Sean O'Grady: The real pain of the financial crisis is only just beginning

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The Independent Online

Well, what would you do if you were George Osborne? What would you do if you were Mervyn King? For both men, the dilemmas are exquisitely difficult.

First, Mr Osborne. Before long, and certainly well before the Budget scheduled for 23 March, he will have to decide whether to reprise and tweak one of Margaret Thatcher's most famous catchphrases – "U-turn if you want to, the boy's not for turning" – and carry on regardless. He will, we know, allow what the economists call the "automatic stabilisers" to work, however, which will soften things a little. In other words, if the economy turns down again, he will allow the deficit to widen as tax revenues fall and spending goes up with unemployment.

That's because ministers want to deal with the underlying "structural" deficit rather than the "cyclical" one, and that is certainly preferable to another turn of the screws to try to get the borrowing numbers back on track. But it will still be a squeeze, and will carry the risk of failure. Or he can quietly ditch his fiscal austerity plan in the light of changing circumstances and administer a mild stimulant to the economy. Might he even be tempted to postpone tax rises due in April?

For now, the money must be on the "Iron Chancellor" approach, but a few more quarters of "disappointing" growth might force his hand. It would resemble a re-run of the Heath years: inflation, strikes, rising unemployment and a government that tried to do too much too quickly. Then, as now, a stagnant economy co-existed with mounting inflation – stagflation.

Mr King faces an equally tough dilemma. If he raises interest rates soon, he will force a monetary squeeze on top of the fiscal one – a double whammy for an economy barely able to stand up. Yet if, as he suggests, he will keep his nerve and keep rates on hold, he will gamble the credibility of the Bank as inflation heads towards an "uncomfortably high" 5 per cent. It certainly looks like staying above the 2 per cent target until well into 2012, which means the Bank will have missed its target for two years or more. Either way, the poor old British consumer has a tough year ahead – actually much harder than the formal recession period in 2008-09 which was eased by VAT cuts, a collapse in mortgage bills for many and, often, falling prices. Even with no pay rise, most families held their own and their homes didn't decline in value by much. It was harsh for those who lost their jobs, but for those in work, it was tolerable.

Now comes the reckoning postponed, with the rate cuts and fiscal stimulus of 2008-09 gone. We will see more tax rises – including national insurance – and all-time highs in petrol prices, rail fares, energy bills and food costs. There will be reduced public services, unemployment nearing 3 million, falling house prices, and perhaps rising mortgage rates.

And even then we will not, as a nation, have paid the full price for past excess. Not to mention the risks of a eurozone meltdown, China's property bubble bursting, or another downturn in the US. The "re-balancing" will be painful.