By Anthony Faiola and Dan Balz
Washington Post Foreign Service
Monday, May 10, 2010; A01
LONDON -- Inside the stately buildings of Whitehall in the shadow of Big Ben, party leaders trying to forge a government hunkered down for talks this weekend with a 167-billion-pound elephant in the room: the British budget deficit.
Investor panic over Greece's debt problems is engulfing Spain and Portugal, and political officials here are racing to head off speculation that Britain could be next. Thursday's election yielded no clear majority in Parliament, plunging parties into intense rounds of horse-trading to assemble a workable coalition. Their most critical goal: the creation of a government willing to undertake what is set to be the most painful round of spending cuts in Britain since World War II.
The focus of the coalition talks underscores the rising alarm over yawning deficits and crushing debt in developed nations since the onset of the global economic crisis. In Britain, stimulus spending and collapsing tax rolls have left the budget deficit -- the shortfall between what the government takes in and what it spends -- set to jump to 12 percent of national income this year, the highest in the European Union and roughly on par with that of the United States.
As with the United States, global confidence in Britain's economy and government has afforded the country the right to borrow vast sums at low interest rates. Now there are fears that such confidence could erode. Some economists have warned that if Britain's parties cannot form a workable government quickly, investors could sharply accelerate Friday's relatively muted sell-off in the pound and British bonds.
"We are facing a financial and economic situation of great seriousness as a result of our dangerous debts and our deficit," the Conservative Party's leader, David Cameron, told reporters in London as he unveiled a coalition proposal Friday. "We need a government that reassures the international markets, we need policies that will bring economic recovery, and we need a government that understands that great change is needed in order to restore faith in our political system."
The Conservatives, who emerged from Thursday's vote with the most seats but shy of an outright majority, have been in tense negotiations with the third-place Liberal Democrats to form what would be the first coalition government in Britain since the 1970s. Cameron met with Liberal Democrat leader Nicholas Clegg late Saturday and again Sunday, after top lieutenants from both camps spent six hours behind closed doors.
William Hague, Cameron's point man on foreign policy and one of his chief negotiators, emerged from the talks Sunday with comments squarely aimed at reassuring the markets before the start of Monday trading. Although the sides had not reached a deal, he said they would meet again Monday and had "agreed that a central part of any agreement . . . will be economic stability and the reduction of the budget deficit."
Prime Minister Gordon Brown, whose Labor Party suffered heavy losses but held on to a second-place finish Thursday, was making his own overtures to Clegg. There were conflicting reports over whether a phone call between the two men had ended in a terse exchange Saturday.
But on Sunday, Clegg and Brown met in face-to-face discussions characterized by the Liberal Democrats as "amiable." Still, most analysts see a Labor-Liberal Democrat alliance as a long shot. The two parties alone do not have enough seats to form a ruling majority. In addition, though Clegg has not ruled out a deal with Labor, he has said he would first seek to forge a pact with the Conservatives, given their first-place finish in Thursday's vote. A deal with Brown, who is highly unpopular in Britain, could also prove difficult to sell to the British public.
Electoral reform is emerging as a stumbling block in the negotiations. Clegg is looking for big changes in how Parliament is elected in order to even the playing field with the two dominant parties. Protesters backing electoral changes staged a rally Saturday in central London to back his calls.
Still, the deficit remains the biggest issue. Despite numerous opportunities during the campaign to lay out their plans, the leaders of the three major parties have largely ducked hard questions about how they would deal with it.
All the parties agree the deficit must come down, but only the Conservatives have called for cuts to start this year. They have not specified where most of them would come, however, other than warning of pay freezes for public workers and cuts that could sharply drive up the cost of a university education. The Conservatives and the Liberal Democrats roughly agree on the scope of the deficit cuts needed in the coming years. But the Conservatives are advocating a faster path that would likely rely more heavily on spending cuts, while the Liberal Democrats would seek to balance cuts with targeted tax increases. The two camps were set to meet again Monday.
On Friday, rating agencies Moody's and Standard & Poor's signaled that the hung Parliament -- one with no clear majority -- would not immediately affect Britain's cherished "AAA" credit rating. But economists warned that investors could grow concerned anyway if the political leaders cannot reach a deal that produces a strong and stable government with the deficit in its sights.
"Britain is not Spain, Portugal or even Ireland, but we have got a big problem, and the markets are looking for an indication those problems are going to be solved," said Howard Archer, chief economist for IHS Global Insight in London. "There is a huge amount of uncertainty, a lack of detail, and that's why there is a need for a quick resolution to the political situation."
Developing a policy to attack the deficit represents only the first challenge for the new government. Dealing with the political fallout will be just as difficult, according to analysts here.
"Partly because the three parties did not come clean with the voters about how great the country's troubles were and what they would do to deal with them, people are going to be in for a bit of a shock when thousands of public-services workers are sacked and when taxes go up," said Anthony King, a government professor at Essex University.
That could produce a backlash of demonstrations and national strikes that, while not on the scale of the protests and riots in Greece last week, would be widely disruptive.
They would also weaken a new government likely to start its term in office already compromised by the muddled election results, unless there is a solid agreement to cooperate across party lines. Even with a coalition, almost any new government will have a slender majority, at best, and no clear mandate from the voters about what actions to take.
A government built on cooperation between the Conservatives and the Liberal Democrats, who together received 59 percent of the popular vote and will hold 56 percent of the seats in Parliament, might have the best chance of withstanding negative reaction to the tough action that economists say is necessary to put the country's fiscal house in order.
If the Conservatives cannot work out a coalition deal, Cameron is likely to head a minority government that is susceptible to falling in the coming months -- and that might prove reluctant to force cuts if it knows an election might come sooner rather than later.