By Fiona Shaikh and David Milliken
LONDON (Reuters) - Britain's coalition government unveiled sharply lower economic growth forecasts on Tuesday and said it would take much longer than hoped to wipe out its deficit, meaning tough austerity measures would extend beyond the next election due in 2015.
Finance Minister George Osborne, in one of two major annual economic setpieces, warned the British economy risked getting dragged into recession if the euro zone debt crisis was not solved.
"If the rest of Europe heads into recession it may prove hard to avoid one here in the UK," he told parliament.
"Much of Europe appears to be heading into recession caused by a chronic lack of confidence in the ability of countries to deal with their debts. We will do whatever it takes to protect Britain from this debt storm while doing all we can to build the foundations of future growth," he said.
The economy was now forecast to grow by only 0.7 percent next year, way below a March budget forecast of 2.5 percent, Osborne said, presenting figures from the independent Office for Budget Responsibility. The OBR expects the economy to shrink by 0.1 percent in the last three months of this year.
Growth was expected to recover to 2.1 percent in 2013, down from a previous forecast of 2.9 percent, before accelerating to 3.0 percent by 2015 - a rate which analysts said was optimistic.
Osborne said pay rises for public sector workers would be capped at one percent once a two-year pay freeze ends in 2013.
That will fuel anger among unions on the eve of a one-day strike by 2 million public sector workers over cuts by the Conservative-led coalition that will make them pay more and work longer for their pensions.
Borrowing will fall much less than expected because of slower growth, erasing any margin for error in the government's plan to erase the structural deficit within five years.
The coalition has made erasing a deficit that peaked at 11 percent of national output its priority. Opposition Labour said its strategy had been blown way off course.
Labour finance spokesman Ed Balls accused Osborne of a catastrophic error of judgment. Center-left Labour, ousted from power in May 2010, says the coalition is squeezing the life out of the economy by cutting too much and too quickly.
It is that argument which will go a long way to deciding the result of the next election, still four years away.
"The country either needs a new Chancellor or a new plan ... The Chancellor needs to change course and he needs to do so now," Balls told parliament.
The new figures bring the government broadly into line with independent forecasters.
The OECD rich nations' economic think-tank said on Monday that Britain will slip back into a modest recession early next year. It lowered its 2012 growth forecast to just 0.5 percent and urged the Bank of England to expand its money-printing program.
"The near-term forecasts are broadly similar to our own but I think the long-term forecasts -- out to 2016 -- are very optimistic given that fiscal restraints will continue for quite some time and the uncertainty created by the euro zone crisis," said Howard Archer, an economist at Global Insight.
"The only strong card the chancellor has is the fiscal restraint he's looking at."
Despite fears that the country is being pushed back into recession, the government will not fundamentally change tack.
Britain has enjoyed record-low borrowing costs thanks to its perceived status as a safe-haven from the euro zone debt crisis, which helps alleviate the pressure on public finances.
The yield on 10-year gilts has been trading at 2.3 percent, well below the 3.8 percent average rate projected by the OBR in March, resulting in a total debt interest saving of 22 billion pounds up to 2015/16, Osborne said.
What stimulus there is, is likely to come from monetary policy.
The Bank of England will pump an additional 75 billion pounds into the economy in coming months, a Reuters poll indicated on Tuesday, taking the total to 350 billion as it tries to revitalize growth.
"The UK is partway through a 'lost decade', and I expect that 2012 will be another difficult year," said Michael Saunders at Citi, who expects the total BoE spend to be at least 500 billion pounds -- the highest forecast in the poll.
Recognizing that he has little scope to alter Britain's short-term economic prospects, Osborne focused on measures that will boost growth in the longer term, such as promoting lending to small businesses and encouraging private sector investment in infrastructure.
He plans to tap British pension funds to provide the bulk of up to 30 billion pounds of investment in building projects, while the government will underwrite up to 40 billion pounds of loans to smaller companies struggling for credit.
(Writing by Keith Weir, editing by Mike Peacock)