Following one of the most severe recessions in a generation, the government inherited the highest level of borrowing since the Second World War and a deficit that is one of the highest in the developed world.
So, yesterday's Budget had to demonstrate the Government could balance its objective of deficit reduction without endangering the economic recovery. All this while seeming to be fair and avoiding the fault lines within the coalition. No one said that it was ever going to be easy.
The aspiration to accelerate the pace of fiscal consolidation is the right one, as is the focus on spending cuts rather than tax rises — in the end we got a 77-23 split. Evidence of past fiscal consolidations suggests this course of action is the one most likely to yield a successful outcome without damaging growth prospects.
But the new fiscal target to eliminate the structural current deficit over the next five years is certainly ambitious. Although there were no big surprises, the overall package was much tighter than most had envisaged — as much as the Chancellor could expect the public to swallow. That should help to keep the financial markets and credit ratings agencies satisfied, at least until the Spending Review in October.
However, the worry is that the extra £40 billion of fiscal tightening by 2014-15 could endanger the fragile economic recovery and thus delay the rally in the headline borrowing figures. With the Office for Budget Responsibility's before-and-after forecasts, we can see an estimate of the impact of a government's package on the wider economy.
The boost to growth in later years from lower borrowing does not look unreasonable, but the short-term effects are surprisingly small. For example, in 2011, with VAT rising to 20% and current spending around £10 billion lower than the pre-Budget forecast, GDP growth is estimated to be just 0.3 percentage points lower. It seems the OBR is underestimating the impact of this significant fiscal tightening. In 2011, when the fiscal tightening measures bite, the recovery will be most at risk from a double dip.
But delaying the increase in VAT until January will help maintain spending over Christmas and delay the impact on the CPI which is critical to the outlook for interest rates. The two-year pay freeze in the public sector will mean the reduction in spending will come in gradually, and will help to maintain the level of services.
Overall, the measures that were announced add up to a well-constructed package that should reduce the risk to the recovery.
Hetal Mehta is senior economic adviser to the Ernst & Young Item Club
