Drive around the towns and villages of Britain at the moment and you’d be forgiven for thinking there’s a party in full swing: the pubs are draped in Union Jack bunting, the shops are heaving with disposable decorations. Much is down to the Queen’s Diamond Jubilee which was celebrated in early June with thousands of street parties. Meanwhile, the patriotic mood is still going strong with the Olympic Torch on its last leg around Britain ahead of the 2012 Games.

Not a hint of austerity and every reason to be cheerful? Not quite. Not if you look beyond the hoopla at the state of the economy.

Recession is back

The U.K. is back in recession. The latest official statistics show output shrank by 0.3 percent between January and March this year, more than the initial estimate of 0.2 percent and while the move may only be slight, it points to a much more sober picture behind the surface celebrations. Consumers are still not out spending as they used to, the carefree credit days are well and truly gone with households having to count every penny and pound. And while unemployment has fallen, there is a growing number of people who are being forced to work part-time because they cannot find a full-time job.

The shadow chancellor has seized on these numbers arguing that the coalition government’s spending cuts have played a major role in the economic mess. But the government also has its supporters who argue that the only way to drive real growth is to stick to the plan of reducing the deficit - which, while it has come down, is still much higher than much of the rest of Europe at 8.3 percent of GDP. So who’s right?

“At heart, this is a debt crisis which makes it different from recessions in the recent past or in anybody’s lifetime,” says Conservative MP Matthew Hancock, who’s sat round many a top table pouring over figures both as an economist with the Bank of England and then with the chancellor at  No. 11 Downing Street. He says that as a nation the British have been spending far more than they should have been so it’s pay-back time now.

“The way to get out of that crisis is to face up to the problem of debt and our impaired balance sheet. We are a quarter of the way. There is still three quarters of the way to go to cut through the deficit.”

That message has not gone down well with the public sector which is beginning to feel the brunt of the government’s cuts. And they are severe - the biggest cuts in state spending since World War II. The plan, announced by the government back in 2010, was to cut 490,000 public sector jobs over four years, reduce benefits and make changes to pensions and some personal income tax allowances. Slight modifications have been made on the numbers and the time frame since then but the coalition has broadly stuck to its plan and that has provoked a wave of demonstrations. Police officers and college lecturers along with civil servants and health workers have been out on the streets. And the government’s own revenue staff and customs officers have just voted to take industrial action. But the scale of the protests in the U.K. has been relatively small, emotions mild and contained, compared to the fiery and often violent protests in cities across the Eurozone.

Challenging Confidence

The Conservative-Liberal Democrat government is keen to present itself as being in touch with the electorate constantly reiterating; “It’s going to be a tough road ahead.” However behind the rhetoric it has yet to convince everyone that it really knows what it’s doing. It has not helped itself with recent U-turns on issues like the “pasty tax” which to anyone outside the U.K. might be considered absurd. The Treasury has just reversed its decision to tax hot food in bakeries after an outcry from the food industry. It has also just retreated from capping tax relief on charity donations. The U-turns have left critics shaking their heads in dismay. When it comes to getting the public finances under control Hancock says they are not going to back down. “Everybody has to play a part in the deficit reduction.”

Both the IMF and the European Commission have carried out recent health checks on the U.K. economy: the IMF has talked about a Plan B and the European Commission has made it clear the government needs to prioritise growth, balancing austerity with investment.

The Commission, of course, can only advise the U.K. Its view, though, is shared by significant voices in the business community. Sir Richard Branson of Virgin has made it clear he’s not impressed with the government’s strategy. He wants to see small businesses get more support. Others agree a boost to business would benefit the economy overall.

Lord Browne - who ran the global oil giant BP and now sits on the Board of the new U.K. Growth Commission (which is drawing up its own recommendations on growth) says “there is no magical bullet for the U.K. economy or the Eurozone but I have real sympathy with businesses - small and medium. They are the key link in the supply chain and can make a real difference to the economy and that needs to be understood. The U.K. government should look around at the best of the best.”
He points to across the Atlantic and the U.S. Small Business Administration which helps to finance start-ups and small businesses.

There is also a need to push exporters to look beyond the Channel. The Eurozone is currently the U.K.’s biggest trading partner. Nearly half of U.K. exports were shipped to the Continent last year while 43 percent of imports into Britain came from the Eurozone.  That heavy dependence is not helping U.K. plc. Some companies have broken the mould and worked hard to find growth opportunities in emerging markets like China and South America. However, that’s not enough.

Germany may be going strong but with so many of the European economies in flux, British companies are highly exposed. If the Eurozone declines further, companies around the U.K. know it will mean less demand for their goods and services particularly if the euro continues its slide against the pound.

Of course should the pro-growth agenda bear fruit in the Eurozone and there is a surge in spending, that could mean a huge boost in demand for U.K. businesses but no one in Britain is counting on that yet. Most companies are simply watching and waiting, deferring any decisions on new investment and taking on more staff until they see what happens.

What next?

So where is the U.K. heading?  On the upside, the latest inflation figures show some hope. Inflation dropped to 2.8% in May; the lowest level in two and a half years and that has cheered up some economists like Martin Weale. He, along with eight others at the Bank of England’s Monetary Policy Committee, controls the U.K.’s interest rate policy and has the challenging job of keeping inflation on target. It has been way off its 2 percent target for more than two years but he is sanguine. “It’s undeniable we are in a stagnant period. Looking ahead it is possible we will see improvements. The squeeze on real household wages should ease and we’ll hopefully see consumer demand grow.”

Whatever the disagreements about domestic growth and the political debate about how to stimulate it, there is a common thread: concern about the Eurozone crisis and the impact on the U.K. Despite its firm decision not to join the Eurozone and to retain the pound; despite its steadfast counter-Continental decision to uphold austerity rather than spend on growth, Britain and many of its businesses are inextricably linked with its Eurozone partners. And when they are in trouble, so is the U.K.

Doom and gloom all round then and yet the flags are still up and more parties are still being planned. The Jubilee pageant proved a huge success - not for the economy admitted the Prime Minister but “it was good for the soul”. And the hope is the Olympic Games will bring more of the same. The Sydney Olympics in 2000 boosted the Australian economy by around three-quarters of one percent. The Bank of England has suggested that a similar pattern of spending would lead to a 0.2 percent rise in growth in Britain. Hardly enough to turn around the U.K.’s fortunes but enough to raise the mood of the nation and celebrate again especially if Team GB can produce a haul of medals.