Next year will be distinctly painful

By Allister Heath, December 29, 2009

Let us start with the good news: it is almost inconceivable that the British economy won’t fare better in 2010 than it did in 2009.

We have just come out of the most severe recession since the 1930s, with our economy shrinking drastically; I would hate to tempt fate but there is little that could be thrown at us in the coming year that would precipitate another such dramatic contraction. Growth is likely to make a return; in fact, the economy almost certainly started expanding again in the last few months of 2009.

But apart from that, the outlook is pretty grim. The economy is facing a huge number of challenges. The banking system is working again (contrary to what most commentators are claiming) but economic growth will be weak — not only in the year ahead but for a long time to come. In the good years, we grew used to the economy expanding by close to 3 per cent every year; we will be lucky to get half that over the next 3-4 years. Unemployment will remain high; incomes growth will be subdued; taxes will go up; many firms will move out of the UK, as will many highly paid individuals; and the public sector will face its greatest squeeze since the end of the Second World War.

We have attempted to borrow ourselves out of a crisis caused by too much debt. One result of this has been the explosion in the budget deficit to around £180bn for the next couple of years, an extraordinarily imprudent state of affairs. Whoever wins the next election will have to slash public spending; if this doesn’t happen, or if we end up with a hung Parliament, we will face a real government debt crisis, with dire consequences for everybody in the UK.

Britain’s budget deficit has only been bearable to date thanks to quantitative easing, which has seen the Bank of England spend a fortune buying up all of the new gilts printed by the government to pay for its spending. At some point this year, the Bank will start to cut back on its purchases and the exchequer will have to convince private investors to start buying its debt. This will be tough; it will require higher interest rates on UK gilts, which in turn will mean a higher cost of borrowing across the economy.

Given how weak the private sector still is, and the fact that so many households have yet to pay down their mortgages and credit card bills, higher interest rates will prove painful. But they will become unavoidable for another reason: inflation is making a return and will soon require firm action. Quantitative easing has led to a collapse in sterling, driving up consumer prices.

At least higher interest rates will start encouraging people to put more money aside and cease penalising savers. But shoppers will have to cut back further and the housing market will also suffer. One of the great false dawns of 2009 was the housing market: the great property crash is not over yet. The six to seven per cent bounce back in prices in recent months lacked all justification; prices could easily fall by another tenth or so next year. This is one of the greatest risks facing the UK: banks could be hit by another wave of write-offs, causing real damage.

The coming year won’t be as tough as 2009 — but only just. Anybody hoping for an easy ride is going to be in for a rude awakening.

Allister Heath is editor of City A.M.

Last updated: 12:34pm, December 29 2009