The Tory election victory has lobbed Osborne a number of economic hand-grenades argues James Meadway

George Osborne is back as Chancellor of the Exchequer. But he’s inherited something of a mess from the last government. Here are the top six reasons he should be having sleepless nights:

1Austerity didn’t work last time. For two years after the 2010 election, Osborne tried diligently to stick to the harsh austerity plans laid out in his June 2010 Emergency Budget. Britain suffered the third worst spending cuts in Europe, behind only Greece and Luxemburg. But, predictably, the economy was forced back into a slump and recession. As the failure of the original plan became evident, the Treasury took the decision to ease off on austerity. By 2014, the pace of deficit reduction had been reduced to a crawl. The failure of austerity meant Osborne missed his original deficit target, and extending austerity for another five years.

2Austerity won’t work this time, either. But the Conservatives are committed to accelerating. Despite the rhetoric, the Coalition eased right off on austerity towards the end of its time in office. The Conservatives are now committed to achieving a fiscal surplus (getting more taxes than they spend) by the end of their current term of office. This implies a further £33bn of cuts. However, if they squeeze harder on public spending now, they’ll likely as not stage a re-run of 2010-2012: driving the economy back into stagnation.

3The low-hanging fruit have been picked. Despite its rhetoric, the Coalition was careful to go for what it considered to be easy targets for cuts. This meant, in the first few years, extraordinary cuts in capital spending on things like buildings and equipment. Expenditure here fell by around 50%, but the effects of cutting this expenditure are not immediately felt. It was careful to apply very deep cuts to local authority funding, effectively sub-contracting austerity to local councils who could then take the flack. And it has targeted certain parts of social security spending, such as disability benefits, demonising claimants as “skivers”. For Conservatives, these are low-hanging fruit, in that the political costs of targeting this spending are minimal. From this point onwards, particularly if it intends to make £12bn welfare cuts, meet its deficit goal, and continue to protect certain parts of spending, it will be very hard to avoid politically damaging targets. Unprotected departments could be facing cuts of nearly 18% over the next few years.

4Household debt is rising again. The only factor likely to dampen the economic impact of a return to full-throttle austerity is rising household debt. Over 2010-2012, British households were still, in the aggregate, repaying the debts they had built over the boom years of the 2000s. But this switched in early 2013, as “unsecured” borrowing (that is, borrowing not on mortgages but things like credit cards, car financing deals, and payday loans) began to rise. By the end of last year, it was rising at its fastest rate since 2006. Rising borrowing fuelled rising consumer spending, despite falling real incomes. By 2013, households had become net borrowers from the rest of the economy, just as they were in the early 2000s. If households carry on borrowing to spend, this will limit the impact of austerity. Household borrowing and spending will compensate. But this means rising household debt, as the official forecasts show (Chart 3.31) – a crisis waiting to happen. This household borrowing is, of course, heavily dependent on rising house prices: although QE and other political interventions have helped sustain the bubble, it’s not clear how long this might last for.

5We are becoming less productive. All of the above problems would matter less if the underlying economy was in a better shape. However, since 2007, productivity, as measured by output per hour worked, has not risen in the UK. This is exceptional: since the Industrial Revolution, productivity has grown consistently, and most other major developed economies have seen a return to productivity growth since the crisis. As a result, every hour worked in the UK produces (on average) 29% less than every hour worked in Germany. The result of this is that scope for real pay increases is very limited; it is easier for firms to increase pay when productivity is rising, since they can make the payment out of the productivity gain. No productivity improvement and, without redistribution, no sustained wage increases. Investment should secure productivity gains, but investment fell at the end of last year. Osborne was got extraordinarily lucky last summer, as falling oil prices translated into low inflation and, finally, some rises in real incomes. (This, plus reduced austerity, may well have cleared the path to election victory.) But it’s going to be very hard to sustain real wage rises on the basis of very low inflation. The deflation risk is real.

6The British economy is not paying its way in the world. The deficit that attracts all the attention is the government’s fiscal deficit. Discussion of this dominated the election campaign, with both the main parties pledged fealty to austerity. But it’s the least important of the three large deficits the UK economy is now running because a secure government with its own currency can relatively easily repay its debts at some point. Of the other two, the “household deficit” (as point 3 says) is now rising sharply. And the current account deficit is around its highest level since modern records began, at nearly 6% of GDP. This deficit is the gap between what we earn from the rest of the world, through exports and investments, and what we pay to the rest of the world, through imports and overseas investments and lending here. It matters because, like any other deficit, it needs financing.Justhouseholds or governments borrow or sell off assets when they wish to spend more than they earn, so, too, can a whole country. Britain has run a persistent current account deficit for decades, which it has paid for by selling off assets (think Eurostar or London property) and borrowing. As a result, we have the highest external debts of any major economy, at over 400% of GDP. This need to finance the current account deficit is a huge vulnerability for the whole economy, since it makes us all highly dependent on the ability to find financing. If the rest of the world no longer wishes to finance us, a crisis could quickly emerge: around a sharp fall in a pound, for example, and an enforced contraction of domestic spending. One possible external shock could be US interest rate rises; or the collapse of the Chinese credit bubble, transmitted rapidly here through our banks.

The slowdown in growth, meanwhile, hints that our debt-fuelled recovery may already have peaked Put all this together, and it should be clear that election victory has lobbed Osborne a number of hand-grenades. There’s no guarantee any of them will detonate. But you wouldn’t want to be in his shoes if and when they do.