Why our economy is shrinking

Despite an overall rise of 0.9% for the whole of 2011, the economy shrank in the last three months of last year, according to preliminary figures from the Office of National Statistics (ONS).

The total value of goods and services produced between October and December 2011 fell by 0.2%, possibly marking the start of a recession and another strong decline in our living standards, and heightening the worries of businesses, investors and consumers across the UK.

These figures on the size of our economy - our gross domestic product (GDP) - are invariably revised at a later date. In recent history, usually downwards. If the economy shrinks again between January and March, we are officially in another recession.

A fall in GDP can indicate a decrease in living standards and it could well show a decrease in sales, which could lead to more wage freezes and job losses and less hiring. That would put more pressure on the taxpayer to pay for out-of-work benefits, it will mean consumers have even less money to support our shops and businesses, and it means more people will struggle to pay their mortgages, which might impact house prices.

An apparently sinking economy also unsettles investors and banks, who might reduce the aid they give to sustain businesses, and to grow and expand them.

The scapegoat?
Commentators are almost unanimously placing most of the blame on the eurozone. Ranvir Singh of market analysts RANsquawk, for example, said: "A lot is riding on the eurozone. What happens there in the next two months, specifically the strong possibility of a Greece default, will play a major role in determining the fate of UK GDP."

Meanwhile, Ben Thompson from Legal & General Mortgage Club said: "The galling thing is that, just as there are signs emerging that the UK's austerity plans might be starting to work, the plight of the eurozone will now dictate how things play out, so to a large extent it is now out of this government's hands."

Cutbacks are showing their effects
Yet businesses exporting to Europe are doing better than they have for a long time, defying chancellor George Osborne's defence that the shrinking economy is "because of what's happening in the world."

Some commentators are signalling that the austerity measures are having major impacts on businesses. The trade unions, which have a poor relationship with the Conservative party at the best of times, are blaming the government's methods for dealing with its debt problems.

Brendan Barber, general secretary of the Trades Union Congress, said: "The grand austerity plan is failing to tackle the deficit, causing unemployment to spiral out of control, and is now dragging the country back towards recession."

Cutbacks and concerns for the UK economy make everyone nervous about spending, including businesses. Nick O'Reilly from chartered accounts HW Fisher & Company said that "In the last quarter I didn't come across a single firm that was planning to invest this year."

This will partly be due to limited bank lending, which will in turn be affected by the eurozone, but it is also down to customers tightening their belts. Last year, personal debt fell for the first time since the beginning of the property boom, albeit only fractionally, according to figures from Credit Action. As a result of consumers making their own austerity measures, there was a record number of profit warnings last year, led by retailers.

Small business outlook
Small businesses do not see a revival starting any time soon either. The Federation of Small Businesses' most recent survey found shockingly low confidence, and a major slump in positivity compared with just three months earlier.

Manufacturing shrank by 0.9%, but, in another sign that the falls might not be being led by the eurozone problems, it is electricity and gas production that showed the most startling fall of more than 4%, most likely due to low use of heating this unusually mild winter.

However, despite austerity measures, government contracts actually boosted the economy by just under half a per cent. The services sector, which makes up the majority of our economy, didn't grow, but nor did it shrink.

Light at the end of the tunnel
Chris Williamson of Markit, which provides financial information services, provided a more upbeat angle to the growth announcement: "The three (purchasing managers' index) surveys collectively signalled the strongest expansion for five months at the end of last year, and other official data released today showed the service sector expanding 0.6% in November, setting the stage for a possible rebound in GDP growth in the first quarter."

He continued: "Similar survey data have also shown business conditions starting to improve in important export markets such as the eurozone and the US, as well as emerging markets such as China and India."

Bank of England governor Sir Mervyn King yesterday reiterated his comments from the beginnings of the crisis: that the country faces an "arduous, long and uneven" path to recovery.

However, he said that there was no reason to despair, because the UK would emerge "on a more sustainable footing than at any point in the past 15 years." In other words, we might have a smaller economy, but it should be a more reliable one.