LONDON (Reuters) - Britain's wall of cash built with new offers of cheap funding to banks will limit the threats from the raging euro zone crisis, economists said On Friday, although the economy may need more action to engineer a proper recovery.
The Bank of England and government coordinated scheme announced on Thursday to get credit flowing through the recession-hit economy by lowering banks' funding costs cheered markets and drew praise from most economists.
But Chancellor George Osborne in particular remains under pressure to spend money directly on infrastructure to create jobs as many companies and households lack the confidence to borrow for investment or consumption.
"Such schemes can stop a meltdown in your banking system in times of very severe stress," said Jonathan Portes, head of macro-economic think tank NIESR. "This is time of stress, so it's absolutely right to put them in place now."
However, just making credit cheaper may amount to pushing on a string, Portes said. "It may not be about the banks but about business confidence," he said. "Most of the problem with business investment is on the demand side."
In the first coordinated policy move since the height of the financial crisis, the BoE and the government announced a plan to provide cheap long-term funding to banks, allowing them to swap company or consumer loans if they pledged to increase lending.
Details and the ultimate size of the package remain unclear. Officials said it could unlock 80 billion pounds - or 5 percent of GDP - in new lending, but Treasury minister Mark Hoban admitted demand would define the size.
And the head of the British Chambers of Commerce called for more radical measures. "Growth cannot wait," John Longworth said, calling for a state-backed business bank and government steps to kick-start infrastructure spending.
The BoE also activated an emergency liquidity tool, providing at least 5 billion pounds per month in six-month funding, in a move to mitigate the stress in the banking system from the escalating crisis in the euro zone.
Markets took heart from the central bank actions, driving the pound and prices of shares in banks and other risk-sensitive companies higher, while pound LIBOR rates fell, indicating the desired relief for banks' funding costs.
The banks' funding costs have risen since the escalation of the euro crisis started in August 2011, and lenders are passing the rise on to clients, driving up rates for mortgages and business loans despite the central bank's ultra-low base rate and 325 billion pounds in quantitative easing asset purchases.
All observers agree that Britain's economy can do with all the help it can get as the euro zone - its largest trading partner - faces recession, and mayhem looms should Greek voters not elect a government seen able to keep the country in the euro zone.
Britain is still reeling from the 2007-2009 financial crisis that has left many Britons worse off and forced the country to rescue its banking system with tens of billions of taxpayers' money, drilling a deep hole in public finances.
Britain's coalition government of Conservatives and Liberal Democrats have made the reduction of the deficit - still around 8 percent of GDP - the cornerstone of their policy. But the Labour opposition is accusing them of choking off the recovery.
A slump in exports in April raised the prospect that the economy is shrinking for a third quarter running, dealing a further blow to the fragile confidence, and even minimal growth for the full year looks increasingly unlikely.
Most economists now expect the Bank of England to restart its quantitative easing (QE) purchases of government bonds with newly created money - which it halted in May - after governor Mervyn King said on Thursday the case for more easing had grown.
And while the funding moves are welcomed, more and more economists say further steps to stimulate demand are needed.
"Having expressed our concerns that the marginal impact of QE was fading, we regard these steps as unambiguously positive for the outlook, even as we are disappointed - though not surprised - that the Chancellor continues to show little flexibility on the issue of infrastructure spending, initially funded directly and undertaken by the state," said JP Morgan analyst Malcolm Barr.
But NIESR's Portes - who has long argued for a spending boost - said there were signs that Osborne's team was shifting the focus, pointing to announcements that the government was looking into ways to use guarantees to underwrite house-building and infrastructure projects.
The political hurdle for any up-front government spending boost is high, as it would be quickly portrayed as a U-turn from Osborne, who has said strict austerity was essential to defend Britain's top-credit rating.
Labour's finance spokesman Ed Balls already said the latest measures showed the government's policy had failed.
At least markets may be more forgiving, said Vicky Redwood from Capital Economics. Even if the rating agencies decided to strip Britain of its priced AAA rating, the market impact was likely to be limited.
"It would be a personal blow to the Chancellor," she said. "But I don't think markets would be too concerned about it."
Editing by Jeremy Gaunt.