Forex Blog

On Wednesday, the Office for National Statistics (ONS) revealed that the UK economy contracted by 0.2 percent for the final quarter of 2011. Economists had predicted a slight increase of 0.1 percent for the last three months of the year.

Despite the feeble ending to the year, the latest ONS data shows overall growth for 2011 was a mediocre, but still positive, 0.9 percent. Still, this level of expansion is well below the Bank of England’s 2 percent growth target and there is a real concern that the economy will continue to shrink during the first half of 2012.

This could hardly come at a worse time for the British government. Like many of its G8 counterparts, the UK is faced with the dilemma of promoting growth, while at the same time, keeping a lid on spending. In fact, government spending was a central theme in the 2010 election and resulted in a coalition government led by Conservative Prime Minister David Cameron together with the Liberal Democrats.

The new government came to power on a promise to address the country’s out-of-control spending which few would argue was not already well beyond a crisis point. And that is actually saying something as Great Britain has a long history of deficits.
In fairness, some of this debt was accumulated as part of the effort to fight two major wars, but even in peace time, Britain typically spends more than it earns.

During the 1970s and 1980s, high levels of inflation forced the government to rely on borrowing to maintain spending programs. In the span of those two decades alone, total debt rose from £33.1 billion ($51.6 billion) in 1970 to £197.4 billion ($308.0 billion) by 1988.

Since then, Britain has actually increased its reliance on deficit financing. By 1997 total public debt was £352 billion ($549 billion), but by the end of 2009, debt had once again more than doubled and has now broken through the £1 trillion ($1.6 trillion) barrier.

Britain’s 2011 deficit is expected to be in the range of £150 billion ($234 billion), making it only marginally better than the previous year’s deficit of £170 billion ($234 billion) despite a full year of government spending cuts. The country’s debt to GDP ratio is still nearly 80 percent and with weaker growth expected in the coming year, this statistic could worsen.

Both the Bank of England and the International Monetary Fund (IMF) recently downgraded earlier growth projections for 2012. The IMF slashed its prediction by a full percentage point and now expects the British economy to expand by only 0.6 percent this year.

Eurozone Crisis and Austerity Measures

With its close proximity and trade ties with Europe, Britain is heavily exposed to the uncertainty arising from the Eurozone debt crisis. In late November, the Organization for Economic Development and Cooperation (OECD) released a stark statement warning that the UK will almost certainly face another recession in the first half of 2012 because of the turmoil in the Eurozone. Britain has already recorded one quarter of negative growth – should the first quarter of 2012 also be negative, the OECD’s prophecy will come true.

While there is little the government can do with respect to solving the Eurozone issue, it will be interesting to see if the government moderates its drive to eliminate the deficit in deference to the slowing economy. Reducing the deficit is necessary, but it is impossible to dramatically slash spending without impacting growth. With growth already on the decline, it may be advisable for the government to moderate its spending reduction plans at least until the economy gathers strength.