Acting too soon on UK debt could kill recovery

LONDON (Reuters) - Markets are looking to the next government for tough action on the public finances, but pruning the record debt too sharply could strangle the green shoots of recovery, analysts say.

The choice before the electorate will be between the Conservatives who want to knock the public finances into shape quickly and Labour's stimulus-friendly, eight-year path back to balance.

But with even Labour planning a degree of fiscal tightening in 2010 and removing stimulus measures, there is a danger the recovery could be snuffed out before it gets going.

"The debt is a fact of life. It's there now. It's best to deal with it as slowly as possible within the constraint of pleasing the markets," said Professor Campbell Leith, a macroeconomics academic at the University of Glasgow.

"Our work suggests that it is optimal to only adjust the debt to GDP ratio very slowly ... as slowly as the markets can bear. The Conservatives are proposing to drag it down more quickly than Labour plans and that would be quite costly."

The Treasury forecasts growth of just over 1 percent next year after a drop in output of around 3.5 percent this year. It thinks growth could be shooting upwards at a rate of more than 3.5 percent in 2011 and beyond.

But the Bank of England is open to the idea that the economy could still be shrinking next year. Many economists regard that scenario as likely.

If recovery doesn't come next year, any proposals to speed up fiscal consolidation may be flirting with disaster.

"One doesn't normally raise taxes in a recession and to raise them substantially, to reduce borrowing, could be catastrophic," said Malcolm Prowle, Professor of Business Performance at the Nottingham Business School.

"Similarly, huge cuts in public spending will create large scale redundancies with the same effect."

Both political parties will be wary of adding to the ranks of the jobless -- unemployment is already expected to hit 3 million this year, a rate of about 10 percent.

APPEASE THE MARKETS

The trouble is that markets, rattled by a warning from ratings agency Standard & Poor's that it may downgrade Britain because of its rising debt burden and the credibility of plans to tackle it, are starting to demand tough action.

"Once you deliver the bad news, you don't have time to be philosophical about it," said Dermot Hodson, a political economist at Birkbeck College, University of London.

"The idea that you can appease the markets once the markets demand a correction in fiscal policy -- and contribute to economic recovery in the short term -- is pretty doubtful."

Like many of the world's major economies, recession and banking support is hammering Britain's public purse. Government borrowing is forecast at a record 175 billion pounds this year.

Chancellor Alistair Darling expects the government debt to gross domestic product ratio to rise to more than 90 percent under Maastricht treaty definitions by 2013/14.

In 2007/8, the ratio was 43.2 percent and it is officially estimated to be 55.2 percent in 2008/09.

Darling doesn't expect the books to balance for nearly a decade -- and that will need consolidation of 0.8 percent of GDP each year after 2013/14.

Consolidation of up to 1.5 percent of GDP per year is pencilled in for the years up to 2014. That begins with a 0.2 percent consolidation next year.

"Whichever government is in power needs to implement a fiscal tightening of the size set out in the budget -- unless things turn out to be a lot better than what the Budget thought," said Gemma Tetlow at the Institute for Fiscal Studies.

That doesn't look likely right now. The risk is that more fiscal consolidation could be required -- not less.

"An option for a new Conservative government would be to accelerate the fiscal tightening and get more of the pain out of the way in the first parliament -- they've talked a lot more about their willingness to squeeze on spending," Tetlow said.

"The further ahead you announce consolidation, the less credible it becomes."

BIG ON RHETORIC

Coy for now, both parties will have to give more of an idea of where spending cuts will come in the run up to the election to boost confidence in fiscal policy.

Labour has said what taxes will rise and outlined the extent of spending cuts, but details are somewhat vague beyond efficiency cuts.

The Conservatives have been big on rhetoric, proposing a "government of thrift," and say they will look at public sector pay, advisory bodies and a proposed ID card scheme to make cuts -- but again details are scarce.

While it is easy to woo investors with the lure of austerity policies from opposition, executing such policies in power could prove politically difficult.

Some economic models show cutting the debt burden too quickly could hurt households 10 times as much as taking much slower action, Glasgow's Leith said.

When push comes to shove, the Conservatives may not be as eager to slash back debt as they may now seem.

"I don't think they are necessarily promising a strategy that is so different," said Birkbeck's Hodson.

And that is exactly what markets don't want.

"It sends a signal that both parties' plans might not be credible," he said.

(Editing by Steve Addison)