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Autumn leaves falling The growing troubles in the euro zone mean Britain is set for another recession PREPARE for some bad news. The prime minister, David Cameron, told an audience of business leaders on November 21st that shrinking the budget deficit was “proving harder than anyone envisaged.” His comments laid the ground for the chancellor, George Osborne, who makes his autumn statement on the economy and public finances on November 29th. The chancellor’s message is likely to be grim: a downgrade to official growth forecasts for next year and beyond seems certain. The coalition government’s hopes of eliminating the “structural” part of the deficit (the bit that cannot be blamed on temporary slack in the economy) and of capping public debt by the end of the current parliament are in serious doubt. Bond markets are likely to be forgiving, given the scale of troubles elsewhere. But a failure to hit its fiscal targets would harm the coalition government’s credibility. And there is a more pressing worry. Britain’s strong links with the wretched euro zone mean that its economy is being dragged into continent-wide recession (see article). Some Conservative politicians seem to believe that Britain stands apart from the euro disaster because it has its own currency. In fact, the economy is increasingly dependent on exports, two-fifths of which are shipped to the euro zone. There is little spending power at home: consumers are still carrying a lot of debt while struggling with weak wage growth and high inflation; public spending is shrinking; and business investment has been sluggish. Worse still, Britain’s banks have lent heavily to the euro area’s biggest trouble spots. Loans extended by British banks to Ireland, Spain, Italy, Portugal and Greece stood at $350 billion (£220 billion) at the end of June, equivalent to 15% of GDP. Most of this was direct lending to businesses and banks but about 10% was to governments. They are indirectly exposed, too: a further $210 billion of banks’ assets in June were loans to French and German banks, who are in turn lenders to Italy and Spain. Growing anxiety about public finances in Europe has sapped confidence in banks which are big holders of government bonds. And the rush by European banks to sell bonds of the least creditworthy sovereigns has made things worse. European banks are finding it harder to refinance their own debts at reasonable interest rates, and funding costs are rising for British banks too. That will eventually feed through to higher interest rates on loans to companies and consumers. Banks nervous about euro-zone assets turning sour and keen to preserve scarce capital will be cautious about making new loans, which will only add to the recessionary forces. Businesses will soon be caught up in this spiral of ever-diminishing confidence. Firms know that credit lines cannot be relied upon when banks and financial markets shun all but the safest investments. There are already reports that firms are postponing purchases and trimming their stocks of supplies to conserve cash. Cuts to discretionary spending, such as capital projects or advertising, will become more common as the euro crisis intensifies and uncertainty and anxiety increase. How far might the economy fall? The central case of the Bank of England’s monetary-policy committee is that output will be broadly flat in the current quarter and in the first half of 2012, though it thinks a worse outcome is more likely than a better one. Its forecast excludes the possibility of a big euro-zone blow-up, not because this is improbable but because there is “no meaningful way” to calculate its impact. Fear that the euro zone will disintegrate will itself weigh on the economy. Absent a complete meltdown, the second dip of a “double-dip” recession ought to be smaller than the first, because there are fewer excesses to correct. Britain’s current-account deficit is closer to balance. The household savings rate is a healthy 7.2%, which means consumers have a bigger cushion between their income and spending than they did when recession first struck in 2008. There is less capital spending to cut back on: companies are already sitting on piles of cash. And the flow of capital seeking a haven from the euro crisis will sustain demand for British government bonds, for fancy houses, and for other assets deemed to be safer than euro-zone banks or bonds. Real household income is likely to rise modestly in 2012 after falling sharply this year because of high inflation and tax increases, notes Kevin Daly of Goldman Sachs. Yet the likely recession will strain public finances. Figures for the first seven months of the financial year suggest that the government is roughly on track to meet its borrowing target of £122 billion (around 8% of GDP) for 2011-12. Yet the number of people claiming unemployment benefit has risen each month since March (see chart). Many economists believe the Office for Budget Responsibility, the independent fiscal watchdog, will take a dimmer view of the economy’s medium-term prospects. That would imply less of the budget deficit will be eroded as the economy expands to its full potential, and that more of it is therefore structural. This leaves Mr Osborne in an uncomfortable position as he prepares his autumn statement. He has made it clear that he does not regard it as a “fiscal event” where spending and tax changes are announced; that will be saved for the budget in March. But it is a political set-piece all the same. So the chancellor will try to knit together a variety of small, fairly cheap policy strands, such as measures to help small businesses with credit, into a coherent growth strategy. Given the unfolding catastrophe on Britain’s doorstep, it is likely to look threadbare.