1. The emergency Budget of late-June saw the new Chancellor, George Osborne, initiate a significant acceleration in the pace of fiscal tightening. Our modelling suggests that the Budget measures will damage short-term growth prospects but, other things being equal, the UK should avoid a double dip. Lower government borrowing should feed through into lower long-term interest rates, providing support to households and companies, while the fact that the Chancellor has 'back loaded' a significant proportion of the spending cuts means that there should be time for the recovery to become firmly entrenched before the deepest cuts begin to hit.rn2. The new Chancellor inherited once of the largest levels of public borrowing in the developed world. Markets have given the UK considerable leeway so far, but this is partly because the incoming government created an expectation of much tighter policy. And though the stock of debt is average for a developed economy - and its maturity long - the UK is adding to it rapidly, risking a debt spiral. There are many arguments in favour of aggressive retrenchment, with empirical evidence linking high levels of borrowing and debt to economic underperformance.rn3. The literature is clear is that retrenchments based on cutting spending have a much better chance of succeeding than those focused on increasing taxation. Tax rises tend to blunt incentives, but spending-based adjustments can boost growth through the effects on interest rates, the exchange rate, unit labour costs and corporate profitability. The government has regularly cited the Canadian retrenchment of 1994-97 as a template to follow and this favoured spending cuts over tax rises by a ratio of 4:1.rn4. In constructing his budget package, Mr Osborne stuck closely to both the literature and the Canadian template. The focus on current spending, in particular reform of the welfare system and reductions in the public sector pay bill are consistent with previous successful retrenchments. The increase in VAT and the adoption of Labour's plans for cutting capital spending appear less than optimal, though it could be argued that the sheer scale of the deficit meant that these measures were unavoidable.rn5. The Office for Budget Responsibility estimates that the Budget measures will have a very modest impact on growth prospects. Our modelling suggests that, in the short-term, their assessment looks distinctly optimistic and our forecast now shows the UK economy growing by just 2.1% in 2011 - much weaker than we would usually see at this stage of a recovery but far removed from a double dip.rn6. However, there are a number of risks to the outlook. The government must first provide a credible plan for cutting departmental spending and then provide tangible evidence that it is achieving those cuts, if it is to keep markets onside. It will also be reliant on conditions outside its control remaining favourable, namely the Bank of England keeping monetary policy loose, the pound remaining weak and our most important trading partner, the Eurozone, weathering its own fiscal retrenchment.
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