The International Monetary Fund is urging George Osborne to boost spending on Britain's infrastructure despite revising upwards its forecast for UK growth by more than for any other developed country.
In a generally downbeat assessment of the state of the global economy, the Washington-based fund said it now expected the pace of expansion to be significantly higher than three months ago.
But it triggered a fresh dispute between Osborne and his Labour shadow Ed Balls over whether the government's austerity programme had helped or hindered recovery from Britain's deepest recession of the postwar era.
The fund's half yearly world economic outlook cut its forecast for global growth in 2013 and 2014, blaming the impact of ham-fisted attempts to cut the budget deficit in the US and a slowdown in top emerging market economies. But it said the UK had bucked the trend, revising its estimates of growth up by 0.5 points to 1.4% in 2013 and by 0.4 points to 1.9% in 2014.
The IMF embarrassed the chancellor in its WEO in April this year, when it called on the UK to ease up on its austerity plans in order to boost the recovery prospects. Although theCity expects growth of about 1% in the third quarter, the fund repeated its call for higher public spending.
"In the UK, recent data have shown welcome signs of an improving economy, consistent with increasing consumer and business confidence, but output remains well below its pre-crisis peak", the fund said.
It encouraged Osborne to take advantage of cheap borrowing to improve the UK's infrastructure, something it said could be done without jeopardising the government's budget plans, saying: "In an environment of still-low interest rates and underutilisation of resources, public investment can also be brought forward to offset the drag from planned near-term fiscal tightening, while staying within the medium-term fiscal framework."
A spokesperson for the Treasury said: "The IMF has confirmed that the UK economy is turning a corner, by revising up its forecast for growth over the next two years by more than for any other G7 economy. But risks to the global economy remain high, and the recovery cannot be taken for granted. That is why the government will not let up in implementing its economic plan, which has cut the deficit by a third, kept interest rates near record lows and created over a million and a quarter jobs."
Olivier Blanchard, the fund's economic counsellor and chief economist was challenged at a press conference about his comment six months ago that the chancellor was "playing with fire" by pressing ahead with deficit-cutting plans. Blanchard said he had been "pleasantly surprised", by the stronger-than-expected growth in the UK. However, he insisted that the recovery had not, "settled the debate" over the right fiscal policy. "It doesn't tell us if the pace of fiscal consolidation was wrong, or if growth could have come back earlier with a different fiscal framework".
Balls said Britain was experiencing the slowest recovery for 100 years and called on the government to take action to boost growth.
"Despite these welcome changes to its forecasts, the IMF rightly warns that the UK economy will remain below potential for many years. That's why the IMF has repeated its view that the government should bring forward infrastructure investment now, which could be used to build thousands of affordable homes," he said.
The IMF now expects the global economy to expand by 2.9% in 2013 and 3.6% in 2014 – down by 0.3 and 0.2 points respectively on its last predictions, made in July – despite stronger growth in the UK and signs of recovery in the euro area.
"Global growth is still weak, its underlying dynamics are changing, and the risks to the forecast remain to the downside," the fund said in its World Economic Outlook (WEO). It pointed out that growth had slowed markedly in the bigger developing economies, cutting its 2014 forecasts from 7.7% to 7.3% in China, from 6.2% to 5.1% in India and from 3.2% to 2.5% in Brazil.
The fund warned that the budget row in Washington would have dire consequences if it escalated and resulted in America defaulting on its debts.
Blanchard said growth had been "hobbled" by excessive deficit-reduction action and described across-the-board spending cuts as a "bad way" to improve the US public finances.
"If there was a problem lifting the debt ceiling, it could well be that what is now a recovery could turn into a recession, or even worse."
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