Britain's gamble might pay off

Britain's gamble has just started with 81 billion pounds of public spending cuts which cost half a million jobs in public sector. The Chancellor of the Exchequer George Osborne revealed the plan yesterday.

Britain will cut half a million jobs, lift the retirement age and slash welfare as part of an unprecedented cost-cutting drive announced on Wednesday which will test the strength of the economy and the government.

The long-awaited spending review confirmed 80 billion pounds of cuts, sent unions into a fury and turned up the heat on the Liberal Democrats, the junior coalition partners who campaigned against such sharp fiscal tightening before the May election.

The jury remains out on whether the economy -- just recovering from the worst recession since World War Two -- can survive the squeeze which will cut growth by around half a percent each year. Analysts expect the Bank of England to keep monetary policy super-loose for the foreseeable future.

Nor is it clear whether the cuts -- aimed at bringing down a record budget deficit of 11 percent of GDP -- can actually be achieved. More of the burden has been shifted to the notoriously hard-to-cut welfare bill -- an extra 7 billion pounds on top of the 11 billion pounds cuts already announced.

Conservative finance minister George Osborne said that was the best way and would mean that government departments outside protected areas like health and international aid would only see their budgets shrink by, on average, 19 percent, not the 25 percent announced in his budget.

Britain's budget deficit in 2009 is, according to IMF, 10.3% of GDP, one of the highest among developed nations. George Osborne is right to say, "Today is the day when Britain steps back from the brink, when we confront the bills of a decade of debt", given the huge budget deficit which is less than Ireland, Greece, and Spain but more than Portuguese and Italy. But the question may arise: Can Britain survive a massive fiscal cut?

The analogy can be found with Japan's experience in the late 1990's, when the country slashed public spending and raised consumption tax rates toward fiscal consolidation, ignoring simmering concern that fiscal contraction might sap vigor out of the economy.

Fiscal contraction starting in the late 1997 in Japan gave rise to huge deflationary pressure, which dragged the country into severe recession. It took more than 10 years for inflation rates to turn to positive in terms of the yoy growth rate of GDP deflator. The biggest difference between Japan and Britain is that Japan's GDP deflator grew only by 1.2% yoy when fiscal reform began, while Britain's has just grown by 4% yoy in the second quarter of this year. That's only the third time for Britain's GDP deflator to increase by 4% yoy in 18 years. Given a large buffer against deflation, Britain could keep away from deflation. Britain's gamble might pay off.