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Election outcome creates new economic risks

The new government faces key domestic economic challenges relating to productivity, the deficit and housing

AFTER weeks of speculation about possible coalitions, the General Election came to a surprisingly decisive outcome with a majority Conservative government. This has removed an important potential source of political uncertainty that could have slowed the economic recovery, but it also creates new economic risks, particularly regarding the proposed referendum on UK membership of the EU, which the new government is committed to holding before the end of 2017.

The first key economic challenge for the government is therefore political: to agree an appropriate set of reforms with other EU member states and then put this to the British public as soon as possible – ideally in 2016 rather than 2017 to minimise the associated period of uncertainty for business. These reforms could centre on making further progress on the EU Single Market, particularly in the business services and finance areas where the UK is relatively strong. There may also be some scope to reform benefits for EU migrants to avoid possible abuses of the system, but not to restrict the freedom of movement that is one of the key benefits of the EU to the UK and other economies.

There are, however, also many domestic economic challenges to be faced. First, there is the problem of low productivity, which has essentially flatlined in the UK since the recession. This is the main reason why real pay growth has been so subdued over the past six years. There are no quick and easy fixes to the productivity problem, but the long term solution must involve increased investment in human, physical and intellectual capital. The government can lead on this in some areas and create the right framework for the private sector to make this investment in others.

Areas where the government can lead include investment in basic science research in new areas like nanotechnology and synthetic biology. It also needs to look more fundamentally at whether the UK education system is providing the right skills in areas like entrepreneurship, computer science and languages.

The government also needs to accelerate plans for critical new transport infrastructure, which would include making a quick decision on much needed new airport capacity around London, as well as upgrading road and rail systems in the North of England to better link up major cities such as Leeds, Manchester and Liverpool. The government could also set up a new Infrastructure Board to guide long-term strategy in the area, as recommended by the LSE Growth Commission.

Second, there is the problem of the deficit. The government has boxed itself in somewhat here with the various commitments to cut income tax, avoid increases in VAT or national insurance, boost NHS spending by £8bn by 2020 and protect other priority areas like schools, military equipment expenditure and pensioner benefits. As a result the squeeze on unprotected departments and working age benefits will have to be severe in 2016/17 and 2017/18. The Treasury will need to make some tough choices here as it prepares for a Spending Review in the autumn, but this should largely complete the programme of deficit reduction.

I would argue that the government should exempt capital spending from these cuts. With long-term government bond yields still very low, this is a good time to lock in long-term borrowing for priority infrastructure projects of the kind discussed above. This does not mean the government has to pay for everything – in some cases it may be a matter of providing seed capital or appropriate guarantees to reduce the political risk premium for private investors.

Third, housing has become one of the major sources of inequality in British society. An increasing number of older people lucky enough to buy at the right time and in the right place are sitting on large assets, often now mortgage free. But at the other end of the scale, younger and poorer households find it increasingly hard to get on the housing ladder, with the proportion renting privately having risen from around 10% in 2008 to around 18% now.

The fundamental problem here is lack of housing supply in the places where people want to live. The last government did take some action to reform planning rules, but too many of the initiatives in the run up to the election were short-term palliatives to boost demand, which will largely just redistribute housing between people and push up prices. More fundament measures to open up the land market and build more affordable housing should be one of the key priorities for the new government.
So there is a lot to do for the new government, but also a clear mandate for it to pursue the radical reforms necessary to address these economic challenges.

John Hawksworth is chief economist at PwC

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