22/05/2012 06:47 BST | Updated 22/05/2012 16:37 BST

Eurozone Crisis: IMF Says Turmoil Could 'Shock' UK Economy Into Contraction

Chancellor George Osborne has always insisted that "there is no plan B" - that the only way to revive the economy was by sticking to his deficit reduction path.

But Christine Legarde, Managing Director of the IMF, begs to differ, and today warned that Britain may need to switch course.

She said the Government would in fact be wise to prepare a Plan B featuring temporary tax cuts and increased spending on infrastructure, to support the UK economy in the case of a collapse in the eurozone or the failure of recovery to take off.

In a report on the UK, the IMF identified uncertainty over the future of the euro as the main danger to recovery, warning "risks are large and tilted clearly to the downside" and suggesting the UK may need a new stimulus from the Bank of England.

The report recognised "substantial progress" towards balancing Britain's books thanks to the coalition Government's deficit-reduction programme, but noted that the economy remains "flat" and warned that the weak recovery may be "more protracted than previously anticipated".

Although recovery is expected to gain pace from the second half of 2012, unemployment is "much too high" and much of the UK's productive capacity could remain "idle for an extended period", said the IMF.

The fund called for further monetary stimulus, in the form of the Bank of England printing money in another round of "quantitative easing" or a reduction in the base interest rate from its record low of 0.5% to make borrowing cheaper.

There is scope for the government to boost growth through higher spending on infrastructure projects, which would increase employment and demand within the economy and could be funded within existing budgets by imposing further public sector wage restraint or reforming property taxes, it said.

And if the UK recovery fails to take off, ministers must be prepared to use temporary tax cuts and more infrastructure investment to give the economy a shot in the arm, even if this means reining in the Government's austerity programme, said the IMF.

To retain credibility in this scenario, ministers would need to deliver a new deficit-reduction programme to show how the books will be balanced over a longer period.

Ms Legarde said in a press conference: "Unfortunately the economic recovery in the UK has not yet taken hold and uncertainties abound.

"The stresses in the euro area affect the UK through many channels. Growth is too slow and unemployment, including youth unemployment, too high.

"Policies to bolster demand, before low growth becomes entrenched, are needed."

Despite a brief respite for Britons with inflation hitting a 26 month low, gloom over the prospects for the eurozone was underlined today by a second international body, the Organisation for Economic Co-operation and Development, which forecast a 0.1% contraction in the 17-nation bloc this year followed by anaemic 0.9% growth in 2013, with Europe falling well behind a resurgent USA.

"Today we see the situation in the euro area close to the possible downside scenario which if materialising could lead to a severe recession in the euro area and with spillovers in the rest of the world," said OECD chief economist Pier Carlo Padoan.

The IMF assessment warned that recession in the single currency area would have a major knock-on effect on the UK.

"Setbacks in the euro area are the key risk to economic prospects and financial stability in the UK, as trade and financial links are substantial," said the IMF.

"An escalation of stress in the euro area could set off an adverse and self-reinforcing cycle of lower confidence and exports, higher bank funding costs, tighter credit and falling asset values, resulting in a substantial contractionary shock.

"By contrast, a decisive and durable resolution to stress in the euro area would aid the UK's recovery and remove this downside risk."

Other risks to the health of the economy include low demand as companies and households pay down debts and volatility in the prices of commodities such as oil, said the IMF.

Commodity price rises and uncertainty over the future of the euro were largely to blame for the sluggishness in the UK recovery, which saw Britain enter double-dip recession in the first quarter of this year, said the IMF report.

But it also highlighted the failure of the private sector to pick up the slack from cutbacks in public sector activity in the way that ministers had hoped.

"The economy has been flat," said the IMF report. "The hand-off from public to private demand-led growth has not fully materialised...

"However, the weak recovery also indicates that the process of unwinding pre-crisis imbalances is likely to be more protracted than previously anticipated, in part due to persistent tight credit conditions."

Output remains more than 4% below its pre-crisis peak, but falling unemployment in recent months gives cause for some optimism, the report suggested.

A "modest" pick-up in growth can be expected in the second half of 2012 , so long as strains from the euro area reduce, said the report.

"Over the medium term, economic activity is expected to gain additional momentum, but the continued headwinds from private-sector deleveraging and the need to reduce the structural fiscal deficit will constrain the pace."

Chancellor George Osborne said: "The IMF couldn't be clearer today. Britain has to deal with its debts and the Government's fiscal policy is the appropriate one and an essential part of our road to recovery.

"I welcome the IMF's continuing support for the UK deficit reduction plan. They agree that, in their words 'reducing the high structural deficit remains essential' and make clear in their statement that they consider the current pace of fiscal consolidation to be appropriate."