How Should the Government Respond to the GDP Data?

The Office for National Statistics reckons that the UK economy shrank by 0.7 per cent in the second quarter of 2012. This is a preliminary estimate that is subject to revision, but if it is right, it suggests the economy has contracted by 0.3 per cent over the last two years since the Coalition came to power.
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The Office for National Statistics reckons that the UK economy shrank by 0.7 per cent in the second quarter of 2012. This is a preliminary estimate that is subject to revision, but if it is right, it suggests the economy has contracted by 0.3 per cent over the last two years since the Coalition came to power.

There were some special factors in the second quarter that affected output: the extra Jubilee bank holiday and the atrocious weather. But it is unlikely they fully explain the fall in output. The underlying economy is performing far worse than the Coalition - and most economic forecasters - expected.

This is not all the result of government policies. Higher oil and food prices and developments in the euro zone have played a part in holding back growth in the UK. But the IMF, in its latest report on the UK economy published just last week, estimated that fiscal consolidation over the last two years has subtracted roughly 2.5 per cent from growth. If we reckon that the economy might have grown at its very long-run average rate of 2.4 per cent a year over this period (a conservative estimate given that growth is normally faster after a recession), then around half of the growth shortfall is due to government policies.

The coalition hoped that its deficit reduction strategy would boost the economy by creating greater confidence about the future, so leading to a surge in private sector business activity. This strategy has clearly failed. Business confidence has declined.

There is no shortage of alternatives being put forward for the Chancellor to choose from. A recently-published IPPR paper set out details of the policies that we think should now be pursued:

  • A two-year, 2p cut in the rate of employees National Insurance contributions.
  • Additional infrastructure spending amounting to £30 billion over the next two years.
  • A further increase in the scale of quantitative easing.
  • Measures to make household debt restructuring easier.
  • A job guarantee scheme for every person who has been out of work for 12 months.
  • An active industrial strategy.

This will mean higher government borrowing in the short-term, but this can be done without jeopardising fiscal credibility. As the IMF says: 'The UK has the fiscal space to make such adjustments.'

The Chancellor, though, clearly thinks otherwise. But there is one thing he could do that would not add a single pound to the government's borrowing requirement. He should publish his contingency plans for a serious worsening of the euro zone crisis. In May, he was reported as saying the British Government is doing 'contingency planning for all possible outcomes" to the euro zone crisis. Now is the time to reveal the results of that planning.

Business confidence is low because of uncertainty about the economic outlook created, in part, by fears that a renewed credit crunch in Europe will extend the UK recession into 2013. If the Government has contingency plans to deal with such a situation, it should not keep them to itself; it should tell businesses exactly what they are.

By setting out credible plans for dealing with a deepening crisis in the eurozone, the Government would alleviate some of the worries that are holding back growth. In particular, if businesses, after seeing the Government's plans, are less concerned about the outlook for the economy, they will be more inclined to invest and take on additional workers.

For George Osborne, here is something he could do that would potentially boost the economy while sticking to his Plan A deficit reduction strategy.