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7 May: Political paralysis will slow austerity

Schroders’ economists Keith Wade, Azad Zangana and Craig Botham examine the implications of political paralysis post the UK general election on 7 May 2015

Political risk is back in the UK. Having just recently avoided a breakup of the political and economic union, the UK is preparing to hold a general election as the fixed five-year parliamentary term comes to an end. The election on the 7 May is set to be one of the most unpredictable in history as smaller parties take a greater share of votes. A range of outcomes are possible, but no clear favourite for investors. What is certain is that the result will not be clear cut, and may delay the UK’s austerity plans.

Without a functioning effective government, not only does passing new laws become a problem, but also passing the all-important finance bill – the legal change needed to put the Budget into effect. Passing the bill is normally a formality for a government, but in a weaker government, this may become problematic.

Further austerity a certainty

All three of the main parties agree on one thing, that further austerity is required after the general election. However, they disagree on the scale, timing and mix of policy in terms of spending cuts and tax increases. Given the parties are looking to win votes at the moment, it comes as no surprise that they are not outlining exactly how they will achieve the difficult reduction in the budget deficit – which currently stands at around 5% of GDP.

The Conservatives have pledged to eradicate the entire deficit by 2018/19, largely through departmental spending cuts, welfare spending reductions, and of course, the policy that keeps on giving: cracking down on tax evasion. Meanwhile, Labour wants to focus more on increasing taxes on wealthy individuals, but will also have to make some spending cuts, albeit less so than the Conservatives. They have not outlined the timing of cuts, but aim to balance only the current spending budget (excluding public investment). This harks back to old ‘golden rule’ which was used by former Prime Minister and Chancellor Gordon Brown of not borrowing other than to invest over an economic cycle. Of course, it did not stop Labour spending excessively during periods of strong economic growth. We estimate that the Conservative plan would mean about 5% of GDP worth of fiscal tightening, while Labour’s policy would result in about 3.5% of GDP worth of tightening. The Lib Dems would go even slower, and also only target the current budget (about 2.7% of GDP).

The differences between the main two parties risk causing paralysis. Whichever party ends up governing, if it does not compromise on the mix of spending cuts versus tax increases, then it risks failing to pass the finance bill, and therefore quickly triggering another election.

Macroeconomic implications

The macroeconomic implications are mixed. In the near-term, uncertainty is likely to lead to a pause in business investment, which may also cause a slowing in employment. Energy providers are concerned about a Labour government as they have pledged to cut home energy bills, while banks are also not looking forward to seeing the annual levy being increased further to fund public spending. Railway companies are concerned too after Labour muted re-nationalising the railways through state-sponsored corporations bidding for contracts when up for renewal.

Meanwhile, a variety of companies that trade with Europe are concerned about the prospects of a referendum on EU membership should the Conservatives win the election. Although Prime Minister David Cameron has said he will campaign to remain in the union if a deal over the UK’s relationship can be struck, there is still a concern that much to the UK’s ills will be blamed on its membership (such as EU migration being blamed for a lack of access to public services – which are being cut). The uncertainty is almost certainly already hitting foreign direct investment, where overseas investors in particular want to have access to the entire European market, not just the UK.

If the UK ends up with a coalition or minority government, then it becomes more likely that austerity becomes harder to implement. This could boost near-term economic growth compared to a scenario where tougher austerity measures are implemented. However over the medium-term, it will slow the reduction in the budget deficit thus leaving the UK vulnerable when global liquidity begins to tighten.

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