George Osborne and the band-aid effect

March 22, 2011

BRITAIN-BUDGET/The second budget presented to Parliament by Chancellor George Osborne is likely to be less talking and more doing when it comes to bringing the UK’s public finances under control.

This won’t be to everyone’s tastes. Some argue that the UK is in less financial danger than Europe’s financially troubled states, yet Osborne is embracing deficit reduction plans with as much gusto as Ireland or Greece.

Osborne has indeed been faithful to the ‘band-aid effect’ when it comes to remedying the UK’s bloated balance sheet. There is to be no picking at the corners for him, he is getting ready to rip that plaster off with all of the short-term excruciating pain that goes with it.

The Chancellor’s fiscal targets are ambitious. He wants to virtually eliminate the budget deficit by 2014-2015 and to halve government borrowing over the same time period. Seventy-seven percent of this will be achieved through public spending cuts, with the rest of the 23 percent coming from tax increases.

In the clip above, Kathleen Brooks says this will be “a budget of no surprises.”

The band-aid method is necessary to continue to placate financial markets and protect the UK’s triple-A sovereign credit rating. Since Osborne’s emergency budget in June 2010, the cost to insure UK government debt for five years has fallen from more than 90 basis points to 56. The vast majority of this fall is down to Osborne’s tough talk regarding fiscal consolidation. If he stops now, so the logic goes, the markets will punish the UK and finance costs will increase, making the country’s financial position even worse.

But with growth expected to moderate this year compared with earlier forecasts (the Office for Budget Responsibility is expected to cut its growth forecast from 2 percent to 1.8 percent) how can Osborne achieve growth alongside his fiscal targets?

In the next clip, Kathleen Brooks talks about the impact of the budget on average people.

In steps the Monetary Policy Committee. MPC governor Mervyn King said that the Bank would “smooth the adjustment process” in a speech late last year as the UK rebalances from a consumption led to export-driven economy. The MPC will also need to plug the same growth gaps when it comes to fiscal consolidation. So as spending cuts bite and threaten growth the MPC needs to stand ready with a tonic to ensure the economy is protected from the worst of the fiscal pain.

What does this means for the markets? At the moment it is a little unclear since the bulk of the spending cuts and the planned rise in national insurance contributions for both employees and employers won’t take effect until the start of this fiscal year in April. The Gilt market will buy Gilts if Osborne sticks to his austerity Britain plan. But if Osborne doesn’t pull off the planned fiscal adjustment combined with economic growth then the MPC will have to artificially stimulate the UK economy by keeping rates low or even embarking on another round of quantitative easing. This would act as a drag on the pound and could stymie further gains in the currency.

For now Osborne’s budget needs to deliver, but if he wants to front-load the bulk of the pain the MPC needs to be ready to act as a crutch to the economy for some time yet.

In this final clip, Kathleen Brooks discusses inflation, cuts and the UK budget.

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