If you listen to the new government and likes of ECB, you might be forgiven for thinking the great challenge of the economy is cutting spending and reducing the deficit. If this is the measure of economic progress, the likes of Ireland, Latvia and Estonia have done very well. But, though Ireland has cut spending drastically, it has caused a recession of - 7%. That's a pretty bad double dip recession.
You might think cutting government spending would make bond markets very happy. But, that's not necessarily the case, Ireland has implemented austerity, but, still faces bond yields 2% higher than Germany. Bond markets may not like high debt, but, nor do they like the prospect of recession, and deflation.
What Are UK's Prospects for a Double Dip Recession?
The UK has benefitted from a fall in the value of the Pound (almost 20% since 24 months). We are also benefiting from near zero interest rates and the impact of quantitative easing. Rather unexpectedly, the housing market bounced; the rise in house prices may have been on thin trading volumes but, it has helped avoid a growth in negative equity. Finally, an inflation rate of 3.7% hardly indicates enormous spare capacity and impending deflation.
Given the above factors, the economy could probably have absorbed a gradual and realistic reduction in the deficit. The problem for the UK comes that our main trading partners are also fearing a downturn as a wave of austerity sweeps the major G20 nations. The government have been so effective in speaking about the ills of the economy and the necessity of drastic cuts, that consumer and business confidence is falling (fears over second recession - Guardian). Suddenly things look less promising. I find it very hard to take seriously the idea that cutting wages, spending and jobs are 'confidence inducing - as Jean-Claude Trichet of the ECB claims they are.
“The idea that austerity measures could trigger stagnation is incorrect,... confidence-inspiring policies will foster and not hamper economic recovery.” - J.C. TrichetSpending cuts, job losses and wage freezes will do the opposite. Hence the unwelcome combination of lower government spending and lower consumer spending as savers continue to save.
Often countries have reduced budget deficits without causing recession. But, usually this has been done in isolation - fiscal consolidation offset by lower interest rates, lower exchange rate and growth abroad.
The UK is unlikely to be able rely on an export boom to Euroland. The weakness of the pound is starting to change. Markets see that the UK economy is perhaps a better prospect than the Eurozone. In recent weeks the pound has been strengthening, we can't rely on future devaluations in exchange rate - with every economy weak, who would we devalue against?
With the ECB showing little signs of targeting strong economic recovery, the UK may be pulled down too.
I certainly hope a double dip recession will be avoided, but, it seems the main plank of economic policy is cutting government spending - hardly confidence inducing.