in the UK economy. The country's GDP grew by 0.9% across the entire of 2011.

Officially, Britain is not in a recession until it has experienced three consecutive quarters of negative growth. However, the fact that the busy Christmas period, which saw high volumes of sales, failed to turn around the numbers is a grim sign of how deep the UK's economic problems have become.

Unemployment in the UK is at a 15-year high, youth unemployment is well above 1 million and is increasingly looking like a structural, rather than a temporary problem. While reducing the country's debt - Chancellor George Osborne's "Plan A" - is an important part of returning the economy to long-term sustainability, simply cutting government spending will not create jobs or wealth in the UK.

George Osborne told Sky News immediately after the figures were released that the country's problems "would be substantially worse" if the debt was not cut. This is probably true - as the experience of Greece, Italy, Portugal and Ireland shows, the capital markets - from which the UK borrows - punish those countries that fail to show credible plans to pay back their debts.

The International Monetary Fund (IMF) cut its forecast for growth in the UK to 0.6% in 2012, down from 1.6% in its previous estimates. This is roughly in line with the Bank of England's estimates and the wider economic consensus.

Public accounts figures also showed that the UK's national debt had passed £1 trillion for the first time - 64.2% of the country's total GDP - although government borrowing fell by £2.2bn to £13.7bn in the month.

Christine Lagarde, the IMF's managing director, was among the signatories to a "call to action" issued ahead of the World Economic Forum in Davos. The call, which was also signed by the heads of the World Bank, the Organisation of Economic Cooperation and Development, the World Trade Organisation and other major multilateral organisations, said that austerity without a clear emphasis on growth would not reduce the huge fiscal deficits that have built up in much of the developed world.

Governments need to "manage fiscal consolidation to promote rather than reduce prospects for growth and employment. It should be applied in a socially responsible manner," the letter said.

As expected, union leaders and opposition figures immediately put the boot in, blaming the government's austerity drive for slowing growth.

Labour's shadow chancellor, Ed Balls, said in a statement: “These figures are a damning indictment of David Cameron and George Osborne’s failed economic plan. Families, pensioners and businesses know it’s hurting – but the evidence is now overwhelming that on jobs, growth and the deficit it’s just not working."

The Trade Unions Congress head Brendan Barber said: "The Chancellor’s economic strategy is going horribly wrong. The grand austerity plan is failing to tackle the deficit, causing unemployment to spiral out of control, and is now dragging the country back towards recession."

Large parts of the UK economy were dependent on public sector spending, and clearly spending and job cuts have impacted growth. But much of the pre-recession economy was also driven consumer and business credit, which are heavily impacted by global economic sentiment and liquidity.

The manufacturing industry, which has at times kept the economy from contraction through strong exports, has also shown signs of turning around, contracting 0.9% in the fourth quarter of 2011.

The Confederation of British Industries (CBI) said in its quarterly manufacturing survey, released on Wednesday, that production had "weakened sharply," but gave a slightly more upbeat assessment for the first quarter of 2012.

The global environment is clearly worsening - as evidenced by the bleak assessment from the IMF released on Monday. The eurozone crisis remains far from resolved, and that is dragging on the UK.

"This is probably the first set of numbers where we can attribute large amounts of the blame to the eurozone. The fact that manufacturing is being hit harder than anything else, because that's our most export-oriented area of the economy. It does rather back up that viewpoint," Charles Levy, senior economist at the Work Foundation, told the Huffington Post UK.

"But, we've also got construction down, which suggests that domestic demand is also weak."

It is almost impossible to disaggregate how much is caused by domestic and external factors - but that, economists said, does not matter. Either way, it needs a response.

"The eurozone situation is having a negative impact, but that doesn't mean we shouldn't be doing things to help the domestic economy," Levy said. "Just because the problem is external, doesn't mean that the solution has to be external."

Investments in infrastructure, entrepreneurship drives and small business financing all point to a credible strategy for growth, Levy said. However, they are being done at a scale that will not have the systemic effects that are needed to restart the economy.

"The government is making all the right noises," he said. "There's lots of little nuggets of good things that they're doing - the innovation strategy was very well thought through. But it doesn't have the scale. Large amounts of money are being spent on things that don't necessarily work so well, like enterprise zones, and smaller sums of money are being spent on these initiatives that help to build the conditions on which growth can be delivered.

"The government is talking in very sensible ideological terms… but it just doesn't have the weight."

Brian Hilliard, chief UK economist at Societe Generale, told the Huffington Post UK that the negative implications of short-term contractions can be overplayed, and insisted that austerity would, in the longer term, drive growth.

Hilliard is anticipating a jump in growth in the third quarter, driven by a return to real growth in disposable income as inflation falls, as well as by increased output and exports around the London Olympics. Until then, however, growth is likely to be flat, and the Diamond Jubilee holiday, with its four-day weekend, will cause a fall in output in the second quarter.

"We shouldn't really expect any growth until the middle of the year. It is a credible medium term plan for growth," he said. "The government is right in pursuing fiscal consolidation, which is growth destroying in the very short run, but lays the foundations for growth. It also allows a very low bond yield environment, which in itself is a form of monetary stimulus."

The ability to keep borrowing at cheap rates is a key part of the chancellor's plan, and despite the falling growth rates, they are unlikely to punish the UK, according to Hilliard, who expects the Treasury to "tough it out" and stick to its Plan A.

"I think the markets are going to be… understanding of the lack of growth momentum in the short term," he said.

Improved numbers in the core of the eurozone, as well as better projections in the service and manufacturing sectors provide some hope, Hilliard added.

"It's easy to be negative when you see a fall in GDP," he said. But it is possible to exaggerate the downward influences. There are definite signs of stabilisation that we shouldn't ignore."