Hold tight, Alistair – it’s going to be a bumpy ride

The risks of a downgrade in the UK’s credit rating are low, but a double-dip recession remains disti

Alistair Darling has delivered his last Budget before the election. The Chancellor had a little room to manoeuvre, given that claims for
unemployment benefits have not been as high as was feared and the take from the tax on bankers' bonuses has been higher than expected. Yet the broader economic backdrop to the Budget was not encouraging. Banks are still not lending. The Bank of England's Trends in Lending survey reported that net lending to UK businesses weakened in January.

Lending to businesses has fallen in recent months, including loans to small- and medium-sized enterprises. The 12-month growth rate has fallen to a new low since the monthly series began in 1999. The Bank of England also reported that lending to households grew by only 0.1 per cent on the month and 1.6 per cent on the year, both rates reaching their lowest level since records began in 1997.

Of the 500-odd manufacturers responding to the CBI's industrial trends survey in March, 22 per cent said export orders were above normal, but 40 per cent said they were below normal. Order books remain depressed, reflecting the continued weakness of domestic demand, and companies anticipate only a modest rise in production in the next three months. "Home-grown demand remains very weak," said Ian McCafferty, the CBI's chief economic adviser, "and as a result we can expect manufacturing output to grow only modestly for some time."

Safety margin

At first glance, the labour-market figures were encouraging, as both the International Labour Organisation estimate and the claimant count indicated a fall of about 33,000 in the number of unemployed. But on further examination, the news was not very good at all. The number of discouraged workers, who say they have withdrawn from the labour force but want a job and can't find one, now stands at a staggering 2.3 million. The number of part-timers who want a full-time job rose by 20,000 on the quarter and the total now stands at more than a million. Year on year, private-sector employment was down by 527,000. Employment was up 62,000 in the NHS and up 20,000 in education, but public spending cuts, which have hit universities this month, will lead to job losses. It's not looking that good on the jobs front.

There was much salivating in the media and among opposition politicians over the European Commission report which argued that "the absence of detailed departmental spending limits is a source of uncertainty" in the UK. What was barely reported was that other big EU countries were criticised, too - Germany because "the budgetary strategy is not sufficient to bring the debt ratio back on a downward path", and France because its deficit reduction strategy "does not leave any safety margin if economic developments turn out worse than projected in the programme". It is extremely hard to forecast the way out of a once-in-a-century global recession, when each country's recovery depends so closely on that of its close economic neighbours. As J K Galbraith joked, "the only function of economic forecasting is to make astrology look respectable".

I have argued for many months in this column that the fiscal stimulus must be kept up until there are signs that hiring and investing in the private sector is fully established. There is no sign that this is happening. I agree with my former colleague Kate Barker, a member of the Bank of England's Monetary Policy Committee, who in a recent interview said that there could be a quarter of negative growth this year. In my view, dealing with the real possibility of a double-dip recession is what we should be focusing on, rather than being held hostage by fearmongering from the same rating agencies that failed properly to evaluate all those structured investment vehicles.

The political consensus seems to be that there is a need for draconian public spending cuts. The debate is about who can cut faster. This, in my view, is wrong-headed and likely to push us back into recession or worse. If the economy does not pick up sharply over the next couple of quarters, it may be necessary by the autumn to implement a further substantial fiscal stimulus focused on private-sector job creation and investment, rather than cutting spending. This is partly because the initial stimulus was (in my view) too small rather than too big. It was certainly smaller than in many of our competitors, such as the US and Germany.

The consequences of a jobless or even a "job-­loss" recovery - as John Philpott, chief economist at the Chartered Institute of Personnel and Development, has called it - brought about by premature fiscal tightening are much more worrying to me than almost any potential consequences for the financial markets.

Tumble-back effect

Current market interest rates, which are at historically low levels, suggest that investors may already be pricing in a downgrade. For instance, the spread of ten-year gilt yields over bonds is broadly the same as the spread on Italian debt. This means that any potential downgrade, if it were to occur, would have minimal impact on the costs of borrowing, as it would not be a surprise to the markets. And while there may be worries about the creditworthiness of sterling, analysts at S&P currently rate Italy as A+, four notches below the UK's AAA status.

So the costs of more fiscal stimulus, including a possible downgrade in our credit rating, may well be less than George Osborne and David Cameron claim. They are potentially not trivial, but likely to be considerably less than the costs of rising unemployment caused by premature fiscal tightening. Colin Ellis of Daiwa Capital Markets has argued convincingly that if a downgrade is already priced in, the actual event could only have a small impact on the government's funding costs - and, if the alternative to a downgrade is faster spending cuts and tax rises, with the associated risk of a tumble back into recession and unemployment lurching higher, it may even be the best thing for the economy. Despite what some politicians claim, losing triple-A status would not be the end of the world, provided there was clear plan to fix the public finances over the longer term.

I agree. Avoiding a "tumble back into recession" and the further job losses it would bring should be the government's number-one priority. Let the markets be damned. Voters care about jobs. Good luck, Alistair, and bon voyage.

David Blanchflower is Bruce V Rauner Professor of Economics at Dartmouth College, New Hampshire, and the University of Stirling.