Chancellor George Osborne should publish broad stimulus plans for an emergency such as a break-up of the euro zone in next month's budget, the country's leading fiscal policy think-tank said on Wednesday.
The Institute for Fiscal Studies said that while austerity is needed in the coming years to fix public finances, the case for some short-term stimulus had strengthened as the economy has probably entered a mild recession.
But it acknowledged the large risks to even a temporary spending boost, saying any loss in market trust could cost Britain dearly as it has to issue 740 billion pounds to fund new borrowing and refinance maturing bonds over the next five years.
Regardless of whether or not Mr. Osborne thinks that a substantial short-term fiscal stimulus is appropriate at the moment, he should set out now broadly what he would do under alternative scenarios where the economic outlook for the UK is sharply weaker - such as were the Eurozone to collapse it said.
IFS programme director Gemma Tetlow said clarity now could avoid accusations of any U-turn later.
It might be reassuring for businesses and individuals that, if something were to go wrong, the government would be prepared and in a position to do something in the short-term, she said.
The debate about the need for a short-term boost is already heating up ahead of the budget, due on March 21, as the economy contracted by 0.2 percent at the end of 2011.
Chancellor Osborne has blamed the euro zone debt crisis for Britain's meagre economic performance over the past few months. The government has said it is working on plans for all eventualities but has so far refused to give any details.
Osborne announced more spending cuts in November to meet his main target to erase the budget deficit within five years as the weak economic outlook drives up borrowing.
A Treasury spokesman said the IFS's report supported the government's deficit policy. The IFS say that ... any fiscal stimulus big enough to make a difference would undermine investor confidence and so risk higher interest rates, he said.
Consultancy Oxford Economics, which provided the IFS with alternative growth scenarios, said if the euro zone breaks up, Britain's economy would slump by 1.7 percent this year and 0.9 percent in 2012. Its central view is for 0.3 percent growth this year and 1.9 percent next, lower than the government fiscal watchdog Office for Budget Responsibility's forecast of 0.7 percent growth in 2011 and 2.1 percent in 2013.
The IFS said under its main scenario - using the OBR's growth forecasts - the government's net borrowing was likely to be nearly 3 billion pounds lower in 2011/2012, and some 9 billion pounds lower in 2016/2017 than the OBR itself predicts.
(Reporting by Sven Egenter)