Recession could be worst for 60 years

Economy shrank 1.5 per cent in last quarter of 2008 / Unemployment set to reach three million next year

The British economy has "fallen off a cliff" and entered a recession that shows every sign of developing into the worst since the Second World War, with unemployment soaring above three million by next year.

The slowdown has turned into recession: the question is now whether the recession will become a slump.

The Office for National Statistics said yesterday that the British economy shrank by 1.5 per cent in the last three months of 2008. Worse than most economists feared, it follows a contraction of 0.6 per cent in the third quarter of last year, and thus satisfies the conventional definition of recession, being two successive quarters of negative growth.

Output is 1.8 per cent lower than this time last year. It is the first time the UK economy has shrunk since 1991, and is the worst performance since the exceptionally deep downturn of 1980. The British economy grew by just 0.7 per cent last year, by far its worst performance since Labour came to power in 1997. The ONS also announced a fall in the value of retail sales last month, prompted by heavy discounting. The pound and the stock market slumped again on the news. Sterling hit a 24-year low against the dollar to close at $1.35. It stayed close to parity against the euro, while the FTSE 100 index fell almost 2 per cent before a late rally.

Despite the rescue package announced earlier in the week, investors continue to fear for the British banking system. The prospect of further nationalisations, and the assumption by the taxpayer of the major banking groups' vast liabilities in foreign currencies, continue to undermine confidence.

Economic commentators agreed that the numbers were dire. Charles Davis, an analyst with forecasters CEBR, said: "The economy fell off a cliff in the final quarter. The figures are the final nail in the coffin for Prime Minister Gordon Brown's claim to have 'ended boom and bust'. The UK economy is most definitely bust at the moment. With 2009 set to be an exceptionally tough year, interest rates are likely to remain close to the zero floor right through into 2010." Given the scale of the public and private debts now being paid back, most observers also believe the recovery, when it arrives, will be anaemic, with sluggish growth in British living standards for years to come.

Almost every sector of the economy is in decline – only agriculture, accounting for just 1 per cent of GDP – showed an increase in activity, and even that was tiny. Britain is in the thick of an "inventory recession". As sales fall and stocks rise, orders to manufacturers have been cut back savagely, amplifying the downturn.

But that could mean the pace of decline may slow. Philip Shaw of Investec said: "Our suspicion is that the scale of the decline reflects a sudden and considerable drawdown in inventories. We are still predicting a very shallow upturn in the second half of this year".

Particularly hard hit is manufacturing, down 4.6 per cent, especially the car industry, where production has almost halved. Distribution, again centring on the retail motor trade, and the rest of the hotel, restaurant and retail sectors, have also suffered. Construction remains in a very depressed state, as is financial services. Even the public sector, usually buoyant thanks to the Government's efforts to stimulate the economy, showed a decrease, apparently pushed lower by services such as recreation and refuse collection, although health and education spending is still growing.

The figures put the country on track for its worst year for economic growth since the Second World War, with a shrinkage in national output of about 3 per cent. That would mean that at the time of a 2010 election the economy may well be smaller than it was when Mr Brown became Prime Minister in June 2007. It would also have serious social implications for crime, drug abuse and social unease. Last week the ONS said unemployment reached 1.92 million in November, and the chances are that it will exceed three million by the end of this year.

That trend seems certain to lead to a still more depressed housing market and a rising tide of arrears and repossession. Repossessions were up by 13,161 between July and September last year, the latest data – or one family every 10 minutes losing the roof over their heads. These are already increasing pressure on the nation's severely depleted stock of social housing.

The consensus in the City is that the Bank of England will cut rates by a further half percentage point on 5 February, despite the parlous state of sterling.