The International Monetary Fund today called for the Bank of England to stimulate UK growth with further quantitative easing or cutting the 0.5 per cent base interest rate.
In its annual report on the state of the UK economy, the IMF said the Government should prepare an economic Plan B, featuring temporary tax cuts and increased infrastructure spending to support the UK economy should the Eurozone collapse or recovery fail to take off.
Christine Lagarde, the IMF's managing director, said: “If the economy turns out to be significantly weaker than forecast, fiscal easing should be considered... measures should be focused on supporting growth and employment.”
And as the IMF warned of the “large” risk of an escalation in the Eurozone crisis delivering a “substantial contractionary shock” to the UK economy, the OECD forecast Eurozone contractions were close to “a severe recession”, with knock-on effects for the rest of the world.
Ms Lagarde acknowledged “substantial progress” in balancing Britain's books thanks to the Government's deficit-reduction programme, and complimented the Bank of England's “nimble” use of quantitative easing and interest rate cuts.
This had given Britain a “hard-won credibility” with international markets which now allows ministers the scope to take measures to support growth, she said.
She added: “When I think back to May 2010, when the UK deficit was at 11 per cent, and I try to imagine what the situation would be like today if no fiscal consolidation programme had been decided, I shiver”.
But Ms Lagarde warned that although recovery is expected to gather pace towards the end of 2012, the UK economy had underperformed, with unemployment remaining “much too high” and the UK's productive capacity potentially remaining “idle for an extended period.”
If the UK recovery fails to take off, ministers must be prepared to use temporary tax cuts and more infrastructure investment to give the economy a shot in the arm, even if this means reining in the Government's austerity programme, said the IMF.
To preserve credibility, any relaxation in the Government's austerity programme would have to be presented as part of a multi-year plan designed to reduce the deficit once the economy is stronger. But the gains from delaying fiscal consolidation might outweigh the cost of tearing up the totemic deficit reduction plan.
“An escalation of stress in the euro area could set off an adverse and self-reinforcing cycle of lower confidence and exports, higher bank funding costs, tighter credit and falling asset values, resulting in a substantial contractionary shock,” Ms Lagarde said.
Despite the gloomy outlook, George Osborne, the Chancellor of the Exchequer, welcomed the IMF’s report into the UK’s economy, saying: “The IMF couldn't be clearer today. Britain has to deal with its debts and the Government's fiscal policy is the appropriate one and an essential part of our road to recovery.
“I welcome the IMF's continuing support for the UK deficit reduction plan. They agree that, in their words 'reducing the high structural deficit remains essential' and make clear in their statement that they consider the current pace of fiscal consolidation to be appropriate.”
He acknowledged that an escalation in the euro crisis would have an impact on the UK and urged eurozone countries to “stand behind” the single currency.
“It is clear that we are now reaching a critical point for the eurozone,” said Mr Osborne.
“Eurozone countries need to stand behind their currency or face up to the prospect of Greek exit, with all the risks that that could involve.
“The British Government is doing contingency planning for all potential outcomes. It is our responsibility to ensure that while we work for the best, we prepare for something worse. The IMF must also prepare for the consequences if members in Europe don't follow its advice.”
The Euro gloom was increased by the OECD’s forecast of a 0.1 per contraction in the 17-nation Eurozone block during 2012, followed by 0.9 per cent growth in 2013, as Europe falls further and further behind a resurgent USA.
Pier Carlo Padoan, the OECD’s chief economist, said: “Today we see the situation in the euro area close to the possible downside scenario which if materialising could lead to a severe recession in the euro area and with spillovers in the rest of the world.”