UK budget 2010: New era of austerity in Europe?

UK budget 2010: Britain today unveiled budget cuts to raise £40 billion in state revenues through tax increases, welfare cuts, and salary freezes. But history suggests that raising taxes during a recession can cause a double-dip.

Britain unveiled its emergency budget today, becoming the latest standard-bearer for a grim reality that is uniting nations across the Continent as deep budget cuts herald a new era of austerity.

Chancellor of the Exchequer George Osborne, who oversees Britain's treasury, described the £40 billion plan aimed at reducing the United Kingdom's record peacetime budget deficit as "tough" but "fair." While vowing to protect the poorest of Britons, the chancellor announced an array of measures that will still pinch pockets: a two-year freeze on public sector pay for those earning more than £21,000; a 2.5-percent rise in the VAT, to 20 percent; and a three-year freeze on child benefits. Higher-income earners will find their capital gains tax rising from 18 percent to 28 percent, and the threshold for higher-rate income tax will be frozen until 2013.

"Today we take decisive action to deal with the debts we inherited and confront the greatest economic risk facing our country," Chancellor Osborne said today (full text of speech).

Britain's budget cuts exemplify a Europewide return of fiscal conservatism less than two years after Keynesian intervention (in the form of stimulus programs) was the emergency tonic for the 2008 financial crisis. From Spain to Hungary, millions of government workers are being fired or told to postpone retirement. Projects are being junked in a bid to tame soaring deficits and win approval from investors.

"There is only so much borrowing that governments can do before the markets will say: 'no more, we can lend you no more money,' " says Richard Wellings, an economist at the Institute of Economic Affairs, a right-of-center British think tank that wants deep cuts.

Dr. Wellings argues that European governments have no choice but to trim spending, since fears of sovereign defaults already have investors backing away from government debt.

Osborne's cuts hold risks

Britain's deficit is a legacy of a spending boom that delivered new schools, hospitals, and roads before ending in 2008. It stands at more than 11 percent of gross domestic product (GDP).

But critics claim that Osborne risks choking off Britain's fragile economic recovery by cutting too much too fast. Others fret about export-led growth potential if Britain and other European states all reduce spending simultaneously.

Even Europe's economic powerhouse, Germany, has unveiled a fiscal austerity program designed to save nearly $100 billion by 2014 and more than halve this year's projected deficit of 5 percent of GDP.

Fears about deficit crises elsewhere in Europe have whipped up a German "austerity frenzy," says Irwin Collier, professor of economics at the Free University in Berlin. Germany, he says, is uniquely placed to make other European states' problems "a lot easier" by spending more rather than cutting back. "When they all start contracting at the same time, they are all going to find themselves back in the same place, but a lot poorer."

So why wield the ax? The answer, at least from Britain's government, is that it has worked before.

Canada and Sweden in the 1990s are held up as models of developed countries who successfully tackled deficits.

Between 1993 and 2000, the former slashed spending as share of GDP by 12 percentage points, while the latter cut spending by 14 percentage points. Canada cut thousands of education and health-care jobs, but the reward, like that for Sweden, was vigorous economic growth driven by a rejuvenated private sector.

The Canadian model

Britain is set to follow the Canadian model, which featured a "bloodbath budget" in 1995 when departmental spending was reduced by an average of 20 percent. Only Britain's health-care and international development spending will be spared. The government has promised to evenly distribute the burden.

"Overall, everyone will pay something, but the people at the bottom of the income scale will pay proportionally less than the people at the top. It is a progressive budget," Osborne said today.

"People will be with you on the great national target of protecting the next generation from these increasing deficits if they believe that they are going to succeed," Paul Martin, Canada's former prime minister and finance minister, said on the BBC recently. "Public opinion was pretty much with us all the way because we spent a year essentially preparing Canadians. We made it clear that cutting the deficit was important ... in terms of the things that counted in their daily lives."

A balancing act

But those arguing against the Canadian model point out that it was rolled out at a time of major growth in the United States, which generated demand for Canadian goods. By contrast, Britain's biggest market, the eurozone, is limping along.

Canada also had room to cut interest rates. Britain's monetary policy cannot be loosened up much more, add critics. They also say Canada's course widened income gaps. "It's important to consider the outcome of what they did in terms of health and child poverty, for example," says Kitty Ussher, a former Labour Party minister and now an economist for the left-of-center think tank Demos. "There is nothing that says recoveries have to be skewed in favor of spending cuts, rather than a mix of cuts and progressive tax rises," she says. "If [the government] wants to pursue only spending cuts ... that is the best way of getting a double-dip recession, along with negative social outcomes."

Proponents of the Canadian model point out that private-sector investment played a more significant role in Canada's recovery than trade. But some fear that Britain may be tempted to increase taxes.

That would risk replaying two disastrous experiences – those of the US in 1937 and Japan in 1997 – both of which relied on tax revenue to cut deficits. "In both cases it led to recession, and outright depression in Japan's case," says former Bank of England economist Danny Gabay, a director of Fathom Consulting. "If you block every hole it's difficult to see how we can breathe. If you are going to cut off government spending and whack the household sector through VAT [value-added tax] rises at a time when the European market is slowing down, then it is difficult to see how you can sustain growth. It's a very fine balancing act."

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