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Austerity Has Diminished Britain—and Cameron, Too

Prime Minister David Cameron in London

Photograph by Andrew Winning/WPA Pool/Getty Images

Prime Minister David Cameron in London

Austerity will be the rude gate-crasher in Lough Erne, Northern Ireland, when British Prime Minister David Cameron hosts the leaders of the Group of Eight nations at a June 17-18 summit meeting. The austerity formula—cut spending, and growth will follow—by and large isn’t working. The big economies of continental Europe are shrinking or barely growing. Britain’s economy has expanded less than 1 percent over the past year. In the U.S., the chill of sequestration spending cuts is expected to reduce annual growth to 1.6 percent in the current quarter.

Cameron’s agenda for the Lough Erne summit isn’t austerity but trade, tax compliance, and transparency. He doesn’t appear to want a freewheeling discussion among world leaders about the downsides of austerity, a policy with which his political career is inextricably linked. In a paean to the late Prime Minister Margaret Thatcher in April, he said she rejected defeatism and “made the political weather.” That’s Cameron’s ambition as well—to set the agenda, not have it set for him.

But as the host nation for the G-8 in 2013, Britain stands out as an experiment in austerity that’s gone awry—a fact that will be hard for the summiteers to ignore. With two years left in Cameron’s five-year term, worker pay is growing more slowly than consumer prices and the unemployment rate is 7.8 percent, scarcely off its 2011 peak. British debt has lost its AAA rating from Fitch Ratings and Moody’s (MCO).

The latest Guardian/ICM poll has Cameron’s Tories running seven percentage points behind the Labour Party. Even with some recent positive data, IHS Global Insight forecasts growth of just 1 percent this year. This is not how things were supposed to go for the confident, 46-year-old Cameron, who enjoys knocking off early and relaxing with his family upstairs at No. 10 Downing Street.

Cameron’s big idea when he campaigned in 2009 and 2010 was to reassure global bond investors with promises of big cuts in spending that spared only the National Health Service and foreign aid, while raising the value-added tax on sales. Smaller deficits would lower interest rates, allowing businesses to borrow, invest, and hire. Interest rates fell, as promised, but growth never picked up because consumers remained overindebted, the banking sector was undercapitalized and in no shape to lend, and businesses didn’t see enough demand to justify expansion. The European debt crisis, which suppressed British exports, was a factor. But so was the dampening effect of decreased government spending. Cameron envisioned a Big Society—his equivalent of compassionate conservatism—in which private charity would fill the hole left by government. That hasn’t happened, either. As Spain and Greece have discovered, economic weakness cuts into tax receipts. So the budget deficit was still over 7 percent of gross domestic product in the year through March even though inflation-adjusted discretionary spending was down nearly 12 percent, according to the Institute for Fiscal Studies.

“The spending cuts have been too front-loaded,” says Angus Armstrong, director of macroeconomic research at the independent National Institute of Economic & Social Research. He says Cameron should have recapitalized the banks first, enabling more lending. “It’s much easier to do bank reform when your economy is growing,” he says.

Doubts about Cameron’s course are creeping into the City of London, the financial district that powers the economy. Malcolm Barr, the chief U.K. economist for JPMorgan Chase (JPM), says the singleminded focus on deficit reduction “always looked to me a little bit risky if growth didn’t pick up.” He says the biggest worry in the markets is no longer Britain overspending but growth staying weak. “I think they’ve been too slavish” in pursuing austerity, Barr says.

To be fair, there’s no miracle cure for what ails Britain. Some retrenchment was essential after the deficit surpassed 11 percent of GDP in 2010, a post-World War II high. The Conservatives argue that if Cameron goes wobbly in the knees now and eases up on austerity, the bond market might react badly, driving interest rates back up and worsening Britain’s predicament. The U.S., with the world’s biggest economy and a reserve currency, can get away with running big deficits without triggering capital flight, but not Britain, says Brooks Newmark, a Conservative member of Parliament.

Groping for ways to soften the blow of austerity without alarming investors, Cameron has cut corporate taxes, subsidized homebuying, and boosted infrastructure spending. All three moves are problematic. Lower taxes on corporate income won’t induce investment if businesses don’t see demand. A Help to Buy program to insure lenders against losses on low-down-payment mortgages could fuel loan supply and push up already-high home prices while exposing taxpayers to possible losses. And Cameron’s new spending on roads is too small to boost the economy, says JPMorgan’s Barr. In May even the International Monetary Fund urged Britain to step up public investment.

Newmark, who sits on the parliamentary committee that oversees the Treasury, says the government’s accomplishments are impressive if not yet complete, with budget deficits cut by a third so far and more than 1 million jobs added in the private sector. He’s optimistic that the economy’s growth rate will return to around 2 percent by the May 2015 elections, which he thinks will be enough to get Cameron reelected.

Like Thatcher, for whom he worked as a twentysomething researcher out of Oxford, Cameron is all about staying the course. “We are making progress, but we have to stick to the plan,” he told the House of Commons in early June. If growth doesn’t pick up soon, he may find that the political weather forecast is rain, rain, rain.

The bottom line: Cameron’s policy of austerity has caused pain without yet delivering growth, but he vows to stay the course.

Coy is Bloomberg Businessweek's economics editor. His Twitter handle is @petercoy.

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