Into the already combustible atmosphere of Wednesday's largest public sector strikes since 1926, George Osborne threw the incendiary announcement that he is imposing an extra two years of real pay cuts for millions of public sector workers, and ending national pay bargaining within two years.

Faced by the need to find new ways to meet his borrowing targets, he said millions of nurses, doctors and teachers would be given only a 1% pay rise in the two years from 2013. With most public sector workers just coming to the end of a two-year pay freeze next year and facing an average 3.2 percentage point average rise in pension contributions, Osborne's new statement of intent will be a bitter blow to them.

In addition, the small print of the Office for Budget Responsibility report shows that as part of the coalition's attempt to rebalance the economy, Osborne intends to oversee 710,000 job losses in the public sector in the six years between 2011 and 2017, out of a public sector workforce of six million. He had previously forecast only 400,000 in the five years to 2016. Many of those job losses will be in already vulnerable regions such as the north-east, Northern Ireland, Scotland and Yorkshire.

Brendan Barber, the TUC general secretary, battling to keep his more militant unions in check, looked despairing as he estimated that public sector workers will have taken an average 16% pay cut over the next five years.

Paul Kenny, leader of the GMB union, said the restraint made no economic sense. "The continuing squeeze on public sector pay will deepen the deflationary pressures. Proposals to cut public sector pay in already depressed regions will cut demand even further.

"The higher unemployment being forecast shows it's not possible to deflate your way to growth and a balanced budget."

Union leaders promised the latest medicine meant the mood on the picket lines on Wednesday would be even more determined.

The Treasury, facing Labour claims that the increased borrowing forecasts show its plan A now lies in tatters, argued the public purse could simply not afford the 2% rises planned from 2013, saying a below inflation rise would save an extra £1bn. Public sector pay had risen at twice the rate of private sector pay over the last four years, Osborne added.

It has not yet been decided whether the pay restraint from 2013 will apply to low-paid workers. In the current freeze workers earning less than £21,000 have been given a lump-sum increase of £500 over the two years.

Deciding to go on the front foot, Osborne urged the unions to call the strikes off, and stop damaging the economy and putting jobs at risk.

Treasury sources accepted the projected level of public sector job losses was massive, but argued those losses would be balanced by 1.7m extra jobs in the private sector, a net increase in employment of 1m. But if these private sector job losses do not materialise at the rate projected, the claimant count will almost certainly go over 2 million.

But the Treasury also regards its proposed plans to create local public sector labour markets as a big long-term structural reform. The various public sector pay review bodies have been asked to show by next summer how they can introduce localised pay rates. Pay represents 30% of total public spending, so restraint is a big prize. The aim is to achieve localised, not regional pay rates.

Currently pay rates in the UK public sector are set at the national level by centralised negotiating procedures. Roughly two million workers in the public sector have their rates set through the system of publicly established but independently constituted review bodies. Other public sector workers negotiate directly with employers (local government workers and firefighters), or through negotiation procedures that allow explicitly for arbitration (the police).

Exceptions are the courts service and London weighting. A Treasury source said: "We are going to bring national bargaining to an end so we can create local labour market conditions. This is an economic reform to boost regions of the economy that are over-dependent on the public sector. All the evidence is that flexible public sector pay to reflect local labour market conditions will allow the private sector to flourish."

The Treasury cited research by the Institute for Fiscal Studies showing that some public sector workers were receiving pay 10% higher than the regional average. The Treasury also claimed public sector pay had risen at twice the rate of private sector pay, but insisted the motive for localised bargaining was not to save money.

The policy unites the coalition. Two thinktanks, the Conservative-inclined Policy Exchange, and the Liberal Democrats' Centre Forum, have recently pushed the case for localised pay bargaining. Professor Alison Wolf, writing for Centre Forum argued individual contracts were possible saying "national pay systems that ignore local differences, handicap struggling regional economies, and make it impossible for public sector managers and institutions to cope sensibly with our fiscal crisis".

But the Lib Dems will have to work hard to prove they are not joining an ideologically motivated attempt to shrink the state. Many natural Lib Dem supporters work in the public sector.

At the very least they will be expecting the business secretary, Vince Cable, to come up with more than woolly exhortation when he announces his reforms to the way executive pay is set in the UK.


Patrick Wintour, political editor

The GuardianTramp

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