The turmoil in the Eurozone markets just one week after the Euro750bn bail-out was announced is ominous.   Having transferred gargantuan private debts from over-indebted consumers and over-leveraged banks to the public sector in massive bail-outs, anxiety is beginning to spread through the markets as to how this colossal sovereign debt can now be repaid by countries afflicted by low growth.   This is no longer just about the potential knock-on effects of a Greek default or debt restructuring, this is now about whether the Eurozone can survive at all, holding together disparate economies within a single economic discipline dictated by the strongest powers, without major structural change.

Even that concern is now being crowded out by worries about the fragility of global growth prospects.   China is still roaring ahead and the US economy is beginning to pick up, but elsewhere the mood is sombre.   Hitherto the financial markets have been demanding early and substantial cuts in the over-large budget deficits, but the fear is growing that over-enthusiastic budget-cutting could indeed engineer the long-feared double-dip recession.  

Sailing between this Scylla and Charybdis is about to become Osborne’s first big test.   So far the Tory emphasis has been heavily on public spending cuts, but fears of the knock-on effects in undermining aggregate demand are now surfacing more strongly.   The Tory instinct to shrink the State is now having to face up to the harsh reality that far the least risky (and politically most feasible) means to cut the deficit is through growth promotion.

Each 1% of economic growth raises the UK GDP by £15bn, so a modest 2% growth over the current 4-year period to 2013-4 would increase it by £120bn.   The Government’s tax take has historically been around 40%, so Treasury coffers would grow by nearly £50bn.   If the intention remains to halve the deficit (now officially stated to be £156bn) over this 4-year period, growth could account for a major part of it.   If the growth rate were 2.5% a year in accordance with average historical precedent, then growth would secure some £60bn uplift in Treasury receipts or three-quarters of the required deficit cut.

The ToryLibDem Government therefore faces a choice in its first major economic announcements this coming week.   Either it actively promotes growth, funded by bank levies, higher capital gains tax and a super-charge on the super-rich which could raise £20bn a year over this period, or it retreats into its comfort zone of big public spending cuts.   If it chooses the latter, a double-dip recession is coming significantly closer.

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