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Recovering from the recession, improving longer-term growth potential and reducing inequality are key challenges for the UK economy. Lingering effects from the global financial crisis, the restrictive impact from necessary fiscal consolidation and headwinds from the euro area sovereign debt crisis risk prolonging and worsening the economic downturn and hurting the long-term growth potential. Monetary policy and the operation of the automatic stabilisers should support the economy in the short term. Structural reforms, including those currently implemented by the government, are crucial to boost growth and equality.

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Monetary policy is the primary tool to stimulate the economy, but the fiscal framework and earned policy credibility allow a flexible response to economic weakness. The recovery from the recession is projected to continue to be slow and uneven. Although the scope for macroeconomic policy is becoming more circumscribed, sustained monetary stimulus through expanded quantitative easing, liquidity provision by the Bank of England and government-backed funding schemes need to continue to support the economy. The government deficit remains high and public finances will come under pressure from population ageing in the long term. The fiscal stance remains appropriate. However, if growth significantly underperforms expectations over the coming months, the flexibility of the fiscal framework should be utilised. In this regard, the Government’s decision in the December 2012 Autumn Statement  to continue with its existing consolidation plans and not override the automatic stabilisers in order to meet the supplementary debt target is appropriate.

The recommendations from the Independent Commission on Banking should be implemented to shield the taxpayer and the domestic economy from failures in the financial sector.

The government should pursue growth-enhancing and inequality-reducing structural reforms. A prolonged period of weak growth risks worsening social inequalities. Labour market and social policies need to mitigate this risk. In particular:

• The welfare reform, which introduces a Universal Credit with generous earnings disregards and a single taper rate in place of myriad means-tested benefits, will improve work incentives for many individuals. Nevertheless, work incentives could be further improved, especially for lone parents and second earners dependent on formal childcare. Measures to lower childcare costs and increase public support to make work pay for these individuals should be considered, although this comes with a fiscal cost. On the other hand, better incentives for lone parents and second earners would increase the effectiveness of the benefits reform and thereby raise the economic growth potential and reduce inequality.
• Active labour market policies must be reinforced to ensure that vulnerable groups do not become permanently excluded from work. Despite a highly flexible labour market that has maintained fairly high levels of employment through the downturn, unemployment is high, especially among youth and low-skilled individuals.
• Weak skills in some segments of the workforce hinder employment and growth, and contribute to large differentials in employment and earnings across education levels. Workers’ skills need enhancement, especially among students from disadvantaged backgrounds, through improved educational outcomes, reinforcing vocational training and by facilitating transition from education to work.

Other growth enhancing reforms should also be pursued. Investment in productive assets is low in an international context, hampering innovation and growth. R&D support policies and corporate taxation should be reformed, with more focus on rewarding social returns in excess of private returns. Increased investment in productive infrastructure could boost long-term growth, and would justify further prioritisation in spending. Other obstacles to investment, notably linked to stringent planning rules, should also be removed. Productivity in large swathes of the public sector seems low and should be raised through better management and greater regional flexibility in public sector wages.

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