My regular column is available to subscribers on www.thesundaytimes.co.uk This is an excerpt.

Spring has sprung with a vengeance for stock market investors. In recent days we have seen the Dow Jones industrial average close above 15,000 for the first time, Germany’s Dax hit record levels and the MSCI world equity index reaching its highest level since before the worst of the global financial crisis in 2008.

Even the FTSE 100 has been joining the party, trading comfortably above 6,500 and within sight, though not for the first time, of its all-time high of 6,930, reached as long ago as December 1999.

What lies behind this outbreak of stock market optimism and is it a harbinger of better economic news to come, or just a flash in the pan? Are markets, as some suggest, divorced from economic reality? A strong German stock market is, on the face of it, hard to square with an ongoing eurozone crisis and a European Commission forecast of continuing recession this year.

Stock market strength coincides with some evidence that, partly as a result of the eurozone’s woes, world growth is slowing. The April J.P.Morgan/Markit global purchasing managers’ index (PMI) dropped from 53 to 51.9 in April, signalling that while upturn was continuing, it was at its slowest rate sionce October last year.

Some economic news, it should be said, is consistent with market optimism. Investors were cheered by the 165,000 April rise in America’s non-farm payroll employment and a drop in the unemployment rate to 7.5%. Strong March German industrial production and manufacturing orders encouraged the view that its economy is riding out the eurozone recession.

Though the FTSE 100 is more usually moved by global developments, Britain’s economic data has improved. The 0.3% rise in first quarter gross domestic product was followed by stronger purchasing managers’ surveys for April and the announcement of a 1.1% bounce in manufacturing output in March.

The better news, together with the National Institute of Economic and Social Research’s estimate that GDP grew by 0.8% in the three months to April (helped by the recovery from a very weak January), has taken the sting out of the International Monetary Fund’s current visit to Britain.

Even Christine Lagarde, the IMF’s managing director and George Osborne ally, warned last month that Britain’s growth numbers were not good. They are still not great but they are looking better.

Ian Harwood, economist with Redburn Partners, says there is nothing in the global PMI to suggest that growth in the world economy is seriously faltering, and he sees some evidence that the upturn in global trade - which had stalled - is gaining momentum again.

But the stock market rally is not, to repeat, mainly a reflection of better economic news, though that does not make it irrelevant to the economy.
Equity markets are reflecting the fact that risks appear to have diminished.

Though the eurozone is still in trouble, the fear of imminent collapse has abated. Banks are not out of the woods but are inching towards something that resembles normality. Investors have moved from “risk-off” towards “risk-on” behaviour.

Stock markets are also benefiting, however, from what looks like a win-win situation, for the moment at least. Share prices gain when economic news is good, because that means companies should do better. But they can also gain when the news is not so good, because that increases the likelihood central banks will engage in further asset purchases - quantitative easing - thus boosting markets via that route.

Johannes Jooste of Merrill Lynch Wealth Management notes that even when economic data has disappointed, as some recent numbers from America and China have, “continued easy monetary policy supported global equity markets”.

The Bank of England’s monetary policy committee stayed its hand on Thursday but other central banks are engaging in plenty of unconventional activity in the form of asset purchases, including America’s Federal Reserve, $85bn (£55bn) a month, and the Bank of Japan with a monthly $79bn (£51bn).

The European Central Bank, which cut interest rates earlier this month, is contemplating purchases of asset-backed securities made up of loans to small firms. The Bank, with Mark Carney set to arrive within weeks, may not have done yet. This month has seen a slew of interest rate cuts, from central banks in India, Poland, Denmark, Korea, Vietnam and Australia, amongst others.

Central banks will see the rise of stock markets as a good thing. It is one way their policy gets transmitted to real economic activity. Booming markets boost wealth, increase business confidence and make it easier for firms - larger ones at least - to finance expansion.

Rising equity prices do not always signal there are better times on the way (or, for that matter, worse times when they are falling) but they are better than the alternative. In Japan, the rising Nikkei, up more than 60% since August last year, is regarded as a sign that the Abenomics of prime minister Shinzo Abe is working.

But you can have too much of a good thing. When does the rise in stock markets, given that much of it is driven by the actions of central banks, become dangerous? When does it become a bubble whose bursting would be very damaging?

The risks are there, and they are present in the fact that markets have moved well ahead of real economic activity. Markets that are mainly driven by monetary policy are, by their nature, unsustainable.

Any sign central banks were ready to start tightening policy, by raising rates or selling back some of the assets they have purchased, would send markets diving.

That may not be entirely logical: central banks would only start tightening if they believed the economy was well through the worst, but markets are not always logical. The danger is that central banks get trapped by the markets into keeping their foot on the monetary accelerator too long.

My regular column is available to subscribers on www.thesundaytimes.co.uk This is an excerpt.

On Thursday the European Central Bank (ECB) cut its official interest rate from 0.75% to 0.5%, its president Mario Draghi citing the fifth successive quarterly decline in gross domestic product (the eurozone has only escaped a triple-dip because it is still in a double-dip) and very weak economic sentiment.

Economic weakness has spread from the periphery to “core” economies such as Germany, France and the Netherlands, which had been doing much better. While the ECB expects an improvement in the eurozone economy later in the year, it warns that the risks are on the downside.

The English Channel is not that wide but it seems some clear blue water is opening up between Britain and the eurozone. It has been there for some time when it comes to unemployment. Eurozone unemployment, at 12.1%, is more than half as much again as Britain’s 7.9% rate. Youth unemployment, which ranges as high as 59% in Greece and 56% in Spain, is also significantly higher on average.

Britain’s growth performance, while nothing to write home about, is also beginning to pull away from the eurozone. The latest forecast from the National Institute of Economic and Social Research is for another year of recession in the eurozone, with gross domestic product contracting by 0.4% after a 0.5% fall last year. It predicts that Britain will grow by 0.9% following last year’s 0.3% rise. Next year it expects 0.9% growth in the eurozone but 1.5% in Britain.

These differences do not, of course, alter the big picture of a weak recovery in Britain, or the fact that there is nothing to celebrate about Europe’s troubles, given the dependence of the UK economy on eurozone trade.

Even on that, however, there are signs of something stirring; a hint of the necessary rebalancing away from excessive reliance on Europe.

The latest Markit purchasing managers’ index for Britain’s manufacturing sector showed a rise from 48.6 in March to 49.8 in April, while its eurozone equivalent slipped from 46.8 to 46.7.

More importantly, Britain’s manufacturers reported the strongest rise in export orders since July 2011, driven by “increased sales to clients in North America, the Middle East, Latin America and Australia”. Eurozone export orders, by contrast, remained depressed.

This is part of an ongoing story. In 2008, Britain exports of goods to the rest of the EU totalled £142bn. They slumped to £125bn in 2009, recovered to £142bn in 2010 and grew well in 2011, rising to £159bn. But last year they dropped again to £151bn, helping to explain 2012’s weak GDP growth.

Exports to the rest of the world, in contrast, fell by less in the crisis - dropping from £110bn to £103bn from 2008 to 2009 - but have been rising since: £124bn in 2010, £140bn in 2011 and £149bn last year.

It has been nip and tuck in recent months whether exports to the rest of the world are marginally higher or lower than those to the EU. In the latest three months, non-EU exports were ahead, and this is likely to be the shape of things to come.

Comparing 2012, when there was a rough 50-50 split between EU and non-EU exports, with the position 10 years earlier, shows how things are changing. In 2002 nearly 62% of exports went to the EU. This is quite a shift.

Though Britain’s top five export destinations last year - America, Germany, the Netherlands, France and Ireland, in that order - were the same as three years earlier, plenty is happening further down the list.

China is now Britain’s seventh largest export destination (from ninth in 2009) and Russia is up from 22nd to 12th. The old chestnut about Britain exporting more to Ireland than Brazil, Russia, India and China put together, has not been true for a while. Last year 7.9% of exports went to the BRICs, 5.8% to Ireland. Not a big enough shift yet but a move in the right direction. A decade ago only 2% of exports went to these economies.

Britain’s biggest exports by category last year, incidentally, were mechanical machinery, electrical machinery, medicinal and pharmaceutical goods, and cars.

It seems reasonable to plan on the basis of European markets continuing to be weak, as the eurozone crisis plays out. The structural, fiscal and demographic challenges Europe faces argue for subdued growth, at best, in coming years.

The question is whether Britain’s exporters can do more than just substitute stronger markets elsewhere for eurozone weakness, but create a long-lasting upturn on the back of the faster-growing parts of the world.

When economists look for a rapid response from exporters they often underestimate the challenge firms face in establishing themselves in new markets, a challenge that is particularly acute for smaller firms. These things cannot be just turned on with the flick of a switch, they require planning and investment and help from official bodies such as UK Trade & Investment (UKTI).

But there are at least some reasons to be optimistic. Research by the EEF, the engineering employers’ federation, suggests firms are gearing up rapidly in emerging markets, with a clear majority of the businesses it surveyed planning to invest in the development of these markets.

The EEF notes that the fastest growth in Britain’s exports over the past six years has been to Qatar, China, Russia, Brazil, Thailand, India, Australia, Singapore, Norway and Malaysia.

The main problem, it found, was that firms encounter protectionism in countries like Brazil and Russia, and threats to their intellectual property in China.

The government’s aim is to increase Britain’s exports of goods and services to £1 trillion by 2020, from £488 billion last year. It is a huge challenge, requiring export values to grow more than 9% a year, with most of the heavy lifting in exports to the emerging world. But it is challenge exporters have to take up - they need it to succeed. So does the rest of the economy.

My regular column is available to subscribers on www.thesundaytimes.co.uk This is an excerpt.

0.3 is a very small number, but in recent days it has been hugely significant for George Osborne. It featured, most obviously, in the first quarter gross domestic product figures, the 0.3% rise breaking the hearts of the chancellor’s critics and allowing him to claim the economy is healing. That may be premature; the recent pattern means further quarterly GDP declines cannot be ruled out.

But as small mercies go, this was welcome and should lead to upward revisions of 2013 growth forecasts. The consensus was for 0.1% and the Office for National Statistics has a penchant for nasty surprises.

The other 0.3 relates to public borrowing: the deficit. Since December, when the Office for Budget Responsibility (OBR) endorsed the Treasury view that borrowing in 2012-13 would be down on 2011-12 (against the run of the numbers), the worry was that this would turn out wrong.

In last month’s budget, even after strenuous efforts by Treasury ministers and officials, the OBR concluded the margin would be wafer-thin, just £0.1bn. It was indeed wafer-thin, but £0.3bn - borrowing fell from £120.9bn to £120.6bn - and as the OBR pointed out, initial figures have tended to be revised lower in recent years.

Growth, of course, is still weak, and borrowing very high; about £30 billion higher in 2012-13 than officially predicted at the time of Osborne’s first budget in June 2010. Public sector net debt is rising and at the end of March was £1,186bn, 75.4% of GDP.

So what’s changed? Well, the heat has been taken out the International Monetary Fund’s visit to Britain next month. A GDP fall would have lent weight to the call by Olivier Blanchard, its chief economist, for Britain to relax austerity.

That was never going to happen. Osborne told the IMF he would continue with his medium-term deficit reduction plan. The IMF’s own research, showing so-called fiscal multipliers are very small in Britain - tax hikes and spending cuts do less harm than elsewhere - made its chief economist’s advice look odd.

If too much austerity is doing damage it is in the eurozone, where latest German surveys were weak and Spanish unemployment has hit 27.2%. But the IMF declared eurozone fiscal policy broadly appropriate.

IMF fireworks have been avoided, as probably have fireworks at the forthcoming monetary policy committee meeting on May 9. The MPC will probably refrain from further quantititative easing, particularly with the extension of the Funding for Lending scheme until 2015. This does not rule out action when the new governor, Mark Carney, arrives, though he is playing down expectations.

The great virtue of the GDP figure, however, was it should allow a sense of perspective to be restored. Anybody listening to the debate over the past week might conclude that the case for austerity had evaporated as a result of errors and omissions in research by two American economists, Carmen Reinhart and Ken Rogoff.

Reinhart and Rogoff, famous for their book This Time is Different, on financial crises, published research three years ago showing government debt above 90% of GDP is associated with slower growth.

That is still their finding, as they are at pains to point out. One always implausible result - debt levels above 90% are associated with negative growth of 0.1% - has been rightly removed from the record by the discovery by University of Massachusetts economists of the error. But the big picture, growth around a percentage point a year slower at high debt levels, remains.

There are two essential points on this. The first is that many studies have shown high debt is associated with slow growth. A 2011 Bank for International Settlements (BIS) paper by Stephen Cecchetti and others, concluded: “Our results support the view that, beyond a certain level, debt is a drag on growth. For government debt, the threshold is around 85% of GDP.”

The IMF said in this month’s World Economic Outlook high debt overhangs lead to lower public and private investment and reduce room for manoeuvre. Other IMF studies found a 10% rise in the debt ratio associated with a growth reduction of 0.2%, while a 2011 study found significant negative growth effects with debt above 70%.

Of course there is nothing magical about 70%, 85% or 90%. Circumstances matter. When Britain ran debt of over 250% of GDP at the end of the Second World War it necessitated austerity but there was also a route out. The economy would return to peacetime spending, as war operations were run down. Debt to GDP halved in a decade.

It is different, however, when - as the Institute for Fiscal Studies pointed out in its green budget - without action to rein back the deficit - public sector debt would have been on a trajectory that would have taken it back up to 250% of GDP.

So we should step back from the often vicious debate among American economists. The case for austerity was never based on one paper, or mainly on the growth consequences of high debt.

It was about trying to stabilise an appalling deterioration in the public finances: a record peacetime budget deficit, a huge structural deficit and rocketing government debt and interest payments. It was about trying to avert a fiscal crisis.

That was why Labour proposed a Fiscal Responsibility Act with debt falling as a percentage of GDP by 2016, and why the coalition aimed, though will not achieve, an earlier fall. The sustainability of the public finances meant not letting debt rip.

What if the cure is worse than the disease? For austerity critics, the direction of causation is from growth to debt. In other words, if austerity had been less, growth would have been stronger.

That may be true in the short-term, though in Britain growth would have been weak even in the absence of austerity because of the credit crunch, falling real incomes and the eurozone crisis. Growth might have been slightly better at most but debt would have risen more.

In the long run, growth depends on the supply-side, not short-term fiscal or monetary activism. Look at high debt/slow growth economies like Italy and Japan. Japan’s current burst of expansionary policy will not change this. It is a slow-growth model Britain has to avoid.

My regular column is available to subscribers on www.thesundaytimes.co.uk This is an excerpt.

The old labour market rules have been turned on their head: there has been a revolution.

One of those rules is that when growth is weak, employment does not grow. That has not been true in the past 2-3 years. Even last week’s softer job numbers, which showed employment slipping by 2,000 to 29.7m in the latest three months, showed an increase of 488,000 on a year earlier.

And even in those numbers, full-time employment rose by 60,000 in the latest three months, while part-time employment fell by 62,000. Economic inactivity fell to its lowest rate since 1991.

The other rule, also apparently broken, is that pay (average earnings) rises more than inflation. I know this should be true, and not just in recent times. In the 1990s, the Bank of England marked its 300th anniversary (it was founded in 1694) by looking back on three centuries of inflation.

Its analysis showed that after a torrid time for workers in the Bank’s first 100 years or so, things then improved a lot. By the end of the 20th century real wages (i.e. adjusted for inflation), were six times their level in 1800.

Rising real wages were the norm, independently of the ebbs and flows of trade union power. In the 1980s inflation dropped as low as 2.4% but average earnings growth never fell below 7.5%. Now, of course, things are different.

The latest average earnings figures show growth of just 1% over the past 12 months. That is the lowest since the current data series began in 2001 but you would have to go back very many decades, probably to the 1930s, for anything lower. Excluding bonuses, earnings rose by only 0.8%.

Inflation, on the latest figures, is running at 2.8% (3.3% for retail price inflation). Real earnings are falling, as they have been for most of the past five years.

These two broken rules, employment rising in a subdued economy and prices outstripping prices, are part of the same story. Looked at positively, it reflects the great flexibility of Britain’s labour market: pay restraint making possible a higher level of employment.

Looked at negatively, as some do, it is employers exploiting economic fragility to hold down pay. Either way, it means that the wage bill is being shared among a larger number of people.

Flexibility has kept a greater number of people in jobs. Most of the recent net increase in employment, 88% of it in the past year, has been among British nationals. My attitude so far is that this is good news. Far better to have more people in work, even if their real pay is falling.

Now I am wondering if you can have too much of a good thing. Even if inflation gets back to the official 2% target, it will still be running ahead of current earnings growth. In fact, we may be entering a period in which both employment and wages are weak. That is not quite the worst of all worlds but it is heading that way.

So what should happen? Some say the minimum wage, which will rise from £6.19 to £6.31 in October, should rise much more. Others think that all employers should pay what has been defined as the living wage, the minimum needed to get by, defined as £7.45 an hour (£8.55 in London).

The living wage is an interesting idea, and has been taken up by some employers, but I do not think it would be good to impose either it or a much larger minimum wage on employers. That would not only hurt marginal workers but it could be the last straw for marginal firms.

I do think, however, the private sector as a whole would benefit from higher wages. They would feed directly into stronger domestic demand, sorely needed by business. Consumer spending remains well below pre-crisis levels and retail sales are struggling to gain any kind of momentum.

The weakness of private sector pay is striking. Total private sector pay in February was 0.5% down on a year earlier. Though this was dragged down by lower bonuses, the picture for regular pay, up just 0.6%, was barely better. Public sector pay, up 1.1%, was stronger.

Imagine the difference it would make to demand if private sector workers, 79% of the total, were given increases of 3% rather than next-to-nothing. The CBI would risk a a re-run of the “Red Adair” headlines it attracted when Lord Turner was its director-general and bemoaned the decline in the workers’ share of GDP, but should it not encourage its members to sign up to a 3% club, for employers happy to award pay rises that at least keep pace with inflation?

The potential advantages would not, of course, just come through in stronger demand. Thanks to the tax credits introduced by Labour and other in-work benefits, employers have been able to free-ride on government largesse. That gets more difficult now most working-age benefits are now capped at 1% (in line with earnings growth) but has meant many workers have been spared the full pain of the real squeeze on wages, because the state tops them up.

Stronger wage growth would benefit the public finances both directly and indirectly, restraining welfare spending and boosting tax revenues.

I know what you are thinking. If private sector firms paid their workers more, they would employ fewer of them. Wages going up would mean employment going down.

That is possible, though could be balanced by two factors. One is the employment-generating impact of the greater demand resulting from higher wages. The other is that firms, particularly large ones, have very healthy balance sheets. They may not feel confident enough to invest but for most a relaxation of wage restraint would be easily manageable.

The more telling argument is about productivity, which has barely risen in the past three years and on some measures has fallen. Isn’t weak pay the natural corollary of weak productivity growth?

Perhaps, but it may be possible to turn things around. It is not quite a question of paying peanuts and getting monkeys but declining real wages may not be a recipe for rising productivity. If workers are demoralised, stuck in a rut, it could take a decent pay rise to jolt them out of it, and into higher productivity. That 3% club could be worth joining.

My regular column is available to subscribers on www.thesundaytimes.co.uk This is an excerpt.

Lady Thatcher's death has produced an avalanche of remininscence and interpretation of the 1980s' decade. I was around in the 1980s, and have the suits and Filofax to prove it, The first chancellor I interviewed was her first, Sir Geoffrey Howe. But fear not, this is not going to be another stroll down memory lane.

Rather, I wanted to draw out a more fundamental lesson. At the recent Royal Economic Society conference, LSE professors Tim Besley and John Van Reenen presented the findings and recommendations of its Growth Commission. One of the most striking was in what they called “the economic story of the UK”.

From 1870 to 1980, Britain suffered more than a century of relative economic decline. The British economy grew but France, Germany, America and other competitor economies grew faster.

Since 1980 that has not been true. On a range of measures, Britain’s relative performance improved. There was a turnaround. From 1980 to 2011 - including the 2008-9 recession and some of the subdued recovery - gross domestic product per capita outgrew America, Germany and France. So did GDP per working-age adult. The productivity gap narrowed and in some cases was reversed. Things got better. North Sea oil helped in the first haf of the 1980s but made little difference over the period as a whole.

Some people are determined not credit Thatcher for any of this, or say that it was more than outweighed by the huge negative of the crisis. I’ll return to that.

I regard the LSE’s Van Reenen as a fair witness. He was no fan of Thatcher when younger. Had he been at the LSE in 1981 he would no doubt have joined the 364 economists who signed a letter protesting at her policies. The rise in inequality and failure to invest enough in infrastructure were significant downsides of the Thatcher era, he says. But he also gives credit where it is due for the supply-side changes that led to the improvement in Britain’s performance.

Those changes: union and other labour market reforms, removing industrial subsidies, privatising and regulating state industries, strengthening competition policy, membership of the EU single market, opening the door to inward investment and expanding the higher education system all contributed to the improvement. As he puts it: “Most, but not all of these were initiated by Mrs Thatcher.”

Her supply-side changes mainly survived, Helped by changes in the structure of the economy, there was no return to destructive union power or, despite some huffing and puffing from Labour, no renationalisation of privatised industries.

Under Tony Blair and Gordon Brown from 1997 there was some re-regulation of the labour market but this was partly balanced by an improved competition regime, with the Office for Fair Trading and Competition Commission. Tax got much more complicated, though until the very end of new Labour the consensus held that low rates of direct taxation were best.

In the long run, it is the supply-side that matters and Thatcher enacted a series of supply-side reforms. Those changes laid the foundation for Britain’s improved perforamce over three decades.

We should remember that. Though we devote acres to whether George Osborne should relax austerity or whether the Bank of England should announce £25bn of quantitative easing, supply-side policies matter much more.

So cutting corporation tax to 20% and other changes to try to make Britain a magnet for inward investment; tax and welfare changes to improve work incentives;, education reforms and the cut in the top rate back to 45% matter a lot more than the fiscal picture set out in the next budget or autumn statement, or the next meeting of the monetary policy committee.

You can see that in the macroeconomic record of the Thatcher government. Though fiscal policy was prudent - average cyclically-adjusted net borrowing of less than 0.5% of GDP over the period 1981-9 was close to a balanced budget - it was too tight at the start and too loose at the end.

Monetary policy was a dog’s breakfast. Sir Alan Walters, her economic adviser, pointed out in the early 1980s that 17% Bank rate and a sky-high exchange rate inflicted unnecessary damage on industry.

When, after many twists and turns, her period in office ended with Britain in the European exchange rate mechanism, Walters told me it would undo 30% of the economic gains made. As it was, despite an average Bank rate of 12%, she left with inflation back in double figures.

The consensus is that inflation-targeting in 1992, followed by Bank independence in 1997, improved considerably on the turbulence of the 1980s. It certainly led to much greater stability, with low inflation and interest rates. But that, in turn, fostered excessive risk-taking. Once fear of sharp upward lurches in rates went, many of the normal constraints were removed.

The search for the Goldilocks macroeconomic policy middle-ground - which neither scares the hell out of people nor encourages them to throw caution to the wind - will go on. But through short-term macro trials and tribulations, we should remember the supply-side. Anything that can be done to improve it, even or perhaps especially in difficult times, will pay dividends in the long run.

What about the crisis? Wasn’t there a direct route from Big Bang in 1986 to the banking collapse in 2008? Wasn’t that the legacy? No. People forget Big Bang was all about ending the stock exchange’s restrictive practices. It was not just unions forced to change their ways: the City’s cosy cartel ripped off its customers.

Big Bang helped London regain its position as the world’s leading financial centre but did not give a green light for irresponsibility to investment banks, which occurred long after she left office. If you want to pin the crisis on anything, pin it on the rise of America’s shadow banking system and the relaxation and eventual abolition of the Glass-Steagall restrictions on its banks.

She would have taken a dim view of the irresponsibility. Given her unhappiness with the Bank in the early 1980s, I suspect she would have taken a dim view of independence too. That would have left the Bank in charge of banking supervision. Whether it would have done better than the Financial Services Authority we will never know.

Monetary policy changed dramatically during Margaret Thatcher's period as prime minister, from hard-line or 'punk' monetarism to membership of the European exchange rate mechanism (ERM). This, from my book Free Lunch, explains how her period in office accounted for four of my seven ages of modern UK monetary policy. By comparison, the past 16 years have been remarkably stable.

There are seven ages of man and there are seven ages of modern UK monetary policy. It is a good way of looking at the trials and errors. Other countries have also groped for the ideal monetary policy, although few have done so as ineptly as Britain. If we go back a quarter of a century so, to the 1970s, this was a time of enormous turbulence for the world economy and near-disaster for Britain. It is also my first age of modern UK monetary policy, reluctant monetarism. In 1976 a near-bankrupt government had to call in the International Monetary Fund. This was the occasion for the burying of Keynesian fine-tuning. Peter Jay, sometime British ambassador to Washington, and economics editor of The Times and the BBC, drafted a speech for his father in law James Callaghan for the 1976 Labour party conference, which contained the immortal words ‘I tell you in all candour that you can’t spend your way out of recession’. The IMF’s prescription contained two main elements. It insisted on sharp cuts in public spending – the biggest by any government in the post-war period. And it forced the government to adopt monetary targets, to control the money supply or, more particularly, two measures of ‘money’, sterling M3 and for domestic credit expansion. There is no need to worry about the detail of what these were. The essential point was a simple one. To stabilise the economy, and to control inflation (which had risen above 26 per cent during 1975) it was necessary to control the money supply. There will be more on this when we meet Milton Friedman in the next chapter but the basis of this policy was quite simple – just as you cannot drive a car without petrol, you cannot have inflation without money. The faster that money is printed, and credit allowed to grow, the higher will be inflation. Targeting the money supply was by no means trouble-free. The Labour government found, as many governments have, that it was not possible to control the money supply and the exchange rate at the same time. By the time it lost the 1979 election inflationary pressures were starting to build up strongly. Even so, this ‘reluctant monetarism’ helped to save the economy.

In 1979, we had the second age, willing monetarism, under a Thatcher government philosophically committed to controlling the money supply as a means of limiting inflation.

Despite being acolytes of Friedman, the Conservatives chose a ‘broad’ monetary target, sterling M3, which he would not have recommended. They then proceeded to undertake other policy actions, notably the abolition of exchange controls – limits on the amount of currency and capital that could be taken in and out of the country - and of the Bank of England ‘corset’ (controls on the banks’ lending), which made it impossible to hit the targets for sterling M3. To this day many people think monetarism has something to do with public spending cuts. This was because the Thatcher government’s choice of money supply target was linked to the level of public borrowing, and therefore the amount of government spending. This phase of willing monetarism lasted two or three years, before giving way to third age, pragmatic monetarism.

By the early 1980s Charles Goodhart, then chief monetary adviser to the Bank of England, had come up with Goodhart’s Law, a kind of Murphy’s Law for economics. This did not say that if you drop a piece of toast it is bound to fall buttered side down but, rather, that any measure of the money supply you try to target will automatically become subject to distortions that make it hard to control. So the Conservative government adopted a more relaxed approach, making it clear that they still believed in controlling the money supply but also choosing to target a range of measures and not losing too much sleep if one or more of them missed the target. This approach worked pretty well. From 1982 until 1985 Britain had reasonable economic growth, albeit alongside high unemployment, and low inflation.

Unfortunately, sterling, the traditional Achilles heel of the UK economy, was still subject to periodic crises. In January 1985, not long after I had joined The Times as economics correspondent, the month began with interest rates at 9.5 per cent and ended the month at 14 per cent, sterling having come within a whisker of one-to-one parity with the dollar in the process. These days, we get excited when interest rates change by a quarter of a percentage point in a month and at time of writing they had not changed at all for well over two years. And so, in about 1985, Nigel Lawson, the then chancellor, became rather keen on taking sterling into the European exchange rate mechanism – the system of ‘fixed-but-adjustable’ exchange rates in Europe that had come into being in 1979 as a forerunner to the single currency. When Thatcher rebuffed him, he developed an alternative. Under the cloak of international efforts to stabilise currencies, the so-called G5 (Group of Five) and G7 (Group of Seven) Plaza and Louvre accords, that alternative was unofficial exchange rate targeting – shadowing the D-mark, my fourth age of monetary policy. How much was this responsible for the boom and bust of the late 1980s? Quite a lot, because interest rates were cut to try to hold the pound down. The earlier pragmatism was replaced by dogmatism, with dogma directed at preventing the pound from rising above three D-marks (Germany’s currency before the euro).

My fifth age is official targeting of the exchange rate – the ERM period. John Major was more successful than Lawson in persuading Thatcher of the virtues of joining the ERM, partly because he persuaded her that it was the route to lower interest rates. And so, when in October 1990 it was announced that the pound would be joining the ERM at an exchange rate of DM2.95, it was also announced that interest rates would be reduced at the same time. The problem with ERM membership was, however, the opposite of the one Major suggested, Far from being a route to lower interest rates, it blocked interest rate cuts at the very time they were needed. The combination of what was seen as a high exchange rate and the persistence of high interest rates meant that the period of ERM membership coincided with the 1990-92 recession. There was an additional complication. As a result of the pressures created by the unification of East and West Germany, German interest rates were higher than usual, and they set the pattern for the rest of Europe including, at the time, Britain. By the summer of 1992, the Conservative government, having narrowly won re-election in April 1992 (this time with Major as prime minister) was hanging on for dear life in the ERM. On September 16, 1992 the game was up. ‘Black’ Wednesday to the headline writers, ‘White’ or ‘Golden’ Wednesday to others, this was the day the Bank of England ran out of the reserves needed to prop up the pound within the system (it bought large quantities of sterling with its own foreign currency) but, thanks to George Soros and other speculators, it was to no avail.

The sixth age came after Black Wednesday and sterling’s departure from the ERM, and it can be called quasi Bank of England independence. In putting together a monetary policy framework out of the ruins of the ERM failure, and in doing it both quickly and in an environment where it seemed the government could fall at any moment, the Treasury and the then chancellor, Norman Lamont, performed a minor miracle. That framework, adopting an inflation target instead of money supply or exchange rate targets, requiring the Bank of England to produce a quarterly inflation report, and getting the Bank to advise openly and regularly on interest rate changes (this became the ‘Ken and Eddie show’ after Kenneth Clarke, Lamont’s successor and Eddie George, the Governor of the Bank) was enormously successful. It paved the way for the 1990s to be a period, after the disasters at the start, of non-inflationary growth, the holy grail of economic policy. From there it was a relatively short step to giving the Bank the job.

The seventh age is thus operational independence for the Bank in which the Bank sets rates to meet an inflation target, 2 per cent, set by the government Is this the final resting place for monetary policy? One is tempted to say yes. The possibility of Britain embracing Europe’s monetary union, the euro, under which the governor of the Bank would simply become a voting member of a large European Central Bank council, seems very remote. A question may arise over the Bank’s wider responsibilities, acquired in the wake of the crisis, for supervising the banks and the wider financial system. Errors made in this area could compound criticism of the Bank that emerged before, during and after the crisis. That criticism centred on the Bank’s failure, during a period its governor Mervyn King described as the ‘Nice’ decade (non-inflationary, consistently expansionary), to respond to sharply rising asset prices – mainly property – and rapid credit growth. This criticism, which was also directed at other central banks, and most notably the Federal Reserve, argued that an obsession with achieving low inflation meant that other dangerous developments were ignored. Had central banks adopted a more rounded approach, it was argued, they would have kept interest rates higher and used other methods to restrain credit growth, even if it meant measured inflation was below the official target. Such criticism persisted after the crisis, when soaring commodity prices and in Britain’s case a weak pound, pushed inflation up sharply. The ‘Nice’decade, more generally known as the ‘Great Moderation’, in which central banks seemed all-powerful, appeared to have benefited from considerable good fortune.

My regular column is available to subscribers on www.thesundaytimes.co.uk This is an excerpt.

What's changing in the economy? The promised rebalancing towards exports and investment has not occurred.

Nor, according to the Office for Budget Responsibility (OBR), should we hold our breath. Thnough it is optimistic on business investment from next year onwards, it does not see net trade contributing significantly to growth for the next five years.

Some things are changing, however. Last week I noted the financial sector’s shift from boosting growth to dragging on it. George Osborne wanted less reliance on financial services and has got it, though the effect on the measured recovery and the public finances suggests chancellors should be careful what they wish for.

There is another big change I want to focus on, and it concerns household debt. The rise and rise of debt has been one of the stories of our age. A nation of homeowners - nine-tenths of the debt is in mortgages - combined with easy credit availability to produce a striking increase in the amount owed by households.

From £239 billion at the beginning of 1987, household debt saw a more than fivefold rise to a peak of £1,550 billion at the end of 2008. Roughly £1 trillion occurred from the end of 1996. Though inflation played a part, debt rose from under 100% of annual household income to a high of 167.5%.

Times have changed. Household debt does not normally fall. In cash terms it carried on rising through the recession of the early 1990s, before regaining momentum as the recovery gathered strength.

This time, it has fallen. Not much, but it has fallen. At the end of 2011, household debt was £21bn lower than three years earlier. Though it has edged up a little since, it remains below its pre-crisis peak.

A more striking demonstration of this is when debt is measured against income. From that 2008 peak of 167.5%, it dropped to 141.4% in the final quarter of last year, according to the Office for National Statistics in its latest monthly economic review.

Nothing like this has happened before. Debt edged lower as a percentage of income in and after the recession of the early 1990s but not to any significant extent. This time the adjustment has been dramatic, and it many not yet have finished.

Why has it happened? If debt is to rise it needs to be available. Six years ago two-thirds of new mortgages came from so-called wholesale funding sources, rather than conventional bank and building society deposits. When the financial crisis hit, wholesale funding slowed to a dribble, turning mortgage feast into famine.

Even if mortgages had been available, households would still have been reluctant to take on debt. Debt appetite was replaced by an almost Pavlovian debt aversion.

If not, you might have expected individuals to compensate for the squeeze on their incomes by borrowing more. They did not do so, which is why consumer spending, despite a gentle rise since late 2011, is still 4% below pre-crisis levels.

People borrow when real incomes are rising and confidence high. It is not surprising falling real incomes and weak confidence results in a reluctance to borrow.

What happens now? The housing market is the key. Rising household debt is the natural consequence of a normally functioning housing market. Those who enter it, first-time buyers, do so with with debt, having taken on a mortgage to do so. Those who leave it, mainly older people, do so having paid off their mortgages years before. The net effect is a rise in debt.

Will the housing market ever function again in a normal way? The Funding for Lending scheme (FLS) has done a better job at boosting mortgage availability than it has in boosting small business lending, notwithstanding a small dip in mortgage approvals in the latest figures.

The Help to Buy scheme unveiled by George Osborne in the budget takes it further and has produced a curious reaction. The centrepiece of the scheme - £12bn of government guarantees to support £130bn of new mortgages over three years - seeks to address the mortgage famine that has so depressed housing activity.

Some of the criticism, suggesting it will create a sub-prime crisis in Britain, is preposterous. If we see mortgage lenders doling out loans to borrowers with no income, no jobs and no assets, America’s infamous Ninja borrowers, you might believe it. But that is not going to happen.

As for taking action at all, governments have always intervened in the housing market. In the 1970s local authorities were an important source of mortgage lending. For more than three decades homeowners received tax relief on their mortgage interest payments. A three-year time-limited scheme is modest in comparison.

Will the scheme pump up pver-inflated house prices? Prices have adjusted significantly, falling by by 26% in real terms since autumn 2007, according to the Nationwide building society. As Oxford Economics pointed out in the Institute for Fiscal Studies green budget, prices are now undervalued relative to their long-run trend.

The house price-earnings ratio is not a very useful measure of anything, but it has fallen by a quarter since before the crisis and, as Oxford Economics also pointed out, is in line with its average since the period of low interest rates began in the 1990s.

Will not government mortgage guarantees lead to the household debt burden rising? No. Even if Help to Buy results in £130bn of new mortgages over three years, which may be optimistic, the household debt ratio would not rise, based on what has happened to incomes in recent years. Nor is it likely to produce a new house-price boom: the scale is not there. Net mortgage lending was rising by well over £100bn annually before the crisis. £130bn over three years is small by comparison.

Should not people be encouraged to run down their debt further? There has already been unprecedented deleveraging and household balance sheets are healthy. Household assets are large in relation to income - 8.5 times according to the OBR - meaning that household net worth is 700% of household annual income.

That is not a bad position to be in. Some people took on too much debt in the run-up to the crisis and the overall level rose too quickly. But household debt, typically 25-year debt, of under 150% of annual income is sustainable. Encouraging it down much further will simply deprive the economy of the demand it needs.

My regular column is available to subscribers on www.thesundaytimes.co.uk This is an excerpt.

This is not a great time to be in the garden centre or outdoor attraction business. If you are a retailer hoping to sell spring and summer clothing lines, this may be time for a quiet weep.

Anybody selling last minute holidays in the sun is probably feeling pretty smug, notwithstanding the fact that this will add to a balance of payments deficit that swelled to a worrying £58bn last year. Our current account is badly overdrawn.

The combination of the bad weather and an early Easter has put gross domestic product(GDP) in the first quarter on a knife edge. It does not take much to tip a fragile economy into negative territory, though both the Office for Budget Responsibility and the OECD expect Britain to avoid the dreaded triple-dip by a wafer-thin margin.

Revisions last week to past data mean the double-dip at the end of 2011 and the beginning of 2012 has now almost disappeared, as we knew it probably would, but that does not change the big picture. An economy that by now would normally be growing well is struggling to gain cruising altitude, for all the reasons we know about.

Today I want to present a slightly more nuanced picture. Some parts of the economy, we know, are growing. A 0.3% rise in service sector output in January, just announced, is the main reason for hoping there will be first quarter growth.

The service sector, which accounts for 77% of GDP, had a milder recession than the rest of the economy and has has a better recovery, growing by 1.1% in 2010, 1.2% in 2011 and 1.2% again in 2012. It is just, 0.3%, above its pre-crisis peak, while the overall economy is still nearly 3% below its peak.
Dig a little deeper into services and an even more interesting picture emerges. Financial services, including insurance, account for just over a tenth of GDP (10.4%) and just over an eighth of services.

They have had a torrid time. Turnover in this broad definition of financial services is 9% down since 2009 - when the economy began to recover - and 12% below pre-crisis levels. Though there is tentative evidence that the decline in financial services is levelling off, it will be a long time before it contributes significantly to growth, as it did in the heady days before the crisis struck.

What happens if you exclude weak financial services from the rest of the service sector? You are left with 66% of the economy and you are left with a picture in which growth has been reasonably healthy by today’s standards. This two-thirds of the economy grew by 6% from mid-2009 to the end of 2012 and is 2% above pre-crisis levels.

Not all of this two-thirds of the economy could properly be regarded as strong. Retail, for example, has been roughly flat in volume terms since the economy turned up in mid-2009. Air transport is down.

There are, however, areas of considerable strength. The motor trade is up 11.4% since 2009, wholesaling 5%, publishing, audiovisual and broadcasting up 15.8%.

What the Office for National Statistics calls accommodation is up 6%, telecommunications 6.3%, computer programming and consultancy 14.6%, arts, entertainment and recreation 6.7%, legal, accountancy and architecture 9.2%, other professional and scientific services 17.4%, and healthcare (including the ringfenced National Health Service) 10.4%.

The fact that these services are doing well may seem to be of small comfort if the rest of the economy is collapsing. Even there, though, the picture is more nuanced than often thought. Within manufacturing, output of capital equipment is up 21% since 2009, while transport equipment, notably cars, is up a stunning 46%.

If you add the parts of manufacturing where growth is good to the lion’s share of services doing fine, the result is that 70% to 75% of the economy is growing at a reasonable rate but is dragged down by the rest.

We know what the rest is, apart from financial services. It includes North Sea oil and gas, down 32% since 2009. It includes those bits of manufacturing, including chemicals, basic pharmaceuticals, wood and paper and textiles, where growth has disappointed. And it includes construction which, though marginally up on 2009, it is more than 10% down on this time in 2011.

What are the implications of all this? For British economy-watchers, the biggest current puzzle is why employment has been so strong when recovery is so weak. This, I think, goes a long way to explaining it.

The number of people in work is 3.3% higher than its 2009 recession low point and 0.7% above pre-crisis levels. Service sector employment is 722,000 up on the 2009 low and 490,000 higher than at the start of 2008, when recession struck. Those increases are 2.8% and 1.9% respectively.

The weaker bits of the economy, meanwhile, have not been shedding jobs as much as expected, either because they are hoping for something to turn up, or for safety reasons. So North Sea employment, while not huge, is up over the past three years and manufacturing employment only down by 30-40,000. Employment in financial services, overall, is barely down.

The main exception is construction, where more than 200,000 jobs have been shed since the recovery began. But the big picture is that the bulk of the service sector is generating jobs at a significant pace (while also raising its productivity). The jobs puzzle may have been solved.

The second big question is about those parts of the economy that are dragging down the rest. Some of them may be beyond saving. There are parts of low-value manufacturing which will struggle even with a competitive exchange rate.

The decline of two of the struggling sectors, the North Sea and financial services, is explicitly linked to the unbalanced economy and that huge current account deficit. We still need to sell financial services to the rest of the world. It is important the sector is better regulated but not over-regulated to the point of impotence.

North Sea oil and gas has come through a period in which taxation provided a major disincentive and is now looking up but will take time to turn around. Construction is highly cyclical. The government’s own test for the Help to Buy initiative George Osborne unveiled in the budget is whether it results in more housebuilding.

The broader message is that most of the economy has been able to grow at a reasonable rate in a very challenging period. Some of the growing parts are the high-skilled sectors we will need in the future. In fact we will need more of them.

My regular column is available to subscribers on www.thesundaytimes.co.uk This is an excerpt.

What is left to say on the budget? By now, most people will have devoured the detail and it hasn't yet unravelled, though it is a bit battered around the edges.

Given George Osborne’s fourth budget was put together with considerably more care than his third, the chances of a big unravelling are not that high. Though this was a budget that disappointed on growth and borrowing, as foreshadowed last week, it was reasonably well-constructed.

On content, while it did not tick every box I set out last Sunday, it did quite a few of them, as well as a few I had not suggested. With little to play with, the chancellor found a lot to say.

This was never a budget with a large-scale assault on spending to pay for aggressive tax cuts. It was never going to be a “Plan B” spending budget.

Instead, there were positive, if modest, measures on jobs, including a new £2,000 employment allowance. Stamp duty is scrapped for “gazelles” (fast-growing firms) and there are funds for an industrial strategy aimed at replicating car industry success in 11 other sectors. The corporation tax cut to 20% in 2015 and a personal allowance in 2014 of £10,000 will top the list of coalition achievements.

Achieving the £10,000 target for the allowance may move it beyond the stealth tax cut described here last week. “Your first £10,000 free of tax” is not a bad slogan.

Some reaction to the Help to Buy scheme - equity loans and mortgage guarantees - was just silly. Anything that increases housebuilding and gets housing turnover up, as this scheme can if the details are got right, is welcome.

Housing turnover is half pre-crisis levels. Boosting it improves economic efficiency - allowing people to move for job reasons - and generates additional spending. When people move, they tend to improve.

There has even been some mildly encouraging post-budget news. The day after the budget official figures showed public borrowing in the first 11 months of the year nearly £3bn below last year’s levels, a significantly wider margin that the wafer-thin full-year £0.1bn deficit reduction predicted by the Office for Budget Responsibility.

The OBR had access to some but not all the figures, and March could be a bad month. But it is also quite possible some of the chancellor’s scramble to secure a face-saving deficit reduction this year will prove to have been unnecessary. There was also a welcome post-budget announcement of a 2.1% jump in retail sales last month.

One good retail sales figure does not, of course, turn muted growth into a strong recovery. It is how to generate that recovery, built on what Osborne described as combining “monetary activism with fiscal responsibility and supply side reform”, that I want to concentrate on.

What exactly might monetary activism mean? On budget day the Treasury published a 68-page review of monetary policy, the main conclusion of which was that the 2% inflation target, “which applies at all times”, should be kept.

So, sensibly, there was no adoption of a target range for inflation, or replacing the 2% target with one for the money value of gross domestic product. Though “at all times” means the Bank can choose when and how quickly it tries to hit the target, it was important to retain it.

The Bank has also been tasked with three things. When it is missing the inflation target it will have to set out clearly the trade-offs causing it do so so, for example if trying to get it down too quickly would push unemployment up too much. The Bank will be required to communicate.

It will be required to ensure that decisions by its new financial policy committee are co-ordinated with those of the monetary policy committee. To take a simple example, it would be odd if the FPC were reining back credit growth by recommending tougher capital controls on the banks while the MPC was trying to get more lending into the economy.

The Bank has also been set a specific task of investigating, in its August inflation report, whether it should issue what is known in the jargon as forward guidance based on intermediate thresholds.

That is a mouthful but in practice it means that the Bank would follow America’s Federal Reserve in, say, committing itelf to undertake further quantitative easing on a montholy or quarterly basis, until such time as unemployment drops below a certain level. The significance of the August inflation report is that it will be the first under Mark Carney, the new governor, who used such forward guidance in 2009 to signal to the markets that interest rates would stay low.

Is it a good idea? Sir Mervyn King has always insisted that the MPC takes one month at a time, not tying its hands for future meetings. Forward guidance would do that and could also run into the problem of leads and lags in monetary policy.

Suppose the MPC said it would do £25bn of QE each quarter until such time as unemployment is back to its pre-crisis level of 1.5m. Apart from the fact that the new norm for unemployment could be 2.5m rather than 1.5m, because of the damage the economy’s has suffered, the Bank could find itself overdosing on QE because it takes time for monetary policy decisions to be reflected in real economic data.

Would such guidance work? There is a lot of scepticism around. At a time when nobody expects a rise in Bank rate for the foreseeable future and most in the City expect more QE, why should forward guidance make any difference.

The circumstances when it might could be if growth picks up and the markets get it into their heads that interest rates will quickly rise in response. Guidance from the Bank that they won’t could prevent fear of higher rates nipping recovery in the bud.

Similarly, as it did last month, the Bank could make a habit of signalling to the markets that it will “look through” above-target inflation. The risk, of course, is that it looks through high inflation for so long getting back to 2% becomes unattainable.

The bottom line is that Osborne wants the Bank to become less opaque and mysterious, and more transparent. That, and the imaginative use of even more unconventional policies than the Bank has employed so far (an easy example of which is buying other assets than gilts) might help growth at the margin. But we should not expect it, on its own, to transform a slow-growing economy into something stronger. That will take time and patience.

My regular column is available to subscribers on www.thesundaytimes.co.uk This is an excerpt.

This week’s budget, it can be safely said, will be disappointing. George Osborne’s fourth risks being his most discordant yet.

It will be disappointing on growth. Weak fourth quarter gross domestic product and January’s awful manufacturing and construction numbers mean the Office for Budget Responsibility will revise down growth forecasts it made only three months ago.

It will be disappointing on borrowing. Unless Osborne has come up with another fiscal trick, his autumn statement triumph of announcing a drop in the budget deficit this year, badly wrongfooting Ed Balls, will have proved shortlived.

Both Osborne and the OBR will have egg on face if, as is likely, this year’s outturn is instead heading for an overshoot of several billion. It should be an open goal for Balls.

It will be disappointing in content. The more the chancellor is constrained by the deficit overshoot and the loss of the AAA rating, the more strident the demands have grown. To call some of those demands naive scarcely does them justice.

Perhaps a Tory government unencumbered by coalition could have slashed spending in its first three years, a Canadian-style short, sharp shock to cut the deficit faster and leaving room for the deep tax cuts beloved of the party’s right-wingers. It did not happen then and is not going to happen now.

Similarly, there are those who would have liked Osborne to emulate the Denis Healey of 1974-5, expanding spending when everybody else was showing restraint, and driving Britain into the arms of the International Monetary Fund.

It would also have been good then to seek an alternative to the big cuts in capital spending inherited from Labour. But that did not happen either. Osborne will announce a further shift from current into capital spending on Wednesday and the big cuts are in any case now behind us. More capital spending will be a theme of the June 26 spending review (surprisingly announced ahead of the budget).

I would be surprised, however, to see a big and explicit increase in borrowing to pay for more infrastructure. That would be too close to a Plan B to present it as a continuation of Plan A, particularly after last month’s ratings downgrade by Moody’s.

Any activism, it seems, will be on the monetary side, with speculation focusing on a looser inflation target for the Bank of England and the new governor, Mark Carney, being given carte blanche to do whatever it takes to boost the economy.

How disappointing will the numbers on Wednesday be? John Hawksworth of Price Waterhouse Coopers expects an £8bn borrowing overshoot this year - so not even close to the deficit reduction officially predicted in December - and for similar overshoots to carry forward to future years.

As for growth, Ross Walker of RBS expects the OBR to predict 1% growth this year, 1.8% next. These forecasts are down marginally on the autumn statement predictions but well down on a year ago, when they were 2% and 2.7% respectively.

What can Osborne do to make his budget less disappointing? He has to do a better job defending the government’s srategy than David Cameron did 10 days ago. To those who say austerity has been a failure, he could point as the Institute for Fiscal Studies did in its green budget to the alternative of Britain’s public sector debt being propelled on an unsustainable path, taking it first to 100% and then to more than 200% of gross domestic product.

The alternative might have been a full-blown fiscal crisis, an International Monetary Fund programme, many ratings downgrades and 10-year bond yields closer to Italy’s (BBB+ rated) near-5%, rather than below 2% as Britain’s are.

Though GDP continues to disappoint, it is not hard to think of an alternative in which employment growth would have been weak or non-existent and unemployment, instead of being under 8%, closer to the eurozone’s 12%, or even the higher rates among its weakest members.

So things could have been worse, but that is not much to build a budget around. What else should there be? I would like to see five things.

On tax, Osborne has spent many billions raising the personal allowance towards its £10,000 target, heading off increases in petrol duty and moving towards a target corporation tax rate of 20%.

All have merits but also shortcomings. Raising the personal allowance is a stealth tax cut. Most do not notice it, while they did notice the 2011 Vat hike. Postponing duty hikes, similarly, means petrol prices have merely risen somewhat less steeply. Business has not responded to lower coporation tax with an investment boom.

So, to the extent that there is any money at Osborne’s disposal, and there always is a little, it should be targeted at specific incentives to get firms to invest in new capacity and home-owners to invest in job-generating home improvements.

On infrastructure, I can’t understood why, when so much of the 2010 Tory mainfesto was torn up for coalition reasons, the commitment on no new airport capacity in the south-east remained sacrosanct.

That is unjustified and the most positive infrastructure signal Osborne could send now would be a commitment to build a third runway at Heathrow. A new London airport in the Thames Estuary is, like HS2, a project for later. We cannot wait that long.

On housing, a proven generator of jobs and growth, progress is being made, via the Funding for Lending scheme (FLS) and an array of other initiatives aimed at first-time and new home buyers.

These should be expanded and talk of redirecting Funding for Lending away from housing forgotten. Social housing has a big role too. Housing associations have been bypassing the banks, raising money directly for new developments through bond issues. We need much more of that.

As for small and medium-sized firms, the FLS is the latest in a series of damp squibs for the sector. While some banks have broken through the barrier of mutual suspicion, others have not, or do not want to. The case for direct lending, giving a government-backed business bank genuine financial welly, grows stronger by the day.

Finally, on the Bank of England, Osborne should be wary of changing its remit in a way that endorses a permanent inflation overshoot but he should encourage the Bank to think more imaginatively about ways of boosting growth.

I would get the Bank to take an active role in building markets for securitised (packaged) small business loans and infrastructure bonds. These and housing association bonds could be swapped for some of the £375bn of gilts the Bank has bought under quantitative easing. Whether this would succeed in generating growth we do not know. You never know until you try.

My regular column is available to subscribers on www.thesundaytimes.co.uk This is an excerpt.

What happens in Europe doesn’t stay in Europe, and right now the picture there is downbeat.

The dampening effect of the eurozone crisis will be one of the factors George Osborne cites in his March 20 budget (of which more next week), and was highlighted by David Cameron in his infamous economic speech a few days ago.

He meant to say that the eurozone, high oil prices and the prolonged banking crisis explained why growth has undershot the Office for Budget Responsibility’s forecasts of three years ago, not the tax increases and spending cuts it had alreday incorporated into its forecasts. But it came out differently, hence the rebuke from the OBR.

But the eurozone is the biggest risk to Britain’s recovery hopes this year, and it remains the central threat to the world economy, in spite of the calming effect of the European Central Bank’s pledge to buy the government bonds of troubled eurozone economies.

Figures last week confirmed that eurozone gross domestic product fell by 0.6% in the final quarter of last year, which included falls of 0.8% in Spain, 0.9% in Italy and 1.8% in Portugal. Even Germany succumbed, down 0.6%. A quarterly figure for Greece was not available, but its GDP was 6% down year-on-year; grim for a recession that began in 2008.

Eurozone unemployment, 19m, or 11.9% of the workforce, has risen by 1.9m in the past year. The European Central Bank, like the Bank of England, sat on its hands on Thrusday but confirmed a 2013 recession for the eurozone, predicting a drop of between 0.1% and 0.9% in GDP this year.

Some say Britain’s problems are unrelated to the eurozone’s woes but that is plainly not the case. Apart from the crisis’s effects on confidence and bank funding, it has impacted heavily on Britain’s hoped-for export-led recovery.

Between 2009 and 2012 exports did recover, by 11% in volume terms, though imports rose at a similar rate. Exports to non-EU countries have risen strongly, by 31% in volume terms, while EU exports have been much weaker.

Since 2009, Britain’s GDP has risen by 2.9%. Had exports to the EU risen as strongly as non-EU exports, GDP would have increased by 8.7%, close to 3% a year, and nobody would be talking about the economy’s failure to recover.

Even if a stronger eurozone economy had simply resulted in 21% rather than 11% overall export growth. the recovery would have averaged a respectable 2% a year.

But the eurozone crisis is the cross Britain’s exporters have to bear. When will it end or is Europe doomed, like Sisyphus, to keep trying to push the boulder up the hill, only to have it roll down again?

We are used to visions of eurozone disaster as set out by British economists. Roger Bootle of Capital Economics did it well recently at the Institute of Economic Affairs, arguing convincingly that the eurozone is not sustainable in its present form, that it will condemn Europe to prolonged economic misery and that partial break-up will be part of the solution, not the problem, for Europe.

What you do not expect is to get equally doom-laden assessments of the eurozone’s prospects from the heart of Europe. The Munich-based CESifo is one of Germany’s “five wise men” institutes, and is headed by Professor Hans-Werner Sinn, one of the country’s leading economists. It has just published its 2013 European economic advisory group (EEAG) report on Europe.

The report highlights, as I have taken to doing, the fact that there is not a single eurozone crisis but three inter-linked ones: the sovereign debt crisis, the banking crisis and what it describes as a balance of payments crisis.

As it puts it: “Large imbalances have emerged in the euro area since 2000 in the form of current account deficits and surpluses. The euro area periphery countries of Greece, Portugal, Spain and Ireland in particular experienced credit bubbles that led to current account deficits and corresponding capital imports.”

Credit bubbles were accompanied by a loss of competitiveness, with the troubled eurozone economies gradually moving further and further away from Germany, Europe’s benchmark economy, losing between 20% and 30% competitiveness since the euro came into being.

What that means, as well as sorting out banking problems and putting sovereign debt on a secure footing (which for countries like Greece will mean further write-offs), the problem economies have to claw back that lost competitiveness.

There are two ways of doing that. One is so-called internal devaluation; cutting their costs, in particular their wage costs. It is, as the EEAG report notes, likely to be painful, involving “prolonged recession and high unemployment”.

The other route, external devaluation - leaving the euro- is no easier, it says, boosting public sector debt, driving companies into mass bankruptcy, with even anticipation of a euro exit causing “destabilising capital flight and contagion effects”.

It is not all bad news. Ireland is held up as an example of a country that is meeting the challenge of clawing back competitiveness, not least because its crisis erupted about two years before the others.

For most of the others, however, progress is painfully slow or non-existent. Italy, having had chronically weak growth for years, is in a political crisis and was downgraded to BBB-plus by Fitch on Friday. France, which is having a torrid 2013 judging by the surveys, is not immune.

Does not the euro hold together as long as Germany will finance it? As Sinn put it wryly: “We love the French, they lover our money.” But German pockets are not bottomless. Germans are suffering a wage squeeze and face the challenge of an ageing and declining population.

Not everybody is so gloomy. Berenberg, a German bank, in a new report, says: “If the eurozone and its member countries stay the course, the euro crisis could be largely over by the end of the year.”

It thinks the weaker countries are making better progress in restructuring their economies than CESifo believes. Even here, however, there is a sting in the tail. France, it says, is not making progress and urgently needs economic reform. My take would be harsher; that France is goijng backwards under Francois Hollande.

We need to hope that the optimists are right and that the eurozone is closer to resolving its crises than appears. Britain needs growth, not fog, across the Channel. But Europe has disappointed before. The fear is that it will do so again.

My regular column is available to subscribers on www.thesundaytimes.co.uk This is an excerpt.

When the Bank of England was made independent in 1997, I thought it was an excellent move. What better way was there to protect the economy from flaky politicians? The days of interest rate cuts timed for party conferences or to secure a pre-election political advantage would surely be over. Low inflation would be safe in the Bank’s hands.

Now, the boot is on the other foot. George Osborne, responding to the Moody’s downgrade, has shown a lack of flakiness so far, saying it strengthens his determination to cut the deficit. The Bank is another story. It has taken me longer than some but I am no longer so sure monetary policy is safe in its hands.

As most will have seen from the headlines, a few days ago Paul Tucker, one of the deputy governors, took the Bank into new territory by floating the idea of negative interest rates. “I hope we will think about whether there are constraints to setting negative interest rates,” he said in evidence to MPs on the Treasury committee. “This is an idea that I have raised.”

He was talking about the possibility of a negative rate on some of the £280bn of reserves commercial banks hold at the Bank, with a view to encouraging them instead to lend into the economy. He probably did not expect it to be reported as a new assault on savers.

The confusion was, however, justified. Bank rate is what the banks receive on their reserves. To pay them a negative rate without penalising everybody would require an entirely different system, which is one reason why Charlie Bean, Tucker’s fellow deputy, distanced himself from it the following day. He would need some convincing that such a policy would work to justify the shake-up it would require.

The confusion did not end there. Markets, encouraged by speeches by Sir Mervyn King, and the monetary policy committee’s (MPC’s) own minutes, had got used to the idea that quantitative easing, £375bn so far, was being paused while the Bank gave the £80bn Funding for Lending scheme time to work.

Now, the Bank appears back in full QE mode. It emerged 12 days ago that three of its members, including King, voted for a further £25 billion of QE. Tucker told MPs that “nobody on this committee thinks that QE has reached the end of the road”.

Paul Fisher, his colleague, the Bank’s executive director for markets, said in a speech he favoured a “prolonged run” of gilt purchases. He also said, curiously, the Bank was wary of distorting markets. Surely purchases of gilts equivalent to 25% of gross domestic product are distorting?

This outbreak of hyperactivity from senior Bank people does not seem to have been driven by any deterioration in the economy. The bottom line is that the Bank is prepared to relax policy further - nobody will be surprised by another £25bn of QE this Thursday - even as its forecasts (which are usually optimistic) show inflation above target for at least the next two years.

This has not gone unnoticed in markets. BNP Paribas says there is “total confusion” over the Bank’s use of its policy tools. J.P. Morgan says the Bank’s policy framework is “creaking” and that there is a “shambles” over the issue of when it will seek to bring inflation back to target.

These are not the only worries. The Bank, by tradition, refrained from comments on the pound. I recall, at an IMF meeting in Prague in autumn 2000, trying to get Eddie George, the previous governor, to say something about sterling, which was strong (1.70) against a sickly euro.

I thought it was a subtle question but Eddie saw straight through it. He didn’t quite say: “I didn’t get where I am by talking down the pound”, but it was close. The last thing the Bank wanted was to be associated with a sterling slide.

Times have changed. Short of erecting a sign on the front of the Bank saying “Sell Sterling”, it could barely do more than signal its desire for a lower pound. King has been a champion of sterling depreciation, if that is not a contradiction in terms.

When he introduced the Bank’s November inflation report he said it was hard to see anything other than a “slow and protracted recovery” in the absence of a fall in the real exchange rate. The pound duly obeyed, vying wih the yen as the weakest major currency of 2013. In its latest minutes, the MPC noted the “expansionary impetus” from the pound’s fall.

Martin Weale, a fellow MPC member, in the most explicit endorsement of a lower pound, said in a speech on February 16 it was the “most natural” way of resolving Britain’s balance of payments problem.

The trouble with this is that we have already had one of the the biggest sterling falls in history, the 25% drop in its average value in 2007-8, the effect of which has been to push up inflation through higher import prices while doing little for exports. There is no reason to believe a further fall would be any different in its effects.

The pound, clearly overvalued against the euro in 2000 when it was 1.70, is undervalued now at 1.16. It should not be falling against a euro whose problems go beyond the tendency of Italians to vote for clowns. For the Bank to try to push it down is wrong.

What can be said in the Bank’s defence? Its senior officials seem determined to show, before the summer arrival of Mark Carney, that they are capable of imaginative thinking on monetary policy, even if those ideas come to nothing.

There is something in this, though it represents a late flowering for what has always come over as a conservative institution. There is also a proper way to convey new ideas, not in impromptu answers to Treasury committee questions.

The Bank can also argue that the inflation it influences is under control. Average earnings are rising by 1.4%, while the gross domestic product (GDP) deflator, which measures economy-wide inflation, rose just 1.1% in the past 12 months.

These are not, however, the things the Bank is supposed to target. It has rarely hit the 2% inflation target in the past eight years and, on its own forecasts will not do so in the next 2-3 years. A decade of above-target inflation is, for any central bank, flaky. The Bank has lost its compass.

My regular column is available to subscribers on www.thesundaytimes.co.uk This is an excerpt.

Why is Britain's productivity - the amount we produce per worker - in such a bad way? Why, relative to other countries, is it going backwards?

Official figures showed that in 2011, output per hour in Britain was 16 percentage points below the average for the rest of the G7 (America, Japan, Germany, France, Italy and Canada). The productivity gap, on this basis, has not been wider for two decades, since 1993.

Every hour worked in America produces 27% more output than in Britain; 26% more in France, 22% in Germany and even 3% more in Italy.

The gap when measured by output per worker was even larger, 21 percentage points. The rest of the G7, in other words, is roughly a fifth more productive than Britain. America, on this basis, is 39% more productive than Britain.

Should we be bothered? Yes. In another release, unusually, the Office for National Statistics(ONS) quoted Paul Krugman, the Nobel laureate turned New York Times columnist, and his observation that: “A country’s ability to improve its standard of living over time depends almost entirely on its ability to raise output per worker.”

Krugman’s slightly snappier version is that “productivity isn’t everything, but in the long run it is almost everything”.

The weakness of productivity is directly linked to another phenomenon highlighted by the ONS: falling real wages. Adjusted for inflation, average earnings in Britain have been falling since 2009 and are now back at the levels of 2002-3. For the self-employed, the picture is even grimmer: real incomes are a fifth lower than they were a decade ago.

As far as the growth in real pay is concerned, it is almost as if the period between the Queen’s golden and diamond jubilees never happened. Worse, with inflation still running more than a percentage point above average earnings, the fall in real wages is not yet over.

I had always thought that the drop in real wages was a function of what we must now call the Bank of England’s “flexible” inflation targeting regime, as elaborated on by Sir Mervyn King in presenting his penultimate inflation report.

The Bank, in other words, is prepared to tolerate years of above-target inflation because it thinks the alternative would be worse. But that above-target inflation, as often noted here, stands in the way of meaningful consumer spending recovery.

The productivity numbers, however, suggest another explanation, which is that real wages are so weak because we are falling behind on productivity. It is not quite “pay peanuts and you get monkeys” but it does suggest employers have little choice but to hold down pay because productivity is so poor.

Britain, is seems, is turning into a low wage/low productivity economy or even a falling wage/falling productivity economy. It is particularly galling because only a couple of weeks ago I quoted figures showing that, starting in about 1980, Britain had reversed her long-term relative productivity decline. The good work, it seems, is being undone.

So how worried should we be? Are we condemned to falling living standards and never trading our way out trouble? If you have ever wondered why Britain’s exports are not doing better, a chart in the Bank’s inflation report provided an explanation.

Wages have been weak, but productivity even more so. Combining the two gives unit labour costs and Britain’s relative unit labour costs, what the Bank calls the real effective exchange rate, is up by between 15% and 20% over the past four years.

The question is how permanent is the poor productivity performance. Here, there are one or two grounds for optimism. Weak productivity since the financial crisis hit has been a European phenomenon, experienced by Germany, which we do not think of as busted flush, as well as Britain.

Countries that have done well in maintaining jobs, such as Germany and Britain, have done much worse on productivity. America, in contrast, had a much bigger drop in employment (and still suffers from higher unemployment than Britain) but has done better on on productivity. That is the way the arithmetic, always of course subject to statistical revision, works.

Second, most economists believe that Britain’s productivity weakness is temporary and will recover. History suggests it is is rare for economies to hit a brick wall.

Even the Bank’s monetary policy committee, which has been accused of productivity pessimism, is basing its new forecasts on what it describes as “a gradual revival in productivity growth” and allows for the the possibility that it could recover more rapidly than expected.

Finally, we should look at the particular causes of the productivity problem in recent years, over and above the need for more investment (the more capital per worker, the higher the labour productivity) and higher skills.

ONS research shows that plunging North Sea output, without a matching drop in the number of workers, has hit productivity hard in recent years. Without this, measured productivity would have grown by 1% a year more. Though North Sea output appears to have stopped slumping, we may have to wait for shale gas for a sustained productivity boost from energy.

The other important sector is financial services. Before the financial crisis iits productivity growth rate was more than 4% a year. Since it, productivity has been falling by nearly 3% a year.

That is not the only consequence of a smaller and neutered financial services sector. The Bank governor lamented the drop in Britain’s financial services exports, another reason why the current account deficit has remained stubbornly large.

The North Sea will never get back to its glory days and, whether glorious or not, the City will struggle to regain its former highs. That leaves the onus on the rest of the economy, particularly the wider service sector where productivity is below levels at the depths of the recession, to raise its game, partly by adopting better and more efficient ways of doing things. The alternative is declining living standards.

We do not have to be productivity pessimists. But we do need to work at generating higher productivity.

My regular column is available to subscribers on www.thesundaytimes.co.uk This is an excerpt.

In the past few days we have heard for the first time in Britain from the new Bank of England governor, we had a report on the economy from the Organisation for Economic Co-operation and Development (OECD) and we have had the Institute for Fiscal Studies’ always insightful Green Budget.

Any of these, in a normal week, would provide sufficient material for a column. Let me deftly, I hope, combine them.

Regular readers will not need reminding of the difference between fiscal and monetary policy, though the lines may have become a little blurred.

Fiscal policy, the preserve of the chancellor, is being tightened, through tax hikes and spending cuts. That leaves monetary policy, which from July 1 will be under the leadership of Mark Carney, to do the heavy-lifting or, as George Osborne put it: “Action by the Bank of England can and should continue to support the economy”.

The Bank, which on Thursday left interest rates unchanged at 0.5%, as it has for nearly four years, and maintained the amount of quantitative easing (QE) at £375 billion, would argue that this is precisely what it has done.

This loose money/tight fiscal demarcation - cut the deficit but keep the economy afloat with the lowest interest rates on record, topped up with QE - is the OECD’s favoured prescription. In its annual survey of Britain’s economy, it said that “monetary policy is the primary tool to stimulate the economy” and that “the fiscal stance remains appropriate”.

It backed Osborne’s decision in his December autumn statement to allow the so-called automatic stabilisers to operate - don’t raise taxes or cut spending further to offset a deterioration in the public finances due to weak growth - but does not think the solution to Britain’s growth problems lie with a “Plan B” or any other junking of the coalition’s fiscal strategy.

The question, however, is why loose money/tight fiscal, having generated strong recovery in the 1930s, late 1970s, 1980s (eventually) and 1990s, has struggled this time. Compared with the 1990s, sterling has fallen a lot more - 25% versus 14% - interest rates are plainly lower (real interest rates more so), and QE was not even a twinkle in the Bank’s eye then.

One explanation is that a damaged banking system means monetary policy is far less effective than usual, and there is plainly some truth in that. The other is that it could have been done a lot better.

Carney, in a marathon evidence session to the House of Commons Treasury committee, was urbane, polite about his new colleagues and mainly gave straight answers. He dismissed Lord (Adair) Turner’s idea of a “helicopter drop” of money (not literally) to boost the economy.

Advocates of a ripping-up of the Bank’s existing framework, and its replacement by a money GDP target with a more explicit commitment to growth, did not receive much encouragement. He praised what he described, and which Sir Mervyn King has taken to calling, Britain’s “flexible” inflation targeting regime. If that means the Bank doesn’t hit the target very often, it is a pretty good description.

But coming through the new governor’s testimony - accompanied by a 45-page written submission - were two messages. The first was that monetary policy has not yet reached the end of the road; I doubt if he would have taken the job merely to mop up what was done under King.

The second is that the Bank under Carney will be more open in the way it communicates its actions (there was a hint of that with the long statement that accompanied its no-change decision on rates). And it will be more imaginative in its use of “unconventional” policy - I cannot imagine him being content merely to carry on buying large quantities of gilts (UK government bonds). It will look for new ways of stimulating the economy.

The Bank’s slavish commitment to QE through gilt purchases, which has run into quite significant opposition for its effects on pensioners, is in some ways forgivable. Nothing quite like this, or at least on this scale, had been tried in Britain until 2009.

But if the definition of insanity is doing the same thing over and over again and expecting different results, there is an element of this in the Bank’s decision to persist with its existing model of QE. Quite what a new model might be is not clear but at the very least should widen the range of assets the Bank is prepared to buy.

If monetary policy could be improved, so very clearly could fiscal policy. The IFS’s Green Budget was clear that spending cuts and tax hikes were necessary, without them the budget deficit would still be around 11% of GDP and public sector debt would be on a trajectory that would take it to 250% of GDP in the coming decades.

But the IFS was also clear of the serious shortcomings in fiscal policy. Both Labour and the coalition thought the path to budgetary salvation lay with slashing public investment: the element of spending that has the biggest impact on growth.

Under current plans, meanwhile, welfare spending will rise from 28.5% of all government spending by 2010 to 32.5% by 2017-18. Some would say welfare feeds directly into the economy because those who receive it spend everything they get.

But the lion’s share of extra welfare is going to the elderly and, while those on low incomes do spend what they receive, that is not true for old people as a whole: they have relatively low propensity to spend.

If the “welfare up/investment down” split looks illogical, so does the fact that, in spite of headline government commitments to squeezing public sector pay, it has continued to go up, managers choosing instead to shed workers, which they will continue to do, to the tune of 1.2m in all.

There is also, as the IFS identified, a huge question about whether cuts to departmental spending can be delivered. These, real-terms reductions of a third in non-ringfenced departments by 2017-18, have barely begun. Only 21% have so far been delivered. Small wonder the IFS thinks tax hikes after the 2015 election will be used an alternative to some of them.

So there is a lot of work to be done to improve the effectiveness - and deliverability - of fiscal and monetary policy. Faster growth, the IFS notes, would help resolve some of the fiscal dilemmas.

As the excitement over Carney’s arrival has grown, I have taken to paraphrasing Monty Python and saying: He’s not the Messiah, he’s only a central banker. If he can deliver the growth that gets the government out of the fiscal mess, however, he really would be a miracle-worker. It promises to be an interesting year.

My regular column is available to subscribers on www.thesundaytimes.co.uk This is an excerpt.

A few days ago an unusual report was published on Britain’s economy. It set out some good ideas about how to generate growth over the medium and long-term through infrastructure, innovation, education and skills.

More striking, for me at least, the London School of Economics (LSE) Growth Commission stressed that Britain approaches the future with very conisderable advantages, and an economy that is far from broken.

I count myself an optimist but even I was surprised at some of the findings about our recent economic history. In the past 30 years or so, for example, gross domestic product per head has risen more rapidly than in advanced-country competitors.

As the Commission put it: “Despite the current gloom, the UK has many assets that can be mobilised to its advantage, including strong rule of law, generally competitive product markets, flexible labour markets, a world-class university system and strengths in key sectors, with cutting edge firms in manufacturing and services.

“These and other assets helped reverse the UK’s relative decline over the century before 1980. Over the following three decades, they supported faster growth per capita than in the UK’s main comparator countries – France, Germany and the US.”

Yes you are thinking but wasn’t this all the City? The financial services sector may not be broken but it is badly damaged and likely to remain so for some time.

Again, however, the report finds that the idea of a City-dependent Britain before the crisis is an urban economic myth. Between 1997 and 2007 market (private) sector productivity, output per hour, grew by 2.8% a year, of which only 0.4% came from financial services.

Business services contributed twice as much (0.8%) to productivity growth, industry (1.1%) almost three times. On other measures, as the report notes, growth before the crisis was no “finance-driven statistical mirage”.

The problem since the crisis has, of course, been lack of productivity; jobs are up while GDP has struggled. Again, however, Britain has been far from alone on this. The pos-crisis producivity record has been almost identical to Germany, and similar to Italy and France. Only America stands out among the big advanced economies, because the shakeout of jobs was much more brutal there.

The Commission’s co-chairs were tLSE economics professors Tim Besley and John Van Reenen and its members included Rachel Lomax (ex Bank of England deputy governor), Chris Pissarides (Nobel prize-winning LSE economist), Richard Lambert (ex CBI director-general), Lord Browne (former BP chief executive) and Lord Stern (economist and climate guru).

The LSE is on a roll. Last week it was granted a Regius professorship of economics by the Queen, an improvement in royal relations compared with autumn 2008, when she famously asked at the LSE why nobody had spotted the crisis coming and was not impressed with the answer.

The Growth Commission uses a German word, Schadenfreude, to describe what it sees as the attitude many Britons have to the economy and the way it is reported, “revelling in stories of national decline”.

This is not just the bonkers fringes of the City, media and internet with their constant talk of imminent national collapse. It has always been the case that doom-laden economic stories are more likely to find their way to the top of a news bulletin or the front page of a paper.

The economy is the ultimate political football. Nobody is happier than an opposition politician when economic news is dire. Ministers rarely acknowledge the contribution of an opposing party, When did you last see politicians of different parties working together in the national economic interest?

Yet the lesson of the past 30 years is the reversal of a century-long relative economic decline was not the product of one leader’s time in office. It may have started with the Thatcher reforms of the 1980s but it continued under John Major and Tony Blair.

There are some very good recommendations in the report. On infrastructure, it calls for a new strategy board, planning commission and bank, to get plans approved, financed and implemented, particularly in transport and energy.

On “human capital” it calls for a range of further improvements in schools and teacher quality, and to ensure Britain’s universities can continue to attract international talent, by exempting bona fide students from the cap on net immigration. It also has a range of proposals for tackling the traditional Achilles’ heel, intermediate workplace skills.

These and other proposals to boost investment and innovation, including a greater competition in retail banking, a business bank and new regulatory incentives to encourage long-termism in investment decisions, add up to a meaty package, which politicians should take seriously.

Perhaps the most serious message, however, is for politicians themselves. One reason for the success of the past 30 years was continuity. Eighteen years of Tory government folowed by 13 of Labour offered a degree of stability. Labour did not tear up much it inherited from the Tories.

That cannot be guaranteed. The LSE Commission suggests a National Growth Council whose role would be to challenge governments when growth-friendly policies were not being pursued, and to offer the continuity to pursue a long-term growth programme. As it says: “The absence of stable machinery at the centre of of government makes it more difficult to develop a long-term strategy for promoting economic growth.”

Politicians are not good at the long-term, though perhaps the commitment to HS2, the new high-speed train, is an example of a new approach. Typically, they think of the next budget or, as now, the next Bank governor.

But, while the Right sees the solution in tax cuts, and the Left in boosting spending, and while Mark Carney is seen by some as an economic messiah, the solution to Britain’s growth difficulties does not lie with short-term fiscal and monetary measures.

People have to believe that history did not end with the crisis, and the Growth Commission offers some encouragement. It does not believe, for example, that Britain’s growth rate has been permanently lowered, or that “the pre-2008 improvements in the UK’s economic position relative to the EU and the US are likely to unravel”.

For that optimism to be justified, the economy needs a sustained increase in investment in infrastructure, private sector capacity, education and skills. The gauntlet has been thrown down. The politicians should pick it up.

My regular column is available to subscribers on www.thesundaytimes.co.uk This is an excerpt.

Thanks to Friday’s figures, gross domestic product once again dominates the agenda. The GDP numbers, showing a 0.3% drop in the fourth quarter of 2012, completed a year in which Britain’s GDP was exactly flat, both comparing 2012 with 2011 and the fourth quarter of 2012 with the corresponding quarter of a year earlier.

Squaring that with another measure of how the economy is doing, the 552,000 rise in employment over the past 12 months, the biggest since the late 1980s’ boom, is hard to do. Squaring it with a 113,000 rise in full-time employment in the September-November period is as challenging.

The fact that GDP fell owes a lot to energy shutdowns, which reduced it by 0.2% over the quarter and a drop in "sporting activities" (you can't have the Olympics every quarter) which had a similar effect. Even so, when the economy is weak enough to be pushed off course by such factors, it is weak.

So GDP it is. Does its weakness mean, as Olivier Blanchard, chief economist at the International Monetary Fund has suggested, the government should re-think its austerity plans by the March budget?

No. The IMF is a strange body. Christine Lagarde, its managing director, has been something of an international cheerleader for the coalition’s fiscal strategy.

Last month the IMF published a working paper by three of its economists, Anja Baum, Marcos Poplawski-Ribeiro and Anke Weber, showing that the impact of tax increases and spending cuts on Britain’s economy, so-called fiscal multipliers, is very small.

Blanchard has a different view, which the Treasury is not taking too seriously because, though he is chief economist, his is not the IMF view. Whether or not the IMF does recommend a change of strategy we will not know until May, and its next detailed consultation, known in the jargon as an Article IV consultation.

It looks unlikely, not only because that work on the multipliers suggests austerity is not to blame, but also because the government has not tried to stick to deficit reduction willy-nilly. In the face of weaker growth it allowed borrowing to take some of the strain, allowing what economists call the automatic stabilisers to operate.

So why is GDP growth so weak? A paper by economists from Liverpool and Manchester universities, to be presented at the Royal Economic Society’s annual conference in April, argues strongly for a financial rather than a fiscal explanation for the slow recovery.

The most striking result from the research, which chimes in with the IMF’s detailed work, is how little difference the coalition’s austerity has made to growth. You cannot raise taxes and cut spending without some impact on growth. The point is that this impact has been small.

The economy has grown by roughly 0.5% a year since the coalition took office. In the absence of austerity, it would have grown only a little more strongly, perhaps 0.75%, the research suggests. The unemployment rate would have been a fractional 0.1 points lower annually.

Given the risks Britain faced if there had not been a programme to cut the deficit - the danger was of a full-blown fiscal crisis - this is a small price to pay.

The paper, The Impact of Stock Market Illiquidity on Real UK GDP Growth, by Chris Florackis, Gianluigi Giorgioni, Alexandros Kostakis and Costas Milas, focuses on the key role of liquidity - the availability of funds in the banking system and elsewhere - in Britain’s recent performance.

The drying up of liquidity in 2007, when the financial crisis hit, was a key factor in the severity of the recession. By the same token, it has been a significant constraint on recovery.

The Bank of England, responding to the crisis by providing liquidity to the financial system, and through quantitative easing, has tried to offset the liquidity drought and credit crunch. It has not, however, been able to eliminate the financial hangover.

Sir Mervyn King, in Tuesday’s final regional speech as Bank governor, in Belfast, barely mentioned fiscal policy as a factor in the slow recovery. Instead, as well as the high-inflation squeeze on real take-home pay and the eurozone, he focused on another financial factor.

The problem, he said, was “the extent to which the balance sheets of the major UK banks had grown before the crisis hit, and had been financed primarily by borrowing.

“So the subsequent reduction in bank lending – the deleveraging – was greater here than in many other countries. That deleveraging has as its counterpart a reduction in the amount of (broad) money in the economy and a reduced willingness on the part of banks to expand lending.”

These effects - the financial hangover - were predicted in one of the most important books of recent years, This Time is Different: Eight Centuries of Financial Folly, by Carmen Reinhart and Kenneth Rogoff.

It demonstrated that not only are banking and financial crises more common than we think but that they also lead to far deeper downturns and slower recoveries than normal cyclical recessions.

Rogoff is a former chief economist at the IMF who speaks sense. There is a debate among economists, particularly Americans such as Robert Gordon, about whether the West has reached the end of growth, because the technological progress that has driven living standards for 250 years has, no pun intended, run out of steam.

Rogoff does not believe that, though does think there is a risk the malaise we are suffering after the financial meltdown undermines long-run prospects. One danger is if new businesses that typically drive innovation and new products are strangled at birth by lack of credit.

When I asked him about the dilemma of economies such as Britain caught in a Reinhart-Rogoff slow recovery, he was clear that the solution does not lie on the fiscal side, or at least not with a fiscal stimulus.

The government, he said, could to shift resources to those areas of spending which boost long-term growth, such as infrastructure and education, and away from what he describes as entitlements. George Osborne has been trying to do a bit of this.

What the government also has to do is avoid getting to what he describes as the “rarefied air” of government debt rising above 90% of GDP. Britain has passed an important milestone, according to figures released last week, with public sector net debt rising from 69.3% of GDP in November to 70.7% in December, thus rising above 70% for the first time since the early 1970s.

Get above 90%, says Rogoff, and you get lower growth on a sustained basis that can last for decades. The financial hangover would be compounded by a fiscal millstone. That has to be avoided.

My regular column is available to subscribers on www.thesundaytimes.co.uk This is an excerpt.

A point that is not often made about the long period since the global financial crisis struck is that the world has behaved pretty well in these difficult times.

Beginning with the big G20 (Group of 20) meetings in 2008, countries decided co-operation was better than confrontation. The feared mass outbreak of protectionism, one of the great errors of the 1930s, never happened.

It is as well that it did not. World trade has slowed even without new trade barriers being erected. 2012 looks to have been one of those rare years when world trade grew more slowly than world GDP (gross domestic product). Normally trade grows roughly twice as fast.

Before we congratulate ourselves too much, however, we should keep an eye on what Simon Derrick, chief currency strategist at Bank of New York Mellon, describes as an outbreak of currency wars.

There is more than one way of skinning a cat in times when growth is hard to come by. Protectionism is one. Currency manipulation, often harder to detect, is another. And now we are seeing it.

Much of the focus so far has been on Japan, under its new Liberal Democratic Party prime minister Shinzo Abe, elected late last year. Earlier this month he unveiled a 10.3 trillion yen (£72bn) stimulus to boost the moribund Japanese economy.

But he also signalled what many saw as an explicit attempt to drive the yen lower, in order to boost exports, by urging the Bank of Japan to adopt a looser monetary policy and a higher inflation target.

Abe was pushing at an open door. The yen had already weakened significantly in the final few weeks of the outgoing government, also following a clear lead from the authorities that they favoured a lower exchange rate.

So what? Why should not Japan, which needs all the growth it can get - and some inflation to break out of its deflationary trap - not engage in a deliberate depreciation of its currency? Isn’t this its affair?

Well no, as Derrick points out. Deliberate currency depreciation is counter to the pledges that countries, including Japan, have made in the G20 not to do it. Not only that but one country’s competitive advantage is another’s loss.

South Korea, Japan’s big competitor in electronics, cars and other products, has seen its currency, the won, rise 22% against the yen since last summer. A Hyundai executive described the won’s rise and yen’s fall as “a double-torture situation”.

While describing it as “smoothing operations”, the governor of the Bank of Korea confirmed last week that it has been intervening to try to restrain the won’s rise.

A battle among two of Asia’s most formidable exports does not yet amount to a full-blown currency war but the danger is that it is heading that way.
There are only three big currencies in the world, the dollar, the euro and the yen, with sterling coming in fourth.

European officials appeared relaxed about the euro’s rise since the summer. A stronger euro could be seen as a vote of confidence in the single currency’s survival; market approval for the European Central Bank’s monetary “bazooka” - its outright monetary transactions - and Germany’s more conciliatory attitude towards Greece.

Lately, though, European leaders have been getting restive. The euro’s climb includes a 14% ascent against the weak yen, a fact not lost on German exporters who often have to compete head to head with their rivals from Japan.

Jean-Claude Juncker, head of the eurogroup of eurozone finance ministers, said on Wednesday that the single currency’s rise had taken it to “dangerously high” levels. With domestic demand depressed across the eurozone, exports have been seen as the escape route from its problems. But a sharp slowdown in the German economy to 0.7% growth last year, with a fall in GDP in the final quarter, suggests growth from that source is fading.

Everybody, it seems, wants a weak currency. America, despite its currency quarrels with China, has quietly been pursuing a weak dollar policy since the crisis began, the Federal Reserve under Ben Bernanke ensuring the dollar stayed low with repeated bouts of quantitative easing (QE).

The dollar’s average value is 12% lower than it was before the crisis. Its average value in 2012 was a huge 31% down on its level of a decade earlier.
America’s weak dollar policy has had repercussions. Brazil was one of the countries which protested, and took action, when the effect of Washington’s QE was to push its currency, the real, lower.

Switzerland, caught between the race to the bottom between euro and dollar, established a ceiling for its currency against the euro, and intervened to make it stick.

Britain is not immune from these skirmishes. On Thursday, the pound dropped below 1.20 euros for the first time in nearly 10 months, mainly as a result of the euro’s strength but also because of worries over the the potential loss of Britain’s Triple-A sovereign debt rating and the size of the current account deficit.

There were times when the pound’s fall would have been regarded as bad news. Indeed, there were times when it would have led to a rise in interest rates to defend it. These days it is different.

Sir Mervyn King said in November that sterling’s rise last year was “not a welcome development”. Introducing the latest inflation report, he said: “It may be unreasonable to expect anything other than a slow and protracted recovery absent a further fall in the real exchange rate.”

The Bank should be careful what it wishes for. Though Britain’s large current account deficit - more than £50bn last year - argues for a lower pound, and some of sterling’s safe-have appeal has been wearing off - a lower pound is no panacea.

Indeed, the response of Britain’s trade to sterling’s 25% fall over the course of 2007-8 can only be described as disappointing. Add in that a lower pound undoubtedly contributed to higher inflation, pushing up both industry’s costs and squeezing household incomes. Sterling’s fall was a big factor in the unprecedented weakness of consumer spending in this recovery.

Some countries, including Japan where the ongoing danger is deflation not inflation, are better placed to benefit from a lower exchange rate. But there is one clear and simple fact. All currencies are relative to each other. It is a logical impossibility for everybody to have a lower currency.

Competitive devaluations, as we have seen, cause tensions. The danger is that those tensions lead to a full-blown currency war. That has to be avoided.

My regular column is available to subscribers on www.thesundaytimes.co.uk This is an excerpt.

Stock market performance does not always reflect what is happening in the real economy. Many emerging economies have lousy stock markets. Though it has picked up recently, China’s Shanghai composite index is barely a third of the peak it reached a few years ago, in spite of the Chinese economy’s rise.

Conversely, this year’s strong opening for the FTSE-100, taking it to its highest levels since well before the collapse of Lehman Brothers in September 2008, does not seem to reflect any discernible improvement in Britain’s economic performance.

It does, however, reflect something that may impact on that performance, a perception among investors that the risks of another nasty downward lurch in the global economy have diminished.

So China, predicted by some pundits in recent months to be facing a definite hard landing, appears to have come through its mini-crisis rather gently and is gaining a strength which should mean growth of more than 8% this year.

America, judging from the data and surveys, was not too worried about the fiscal cliff shenanigans and has started 2013 with what looks like reasonable momentum.

Even the eurozone appears to be out of the emergency ward with Olli Rehn, the economic affairs commissioner, declaring that the dangers of a eurozone split are over, and Herman van Rompuy, the EU president, declaring that the “existential threat” to the euro was over and that growth should soon resume.

A pinch of salt is necessary. If we listened to the predictions of EU leaders there would never have been a eurozone crisis, let alone one that posed the biggest risk to the world economy and threatened the single currency’s very survival.

Stephen Lewis, veteran City economic commentator with Monument Securities, warns that America’s fiscal problems and the eurozone crisis will return to haunt markets, with Cyprus and Portugal as the next likely flashpoints.

Even so, the nature of the process of recovering from crises is that things do not go from dreadful to perfect overnight. Healing takes time. The more confidence there is that the healing process is under way, however, the better things will start to look, including in Britain.

What does the economy need this year? It needs the supply of credit to improve, so there is a big onus on the Treasury-Bank of England Funding for Lending scheme. It needs inflation to come down and stay down, restoring real incomes and boosting consumer spending. It needs some of the government’s initiatives on infrastructure spending to start showing through.

And it needs, as described above, the fear of new crises to be replaced by a sense that the world is coming through it. Apart from the direct effects on Britain of the eurozone crisis - with exports to the region down by 6% over the past year - it has been the biggest dampener on business confidence.

There are one or two glimmers of a change. The British Chambers of Commerce (BCC), in its latest quarterly survey, reported stronger readings for most of the measures of activity among its members it monitors. There is, it said, “resilience among UK businesses, coupled with rising confidence that the outlook will improve”.

The fourth quarter showed an improvement compared with the third, the BCC said, including a “marked increase in confidence which ... reinforces our view that the economy will recover slowly in 2013.” Though business still yearns for those untroubled pre-crisis days, export readings for the service sector were better than their pre-recession average in 2007.

The BCC, interestingly, sees a very different picture for what was happening last year than the Office for National Statistics. When the official figures were in double-dip territory in the first half of the year, it thinks there was growth, though is sceptical about whether there was any Olympic lift in the third quarter.

It is not the only hopeful sign. The Recruitment and Employment Confederation, with KPMG, takes the temperature of the job market each month. Its latest survey showed employment continuing to rise and job vacancies at their highest for 20 months.

So what will 2013 look like? Four years into a recovery 1% growth is not a lot to ask for. But, though it partly depends on the fourth quarter gross domestic product number in 12 days’ time, which will be depressed by Friday's weak manufacturing numbers. We can hope for more if the international clouds really do lift, but 1% may be as good as it gets.

The job market, having performed extremely well, will continue to generate new jobs. But employment may merely rise in line with the increase in the workforce, so the claimant count measure of unemployment will probably stay close to 1.6m and the wider Labour Force Survey measure remain within sight of 2.5m, barring a growth surprise.

As for the great rebalancing of the economy, we await final figures but the 2012 deficit is likely to have been well over £50 billion, from £20 billion in 2011. If the eurozone does hold up, a narrowing to £40 billion is likely this year; still very large.

I hope inflation will be closer to 2% than 3% or even 4% by the end of the year but anything lower than 2.5% looks optimistic.

There will be plenty to write about Mark Carney, the new Bank of England governor, before and after his arrival from Canada in the summer. He may signal that rates will remain low for a long time (as they have already) but I would not look for any change from 0.5%.

One day Bank rate will go up, reflecting a shift to more favourable economic conditions and a belief among the rate-setters that the economy is strong enough to take it. But, though I hope and believe things are slowly improving, we are not there yet I fear.

My regular column is available to subscribers on www.thesundaytimes.co.uk This is an excerpt.

Somehow, one senses, the word "triple" is going to feature quite a lot in discussions of the economy in the coming months: the triple-A rating ands the debate over a triple-dip recession..

Some City economists had thought it unlikely gross domestic product will have slipped back in the final quarter of 2012 (which would give the first leg of a triple-dip).

But weak purchasing managers' surveys for construction and services in December have put it back on the agenda - Markit, which prepares the data, expects a 0.2% quarterly GDP fall, and it is always unwise to second guess the Office for National Statistics, which will have its first stab on January 25. More before then.

This week let me look at that other triple, the triple-A rating. Britain’s AAA sovereign rating, having survived until now, is plainly under threat. All three of the main ratings agencies, Standard & Poor’s, Moody’s and Fitch, now have the country on negative watch or negative outlook.

I know what you are thinking. Why should we take any notice of ratings agencies, which have still not redeemed themselves for their performance ahead of the global financial crisis, when they scattered AAA ratings like confetti around securities that turned out to be junk.

The loss of the AAA rating, more likely than not from at least one of the agencies this year, matters less than it did. Had it happened three years ago, when America and France still enjoyed AAA status, it would have emphasised Britain’s particular vulnerability. But it would be a big political event, embarrassing for George Osborne, and reflect genuine concerns about Britain’s public finances.

There are many reasons why you might worry about Britain’s public finances. The loss of the revenue cash cows of the past, including corporation tax revenues from the City and the North Sea, is biting hard.

Weak growth, for reasons mainly not connected with fiscal tightening, is preventing the kind of virtuous circle Britain enjoyed in the 1990s, when a strong upturn under Norman Lamont and Kenneth Clarke resulted in a rapid deficit reduction.

One of the biggest problems, however, and it is not a new one, is welfare. Britain, as the Institute for Fiscal Studies’ excellent A Survey of the UK Benefit System points out, really is a welfare state.

Some 30m people, almost half the population, receive one or more benefit. The bill for all this is more than £200 billion a year, “£3,324 for every man, woman and child in the country”, and the equivalent of 13.5% of GDP and 29% of spending.

Seventy years from Sir William Beveridge’s hugely significant report, which called for the elimination of the “Five Giant Evils” of squalor, ignorance, want, idleness and disease, the welfare state has spread far beyond what he would have envisaged, without eliminating those evils.

Social security spending was just 4% of GDP at the dawn of the welfare state. In 40 years, from the early 1970s, it has risen more than 300% in real terms, double the increase in the size of the economy.

Welfare spending rises in good times and bad. It is hard to think of a period more conducive to control of welfare spending than the Blair years, 1997-2007.

But Labour ignored its welfare reform minister Frank Field’s good ideas. And, without pressures from rising unemployment, spending rose nearly 3% a year in real terms. The welfare state and entitlement culture expanded.

It goes on. So far this fiscal year (April-November) cash spending on net social benefits is up by 5.9% on a year ago, largely because of the 5.2% April uprating of most benefits. Welfare is easily the fastest-growing element of government spending.

Can it be turned around? The coming year is a big one for welfare. 2013-14, the fiscal year that begins in April, will on official forecasts be a rare year in which spending falls in cash terms.

The Office for Budget Responsibility predicts the cost of social security and tax credits will drop from £210.4bn this year to £207.7bn in 2013-14, under the impact of child benefit restrictions, restricting the employment support allowance and limiting to £500 a week total household benefits.

Then it resumes its rise, reaching a projected £230.7bn in 2017-18. That incorporates the 1% limit on annual rises in most working-age benefits for three years, on which parliament will vote on Tuesday.

The 1% limit announced in the autumn statement preserved the so-called automatic stabilisers (not taking money out of the economy when public finances have deteriorated for cyclical reasons) by recycling the cash saved - and more - in extra capital spending and raising the personal tax allowance.

It does not, in itself, represent the kind of far-reaching reform Britain’s welfare state needs. It is not yet clear the plans of Iain Duncan Smith, the work and pensions secretary, which revolve around the new universal credit, do so either.

As with other elements of government spending, we need to re-examine what the country can afford. This does not mean an attack on the poorest, nor should it. It does mean trying to steer the welfare state, for working-age people as well as pensioners, back towards its original purpose. A country in which half of people are on some kind of benefit can never be healthy, even if every attempt to rein it back results in squeals of protests from interest groups.

The 1% limit is a stop-gap. But this week’s vote is nevertheless important. Labour is opposing the change, as it has opposed other cuts, even some of those it set in train when in government.

If the coalition were to be defeated, which looks unlikely, the signal it would send out would be that Britain lacks the political will to tackle the welfare state and deal with the deficit.

Labour would no doubt celebrate the loss of the AAA rating, and the pressure it would put on the government. But something has to give. The fiscal arithmetic requires either further welfare cuts, as Osborne has indicated, or cuts in public services that may be impossible to deliver. This week’s political battle over welfare is the first of many.

My regular column is available to subscribers on www.thesundaytimes.co.uk This is an excerpt. The table that accompanies this article in the newspaper is also available on www.thesundaytimes.co.uk

Even in a flat year the mood ebbs and flow, often quite dramatically.

This time last year the eurozone appeared to be teetering on the edge of the abyss, threatened by its own internal economic contradictions as well as by the politics. I know some very prominent people who thought it was only a matter of time before Europe dragged us back into extreme crisis.

Maybe it was only disaster postponed but it has to be said that this both underestimated the readiness of the European Central Bank, under Mario Draghi, to do “whatever it takes” to keep the euro show on the road, and the determination of European politicians not to let the single currency fall apart.

So the euro survived, and hedge funds and others made money out of betting that it would. There were some tricky moments, notably between the first and second Greek elections, but the eurozone, battered and weak though it is, struggles on.

There was a time when, as far as Britain was concerned, the dreaded double-dip looked like being avoided. In January and February surveys suggested some surprising spring in the economy’s step, despite the eurozone's woes.

One bit of the economy, however, had only concrete in its boots. The construction industry, down very sharply in the first quarter, weakened further in the second and third. Without teh fall in construction there would have been no drop in gross domestic product in the first quarter and a smaller fall in the jubilee-affected second.

As it is, we will have to wait for a few more data revisions to see whether the double-dip, and in particular the small 0.2% quarterly fall at the start of the year, survives long enough to make it into the economic history books.

Nobody expected much growth in 2012. We await fourth quarter GDP figures, which will be published on January 25, but for the moment there is no reason to doubt the assessment of the Office for Budget Responsibility, and the consensus, which is that the economy contracted by a modest 0.1% last year.

Unusually, there were some growth forecasts that were too gloomy. Standard Chartered’s bold prediction that the economy would contract by 1.3% proved to be a little too bold. On the other hand, the hope of some forecasters, that this would be when the economy finally got into its stride was also too optimistic.

Most forecasters, it should be said, did OK by aiming low on growth, but not too low. However, most were also taken by surprise by the continued strength of the labour market.

The lowest forecast for the unemployment claimant count at the start of the year was 1.6m and the average was a shade under 1.8m. The outturn was 1.58m. I will say it again: there is something odd about an economy that apparently does not grow but generates something like half a million net new jobs.

Long ago, economists used to swear by the Phillips curve, the inverse relationship between unemployment and (wage) inflation. The good news on employment and unemployment has indeed been balanced by disappointment on inflation, though not wage inflation, which has remained subdued at sub-2% rates of increase.

The Bank of England gets kicked for always predicting that inflation will return to the official 2% target. To be fair to the Bank’s beleaguered forecasters, however, that was the consensus view at the start of the year, with an average prediction of 2.1%.

Some thought weak growth would drag inflation below target but it was not to be, even if we came close to target in September. The latest inflation reading, for November, was 2.7%, closer to 3% than 2%.

The other disappointment has been on the twin deficits - the budget deficit and the current account. 2012 was the year when deficit reduction ran into serious headwinds after a couple of successful years.

This had less to do with the government’s austerity programme being self-defeating than two other factors: the sharp and unexpected weakness of corporate tax revenues, particularly North Sea revenues, and the fact thaat the low hanging fruit of deficit reduction has already been picked.

We are on the brink of the most important month of the year as far as the deficit is concerned. The Office for Budget Responsibility (OBR) is looking to healthy January self-assessment receipts to put the public finances on track. But it is touch and go whether the deficit falls this fiscal year and there will be egg on face for the chancellor and OBR if it does not. I imagine Ed Balls, the shadow chancellor, is looking forward to that one.

As for the current account deficit, official figures just before Christmas showed that it narrowed to £12.8bn in the third quarter, from £17.4bn in the second. But that still meant a deficit of 3.3% of GDP, and red ink for the first three quarters of the year of £42bn. I have not reason to doubt the consensus view the full-year deficit will be around £54bn.

Exporters have been hit by the eurozone’s weakness but this is still hugely disappointing. The current account deficit narrowed from £37.4bn in 2010 to £20.4bn in 2011, suggesting the economy was undergoing some kind of rebalancing. Now that process has gone backwards.

The economy could do better but which forecasters did best. The clear winner this time is the Economist Intelligence Unit, and congratulations to them. They have been pushing upwards in my forecasting league table for the past couple of years, from 11th in 2010 to 3rd last year. Now they are unchallenged for the top spot.

The EIU got most of the big numbers spot on, only slipping up slightly on unemployment. But nine out of 10 is a great performance in what remains an unpredictable era.

Congratulations too to Deutche Bank, oln its own in second place. Its forecast was closer on growth than the EIU but a little further away on the other variables. Along with most others, they expected the current acoount to do better than it did.

The OBR, like the Bank, gets a lot of flak for its forecasts but its 2012 effort was not bad, and was in the top half of the table. Some of those in the relegation zone at the bottom suffered, like Standard Chartered, from being too bold. Others appear in the Treasury’s monthly compilation of forecasts but handicap themselves by not predicting all the variables.

We will see whether things reverse themselves next year.

My regular column is available to subscribers on www.thesundaytimes.co.uk This is an excerpt.

More than two decades ago Richard Giordano, an American, became the first boss of a British firm, the industrial gases group BOC, to be paid £1m a year.

Now another North American, Mark Carney, Canadian governor-designate of the Bank of England, is blazing the trail for salaries in the public sector. He will get no less than £874,000 a year, including a £250,000 housing allowance.

This is the equivalent of the pay of 42 newly-qualified nurses though perhaps a fairer comparison is within the Bank itself, where the new governor will get more than Sir Mervyn King (£305,368) and Paul Tucker and Charlie Bean, his two deputies (£258,809 each), combined.

External members of the monetary policy committee, on £131,771 - £30,000 of which is intended for them to put into their pensions - may suddenly feel impoverished. External members of the new financial policy committee, on £55,000, are Threadneedle Street’s poor relations.

There are caveats. Carney, like external MPC members, must make his own pension arrangements. The Bank’s non-executive directors say including him in the generous but now-closed pension fund for King and his deputies would have cost at least 100% of salary. The cost of employing him would have been at least double King’s £305,368 salary. That does not, however, explain the big housing allowance.

The Treasury insists you get what you pay for and, in an internationally competitive market, securing a man George Osborne describes as “the outstanding central banker of his generation” is worth a significant public investment.

Certainly if the new governor had steered Britain through the crisis relatively unscathed, as with Canada and her banks, nobody would begrudge adding a couple of zeros to that salary. We will never know. The two economies are very different and we cannot have an exact re-run.

Carney will earn his salary and more, however, if he helps deliver the economic holy grail of non-inflationary growth alongside a safe banking system that supports such growth.

On the latter, he will inherit a system already undergoing far-reaching changes. The challenge is to combine banking safety, including higher capital requirements, with a sufficient supply of credit into the real economy. We are some way away from that.

As for the quest for non-inflationary growth, the challenge is just as great. Last week saw disappointing inflation figures, with consumer price inflation remaining at 2.7% in November, still stubbornly above the 2% target, and set to go higher.

Some analysts think King will have one final letter to write to the chancellor in the coming months, explaining why inflation has risen above 3%. RBS, in a new medium-term projection, sees inflation staying above the 2% target until the end of 2014.

The MPC, in its latest minutes, warned that inflation was likely to be above target “for the next year or so”, blaming factors such as higher domestic gas and electricity bills and university tuition fees that it could not directly influence.

Higher inflation, it seems, is bedding in. The Bank used to blame international factors, such as oil and food prices, for overshooting inflation. But the latest figures show that stripping out energy, food, alcohol and tobacco, inflation, at 2.6%, is very close to the headline 2.7% rate.

The service sector is where the damage is being done, with inflation of 4.2%. Indeed, the norm for prices rises in services looks to be between 3% and 5%. Only when goods prices are falling can service-sector inflation on that scale be consistent with a 2% inflation target. Goods prices are rising modestly but they are not falling.

Some say it does not matter much if inflation is higher: a year ago the Bank’s prediction was for 1.7% now. After all, is not growth a bigger priority than pinpoint accuracy in hitting an inflation target? Who is to say 3% rather than 2% is not an appropriate inflation rate for Britain?

Carney himself has been musing about a switch to targeting the level of money gross domestic product (GDP). Others favour a money GDP growth target, a combination of growth and inflation, which would potentially offer the central bank more flexibility. We favour flexibility in most areas of policy, so why not in this one?

There are circumstances in which the argument for this kind of switch would be unaswerable. Imagine if the Bank, in its determination to hit its inflation target, had been imposing years of unnecessary pain on the economy. If the target meant tens of thousands of lost jobs, it definitely would not be a price worth paying.

That, however, is not the case. The MPC has been bending over backwards and performing somersaults over the past 3-4 years, in its efforts to support growth.

It believed a combination of ultra-low interest rates, £375bn of quantitative easing and a 25% sterling depreciation would deliver the goods. Importantly, it continued to stimulate the economy even as inflation continued above target. It is hard to argue that it was in any sense constrained by the 2% inflation target.

A 3% inflation rate, combined with 5% growth in pay, average earnings, would upset some purists but be far from the end of the world. That, unfortunately, is not where we are, nor likely to be. Inflation of nearly 3% runs alongside earnings growth of under 2%.

The squeeze on real wages continues and the prospect of a sustained consumer revival remains stalled. It is instructive that higher inflation in October and November was accompanied by weaker retail sales.

The struggle will go on. King is unfortunate that his golden age of non-inflationary growth came early, as chief economist, deputy governor and then for part of his first term as governor, he presided over the best of times. But people will probably only remember the last few difficult years.

Nobody knows what shape the economy will be in when Carney gets to the end of his five-year term in 2018. Nobody really knows who will be in government.

If, by then, the economy has broken out of the pattern of stubbornly high inflation and disappointingly weak growth, Carney will get be a hero. But it looks like a long haul. And a change of target is not a sensible way to try to make it happen.

My regular column is available to subscribers on www.thesundaytimes.co.uk This is an excerpt.

Once it was common to think of Britain's economy as being comprised of two distinct parts. There was the onshore, or non-oil economy, and often - I am talking about three decades ago here - its performance was underwhelming.

Then there was the oil economy, booming as a result of the opening up of the North Sea as one of the world’s most important sources of oil and gas from the 1970s. Combine the two and you got a healthy growth picture. Exclude oil and things were not nearly as strong.

Today, the picture is reversed. The non-oil economy is far from strong but it is growing. Output in the oil economy, by contrast, is falling fast.

A few days ago we had another instalment of the economic puzzle. There was a big, 82,000 fall in unemployment over the latest three months and, official figures showed, a net rise in employment of 499,000 over the past 12 months.

At a time when the economy has not grown at all, according to the gross domestic product figures, employment has risen by nearly half a million - to its highest ever number of 29.6m - and hours worked and vacancies have both increases sharply.

Some of this puzzle will be resolved in the fullness of time by data revisions. Some of it reflects the fact that pay has been, and continues to be, very subdued: it is currently rising by just 1.8% annually.

Part of the story, however, is to do with oil. Britain’s onshore economy is doing a lot better than its offshore economy. The decline in North Sea oil and gas output, a trend that began in the late 1990s, is striking.

Britain’s recovery began in the middle of 2009. For the North Sea, however, that was the start of an acclerated decline in output. In October, North Sea production stood at just 51% of its June 2009 level. The overall economy has grown, though not as much as anybody would have hoped, but North Sea output has halved.

In the old days, such a development would have been devastating, because North Sea oil had a bigger weight in the economy. These days the effects are smaller but still significant. So, instead of shrinking by 0.1% over the past year, as the overall GDP figures suggest, the non-oil economy has grown by 0.2%.

Compared with 2009, overall GDP has risen by 3.3%, its non-oil equivalent by 4.1%. Simon Ward, an economist with Henderson Global Investors, notes that this recovery is less of an outlier when adjusted in this way: the profile of non-oil GDP becomes more like the late 1970s and early 1980s.

This does not, I emphasise, solve all the puzzle. If you take the non-oil figures at face value, this is still a much weaker recovery than we would like. It points to an economy that has averaged only 1% to 1.5% growth in the recovery phase, and that growth has slowed the longer the recovery has gone on.

But it is part of the explanation and it has a couple of other interesting aspects. The first concerns Scotland. The debate about Scotland’s fiscal future under independence rests mainly on the proportion of North Sea revenues it would be allocated.

Fast-falling North Sea output suggests this is a shaky foundation on which to build an independent country. The Institute for Fiscal Studies recently concluded that if Scotland were assigned North Sea revenues on a so-called geographical basis - something that would have to be debated - its budget deficit would be proportionately smaller than the rest of Britain, thogh it warned about the volatility of such revenues.

For every swing, however, there is a roundabout. If Scotland were to get most of the oil revenues, its economy would also be more oil-dependent in general. The oil/non-oil distinction, important for Britain as a whole, would be hugely significant.

The IFS calculations suggest that North Sea oil and gas would account for 18% of the Scottish economy. What this means, by my calculations, is that Scotland would have had no recovery at all over the past three years.

It would, in fact, be rather worse than that. Assuming Scotland had the same 4.1% non-oil GDP rise as the rest of the country, this would be more than outweighed by the near-halving of output from a sector that makes nearly a fifth of its economy. Scotland’s GDP would be 4% to 5% below its mid-2009 levels and even further below pre-crisis levels.

The other interesting question is whether we can look to a future in which energy once more drives the economy rather than acts as a drag on it.

On Thursday the government gave its approval to Cuadrilla, an energy firm, for the resumption of “fracking” - hydraulic fracturing - for the exploitation of shale gas reserves. Shale gas is environmentally problematical and most of the evidence suggests that recoverable reserves do not approach those of the North Sea.

The British Geological Survey, however, which is the most reliable independent source, says “UK potential is as yet untested” and that there are “abundant shales at depth”. It has identified significant accumulations, including Widmerpool Gulf near Nottingham and the Elswick Gasfield, near Blackpool.

Caution is justified. Shale gas may never have the transformative effect on Britain it is having in America. But even an echo of those early North Sea days, when oil and gas helped mend Britain’s damaged public finances and helped the balance of payments, would be very welcome.

On both counts, we need all the help we can get.

My regular column is available to subscribers on www.thesundaytimes.co.uk This is an excerpt.

We rarely compare Britain's budgets with those of other countries. Three years ago I had an opportunity to do so, being in Dublin on the evening Alistair Darling had unveiled his final pre-budget report and the Irish government had announced one of a series of austerity budgets.

Britain’s pre-budget report was a tinkering exercise, Darling’s achievement being to head off pressure from Gordon Brown in 10 Downing Street for a pre-election giveaway. Ireland, in contrast, announced a full-blooded austerity budget.

On Wednesday, history repeated itself. Despite the deterioration in the public finances, George Osborne’s autumn statement was broadly neutral in its impact over the next four years.

Ireland, in contrast, had another bloodcurdler, intended to take 2% out of the economy next year, through higher social insurance charges, fuel duty hikes, motor taxes, child benefit cuts, the taxation of maternity pay, a new local property tax.

The two economies are different. Ireland is constrained by euro membership and has had a ratings downgrade and a bailout. Britain is hanging on to her AAA status, for now, and has not had a bailout for 36 years.

I am not a headbanger on this. If you can avoid swingeing spending cuts or big tax increases it is generally better to do so. We have seen the effects of too rapid a cut in capital spending over the past two years.

The Irish comparison shows, however, that perception can differ from reality when it comes to austerity. Theirs is harsh, ours quite mild. A look at the numbers also shows how Osborne has been quietly doing what his critics have been demanding.

Some will recall Margaret Thatcher’s austerity budget of 1981, when the public finances needed fixing. Introduced by Sir Geoffrey (now Lord) Howe at a time of recession, its main measure was to freeze the personal tax allowance at a time of high inflation; it should have gone up by 14.8%.

Contrast that with what will happen in April. The personal allowance - the exempt amount before people start paying tax - will go up from £8,105 to £9,440, a combination of Liberal Democrat pressure and the Tories saying they wanted to do it anyway.

If the allowance were indexed, as was the norm, it would rise to £8,285. The bigger rise represents considerable largesse, and it costs. Had Osborne indexed it, he would have saved himself £4.9bn.

Had he “done a Thatcher” and frozen it, he would have saved £5.7bn. Raising the personal allowance means a £5-6bn tax cut that could have been used for deficit reduction. You could almost call it Keynesian.

A similar attitude prevails elsewhere. Take welfare. I have pointed out the relative generosity of welfare increases compared with wage rises and the statement highlighted it. In five years, out-of-work benefits have risen 20%, earnings 10%.

That is unsustainable but the response is quite mild. While Ireland has slashed welfare in its budgets, Osborne is limiting working-age benefits to 1% annual rises for three years. Tough but far from draconian.

As for the rest, it did not suggest a government under intense fiscal pressure. Cancelling next month’s fuel duty increase costs £890m this year, £1.64bn in 2013-14.

The very useful measures for business do not come without a price-tag either. The unexpected cut in the main rate of corporation tax 21% from 2014 has an eventual full-year cost of £875m, the two-year increase in the investment allowance to £250,000 a peak annual cost of £910m.

What does all this mean? I am not suggesting there is no austerity, but that it is more gradual and nuanced than you would think. Under the new plans, total government spending will rise from £674bn this year to £765bn in 2017-18. It will be higher as a percentage of GDP than this year for the next two years, and not drop below the magic 40% of GDP for five years.

The coalition is also, apart from tax gifts it can scarcely afford, adopting a textbook response to slow growth: allowing the automatic stabilisers to operate. Slower growth weakens tax revenues and pushes up government spending. Osborne, sensibly, has not tried to offset this now with tax hikes and additional cuts.

How bad a shape is the economy in? The surprise in the Office for Budget Responsibility’s (OBR) assessment was that the public finances were not worse, particularly this year.

Much excitement has been generated by the expected £3.5bn windfall from the auction of the 4G mobile phone spectrum in January. Though it is true to say without it borrowing would have been slightly higher than last year (partly because 2011-12 came in below the OBR’s March estimates), there is nothing unusual about governments counting asset sales in advance. The proceeds of this sale, of course, have to be set against future tax revenues from the mobile phone firms.

The more interesting story was that, stripping out all the distortions, the OBR is £5-10bn more optimistic than the independent consensus. Robert Chote, its chairman, thinks it has a better handle on what is happening to public spending than outside economists.

That is why, while most economists and a badly wrongfooted Ed Balls expected the deficit reduction strategy to turn into a deficit-increasing strategy this year, the OBR was able to come up with a tiny cut. If that call turns out to be wrong, Osborne and the OBR will feel the heat come March.

The bigger picture is that, despite disappointing growth, borrowing is still on its way down, if only gently. In that respect, I hope the OBR is right. Osborne was forced to abandon his target for reducing debt as a percentage of gross domestic product by the end of the parliament, shifting it into the next parliament. But he was spared the humiliation of a deficit increase.

What about the economy? As disappointing years go - the OBR estimates a 0.1% drop in GDP - this could have been worse. I have written a lot about the rise in employment but it is also the case, according to the OBR, that real household disposable incomes have risen by 2.1% this year, after falling on an annual basis since the second quarter of 2010.

What about next year and beyond? If the economy can grown by 1.2% in 2013 when the eurozone, according to the European Central Bank, shrinks 0.3%, that would not be a bad outcome, though industrial production figures on Friday showed that the fourth quarter started badly. But we will not see growth top 2.5% this side of the election, according to the new official forecast.

We know why. It grieves me to hear reputable economists blaming it all on austerity, which is a political not an economic verdict. Slow growth is the product of a range of factors, including the eurozone and a slower global economy, a damaged banking system which is not advancing enough credit and a corporate sector with cash to spend but caution holding it back.

Only when all this comes right can we expect good growth to return. In the meantime, we should not lazily lay all the blame on austerity. The lesson of the past week is that it is milder than you think.

My regular column is available to subscribers on www.thesundaytimes.co.uk This is an excerpt.

The coming week looks much tougher for George Osborne than the one just gone, assuming he does not have a Mark Carney rabbit to pull out of the hat in Wednesday's autumn statement.

One day the chancellor will stand up and tell the Commons he was too pessimistic last time and, accordingly, can revise his growth forecasts up and his borrowing numbers down. That day, sadly, will not be next Wednesday’s autumn statement.

In his March budget, growth was supposed to be 0.8% this year and 2% next. Lop a percentage point off those numbers and you have something like the new forecast.

Will he have to abandon one of his fiscal rules, for debt to be falling as a percentage of gross domestic product by 2015-16, the end of the parliament? The Treasury, I sense, has been braced for exactly this verdict from the Office for Budget Responsibility (OBR).

The Institute for Fiscal Studies, where OBR chairman Robert Chote resided before taking on his current job, said a few days ago that even on optimistic assumptions debt was likely to be rising as a percentage of GDP in 2015-16.

But it concedes the possibility emerging from City economists, that a combination of financial jiggery-pokery (the transfer of quantative easing interest proceeds to the Treasury from the Bank), asset sales and shifting around some spending, Osborne might yet convince the OBR he has a better than 50-50 chance of meeting his rule. That one is worth watching, though I think the Treasury agrees it would be daft to expend too much energy meeting a not very sensible rule.

The bigger question, of far more relevance to most people, is what he can do to boost growth. The 1% rise in GDP in the third quarter, confirmed in revised figures last week, has almost been forgotten in the autumn gloom, though November also brought strong retail sales according to the CBI, and a rare jump in consumer confidence, as measured by GfK-NOP.

The GDP figures, and a pocket calculator, also showed where the economy needs most help. Compared with where we were before the start of the 2008-9 recession, overall GDP is 3.1% down. Nearly five years on from that pre-recession peak in the first quarter of 2008, there is still work to be done just to get back to where we were.

There is, however, a big difference when it comes to the performance of different parts of the economy. The service sector is back above pre-recession levels, if only by a modest 0.4%. But manufacturing is down by 8% and construction a huge 18.3%.

Looked at by categories of spending, the biggest casualty is investment, down a massive 18.8% on pre-crisis levels, with business investment more than 10% down. Exports are modestly up, by 2.3%, while imports are 3.9% down. Consumer spending is nearly 5% down but may be starting to mend.

Government spending (excluding capital) is, continuing last week’s theme, up 6.7% on pre-crisis levels. All these figures are inflation-adjusted.

That tells me where the chancellor’s priorities should lie. The service sector is coming through the worst. It, and consumers, can look after themselves and they will get a bit of help from the expected postponement of the 3p a litre fuel duty hike on January 1.

That leaves manufacturing and construction as the sectors where the help is most needed, and it leaves investment - private and infrastructure - as the best way to deliver that help.

Talking the other day to John Cridland, CBI director-general, just back from a trade trip to Russia with medium-sized firms, I found him refreshingly optimistic about the outlook for Britain’s manufacturers.

He thinks they are shifting away from reliance on the European market, and this is supported by the data. But he also thinks there are things the chancellor can and should do to assist, while keeping its fiscal strategy on course.

In the last fiscal year, 2011-12, the government underspent by £1.6bn even its own scaled-back targets for capital spending. Next year it can expect £4bn from the sale of the 4G mobile phone spectrum. That only scratches the surface of the £700bn of assets, some of it unused land and buildings on prime sites, the Treasury could sell to fund an investment programme.

The CBI is not advocated a rushed “selling the family silver” type disposal, but it does think the chancellor has scope, to the tune of £1.5bn, to do something modest now building up to serious numbers later.

Some of that £1.5bn could be put to work on an accelerated programme of road repair and maintenance. Limiting next year’s rise in business rates to 2% would take some pressure off firms. Doubling the annual investment allowance from £25,000 to £50,000, could tip the balance in favour of investing now for hundreds of thousands of small and medium-sized firms, at a cost of just £330m.

The CBI is not the only body to have its eyes on an investment boost this week. The EEF, representing manufacturers, points out that Britain has the least generous system of capital allowances than any OECD country except Chile.

It wants time-limited 100% capital allowances, for two years, to jump-start investment, and points to the success of similar initiatives in America and Canada.

What about construction? The prize remains that of getting the big institutions, pension funds and sovereign wealth funds, investing in Britain’s infrastructure. Progress is being made on that but it is not fast enough. We should here more, however, on the government's infrastructure guarantees starting to have an impact.

In the meantime, the big frustration in the construction sector, and the wider business community, is that Osborne has cut capital spending much too hard, while the government’s current outlays have continued growing.

The chancellor may address that at the margin this week, as he has done before, though substantive action will have to await the next spending review, probably in a year’s time. With public finances tight, there is no room for big net giveaways.

That will leave Osborne open this week to the criticism that he is merely tinkering as the economy deteriorates. And if he does not give businesses some red meat to chew on, the danger for him is that they will join in with that criticism.

My regular column is available to subscribers on www.thesundaytimes.co.uk This is an excerpt.

What should be George Osborne's priority for the public finances in his autumn statement on December 5? And how big is the risk to Britain's AAA sovereign debt rating?

Most monthly economic numbers do not deserve the headlines they generate, particularly those for government borrowing. October’s public borrowing, £8.6bn versus £5.9bn a year ago, was undoubtedly disappointing.

Some of it, however, was the impact of North Sea shutdowns on corporation tax revenues - down nearly 10% on a year ago - and the numbers are prone to revision.

In August, for example, official statisticians told us we had a rare July budget deficit (the figures are usually boosted by corporate taxes that month) and borrowing in April-July was running well above last year’s levels. Now, the red ink in that period has been revised down by over £5bn, and July is recorded as a surplus.

The big picture at present, which because of revisions can change dramatically, is that Britain is heading for a budget deficit of about £130bn this year, compared with an Office for Budget Responsibility forecast of just under £120bn.

That is disappointing. Though the latest official projections - in March - were for only a modest borrowing reduction this year, the latest estimate for 2011-12 being £121.4bn, a deficit reduction programme is meant to be just that. A deficit increase halfway hardly sends out the best signal.

It is not, in narrow terms, disastrous. The Treasury will see a small rise in the deficit as evidence the automatic stabilisers beloved of economists are being allowed to operate. When growth is slow, tax revenues suffer and cyclical elements of public spending rise.

Will the ratings agencies see it that way? Moody’s, which has Britain on negative outlook, downgraded France last week, to which the reaction ranged from “quelle horreur” to complete indifference.

The French think the Anglo-Saxons are ganging up on them, and that their public finances are healthier than Britain’s. But at least we do not have a government which has responded to the fiscal crisis by lowering the state retirement age and introducing a suicidal 75% top tax rate.

Moody’s says it will reassess Britain’s AAA rating early next year, when it has had time to assess fallout from the December 5 autumn statement. Though there is a case for a downgrade, at this stage it is hard to predict which way it will go.

There would be no case for a downgrade if the government had stuck to its deficit-reduction plans. By this I do not mean the ones set out in March - which will be revisited next month - but the original June 2010 plan, just after the coalition took office.

The first two years under that plan were not too bad, as I wrote a few weeks ago. This is the year, however, when it has started to go wrong. Public borrowing under that plan was supposed to be £89bn this year, 2012-13. If it is £130bn or more, that is getting on for a 50% overshoot.

Those June 2010 projections had borrowing down to £20bn in 2015-16. It is a long way off but it is now a pipedream.

What’s gone wrong? Labour pins all the blame on coalition tax rises and spending cuts, though the difference between what it would have done and what has actually happened under the coalition is small. The fact that few advanced economies have escaped post-crisis torpor strongly suggests there is more to it than that.

We know what the problems are, apart from fiscal consolidation: a damaged banking system unable or unwilling to extend credit; the eurozone crisis; risk-averse big businesses lacking the animal spirits to invest cash piles and the high-inflation squeeze on household real incomes.

There is, however, something else happening, and it goes to the heart of the government’s fiscal struggles. Seventy years on from the Beveridge report, we spend an enormous amount on welfare. In 2011-12 the combined figure for benefits (£175bn) and tax credits (£27bn) was £202bn, according to the OBR.

A few days ago, two things were neatly juxtaposed. One was a column in The Guardian by Polly Toynbee, under the headline ‘No amount of moralising will alleviate the hardship caused by Tory austerity’. The other came with the official figures for the public finances, showing spending last month on welfare, so-called net social benefits, up by 7.7% on a year earlier.

This Tory-led coalition is being so brutal, in other words, that benefit spending is up by nearly 8% in a year, or a shade under 15% over three years. October was no aberration, the 15% figure applies when the comparison is for the July-September quarter.

Why so much? It is not explained by unemployment, which at just under 2.5m is close to where it was three years ago. A lot has to do with the government deciding to maintain the real incomes of benefit claimants by uprating them in line with inflation, even as most people in work suffered from a huge real-income squeeze. Fraud certainly plays a part.

The tax credit system set up by Labour - with taxpayers topping up incomes of lower-paid workers - is a factor. Overall it is, however, a huge policy failure, a failure to grasp the nettle. Welfare spending has risen at almost double the rate envisaged when the coalition took office.

The government is getting blamed for welfare cuts it is not making. Under pressure from the Liberal Democrats the Tories have held back, letting things drift until Iain Duncan Smith’s welfare Big Bang, the universal credit, which will not be introduced until the autumn and winter of next year. Or there have been cackhanded reforms like removing child benefit from some higher tax-rate households.

It may be that things start to improve from next April, when the Department for Work and Pensions is targeting a real reduction in spending. It may be that talk of reining back inflation-linked benefit increases comes to something.

But at a time when the chancellor is said to be contemplating cutting pension tax relief, and after a period in which capital spending - infrastructure investment - by government has been slashed, with a devasting effect on the construction industry, it is clear where his priorities should lie. Unless you tackle welfare, you will never deal with the deficit. This government has failed to tackle welfare spending.

My regular column is available to subscribers on www.thesundaytimes.co.uk This is an excerpt.

Moving the goalposts is a groundsman’s nightmare, but it appears to be all the rage. George Osborne is accused of it, with his £35bn or so grab of the Bank of England’s accumulated interest on the gilts (government bonds) it has bought under its quantitative easing (QE) programme.

Nine days after the Treasury and Bank announced what they said was a financial housekeeping exercise - officials said there was no point building up a pot of savings at the Bank while the country was running a huge overdraft - the debate is still raging.

It may rage for a while yet, at least until we get more clarity when the chancellor unveils his autumn statement on December 5 and the Office for Budget Responsibility delivers its verdict on the public finances.

Three points can, however, be made. If there was confusion about monetary policy before - QE is an untried, “unconventional” tool - there is even more now.

The transfer of the £35 billion from the Bank, where it was doing nothing, to the Treasury where it will be used to reduce public borrowing and debt represents a relaxation of monetary policy. This relaxation was, we can assume, at the Treasury’s behest, raising the question of how independent and how much in control of monetary policy the Bank genuinely is.

Second, the Bank always thought it needed the build-up of interest - so-called gilt coupons - to offset losses later when it has to sell them back into the market.

Now that money is being transferred to the Treasury, the Bank has lost this buffer. The result is likely to be that, while the move will improve the public finances in the short-term, it will leave the taxpayer with a significant bill in later years. It looks like the worst kind of short-termism; an attempt to polish up the public finances this side of the next election.

Third, because these transfers of interest from Bank to Treasury will be ongoing, the government can in effect fund part of the budget deficit for nothing. Whenever the Bank buys gilts under QE, the government’s cost of funding drops to zero. If the idea of a central bank buying its government’s own bonds was murky before, it is positively incestuous now.

Officials insist there is nothing wrong with this exercise — other governments whose central banks are engaged in QE do it — but as I noted last week, it is a bit too convenient when the public finances are under pressure. And, because it is a change of policy, it is a definite moving of the policy goalposts. When Gordon Brown was chancellor, such shifts presaged the collapse of Labour’s fiscal rules. The danger is that history is repeating itself.

PS: Not for the first time, I find myself disagreeing with Sir Mervyn King. In presenting the Bank’s inflation report, the governor made clear his discomfort with the pound’s rise over the past 12 months.

However, Britain’s poor inflation record has much to do with the Bank’s devaluationist tendency. Richard Ramsey, an economist with Ulster Bank, has updated his Britain-Ireland inflation comparison. Since August 2007, the start of the crisis, Britain’s CPI has soared 18.6%, compared with just 0.4% for Ireland. The difference is the huge squeeze on British households. Pushing the pound down more would add to it.

The ONS wants to change the way the retail prices index (RPI) is calculated, and is consulting on it. If it has its way, the longest-running and probably most trusted measure of inflation in Britain will look very different next year.

Any individual, business or investor which has its fortunes, revenues or outgoings linked to the RPI will see a change. Retirement funds paying RPI-linked pensions could see payments drop by 10% to 15% over the long-term, with a corresponding loss to pensioners.

Investors in index-linked gilts would see returns lowered and, subject to a judgement by the Bank of England, might have to be compensated. This could take Britain down a very rocky road, with international investors in particular suspecting trickery.

On the other hand, lower retail price inflation would mean smaller increases in rail fares and some utility bills (though these days they have a life of their own).

So why might it happen, and what would be the consequences? Inflation is always controversial. When, in 2003, Gordon Brown shifted the Bank’s inflation target from RPI (excluding mortgage interest payments) to CPI (the consumer prices index), Mervyn King, newly appointed as Bank governor but yet to be knighted, said: “When defending a free kick from David Beckham, you don’t expect somebody to move the goalposts.”

The change was blamed, wrongly in my view, for the Bank’s pre-crisis policy errors. It sparked suspicion the government was trying to foist a dodgy measure of inflation on an unsuspecting public. The ONS, in response, put a personal inflation calculator on its website, for people to work out their own rate. Apparently they still are.

What is the rate of inflation? Figures on Tuesday showed it is 2.7% for consumer price inflation, 3.2% measured by the RPI and 3.1% for RPIX, the old target.

One thing we know is that everybody has a different inflation experience. The average pensioner, living alone, had an inflation rate of 3.2% in the third quarter, but at the end of last year was being squeezed by a 7.3% rate.
Pensioners tend to suffer most when necessities are going up in price, so the latest round of energy and food price hikes will hurt.

People in general tend to notice prices when they are rising but not when they are stable or falling. We have an in-built upward inflation bias, even if when we shop, we try to avoid things rising too rapidly in price, switching to cheaper lines.

What is the ONS proposing? To answer we need to go back to three greats: Gian Rinaldo Carli (1720-95), Nicolas Dutot (1684-1741) and William Stanley Jevons (1835-1882). All three contributed ways of measuring inflation which are used today.

Dutot derived his index approach in 1738, as part of an exercise to compare the real wealth of Louis XII and Louis XV of France. Carli’s in 1764, was as a result of a study into what had happened to prices since the discovery of the Americas. The main contribution in this field by Jevons, in 1863, was the use of the geometric rather than arithmetic mean for calculating price changes.

The RPI is mainly a Carli and Dutot index, with nothing from Liverpool-born Jevons. The CPI is a Jevons index, with a little Dutot and no Carli.

None of the three measures is perfect but the Carli has the oddest characteristic of all, which is that if the price of a product rises but then falls back to its original level, a Carli index will still record it as a rise.

For some items where it is used in the RPI, this leads to huge differences. Clothing and footwear prices last month were down 0.1% on a year earlier in the CPI but up 6.4% in the RPI. At times the difference in clothing inflation between the two has been as 10 percentage points.

Most countries do not use Carli. The International Monetary Fund advises against it and the Consumers Prices Advisory Committee says it should be dropped.

The ONS is consulting, and the consultation period closes in 12 days’ time. By March, the national statistician will have recommended one of four options: no change, dropping the Carli in measuring clothing inflation, dropping it for all items in which it is used and aligning RPI formulae with those used in the CPI.

None of these changes would mean RPI inflation would exactly match CPI inflation. RPI excludes households on very low and high incomes, while the CPI does not.

However, the RPI has owner occupiers’ housing costs, including mortgage payments and a house price measure. The CPI does not, though a new series (CPIH), will next year include private rental costs.

For users of these inflation measures, however, what matters is the change. We have got used to CPI inflation being lower than RPI inflation, often significantly. ONS figures show, however, that if the so-called formula effect were eliminated RPI inflation would have been lower than CPI inflation since April last year. In October, RPI inflation would have been 2.3%, not 3.2%, so lower than the 2.7% CPI inflation rate.

These are surprisingly deep waters. Though any change would not be retrospective, if we have been overestimating inflation in the past it implies real incomes (and growth) were healthier than we thought.

But dropping Carli would mean the Bank would surely have to decide this was a “fundamental and detrimental” change affecting holders of index-linked gilts and National Savings. The ONS might produce a parallel RPI, using the existing method, for investors, though that cannot be a permanent solution. The longest index-linked gilts stretch half a century into the future.

What should happen? It is daft for the ONS to carry on using an RPI formula that comes up with obviously suspect results. From a statistical and economic perspective, the case for change is overwhelming.

The politics, however, are trickier. Unemployment figures have never regained the public confidence there was before the Tories introduced repeated changes to them in the 1980s. The Osborne £35 billion QE "grab" has had less public impact but has a whiff of something dodgy about it.

Anything like that has to be avoided for the RPI. If the public and the markets sense trickery, trust in the inflation numbers will disappear. Like the boy who cried wolf, once you get a reputation, it can be hard for people to believe you.

My regular column is available to subscribers on www.thesundaytimes.co.uk This is an excerpt.

Barack Obama has been re-elected. There is change to a top in China and the Church of England. All that sets things up for the big one, the next governor of the Bank of England, to be announced by George Osborne before the end of the year, probably in his autumn statement on December 5, if not before.

I jest about the importance of this appointment, but not much. The new governor will take over on July 1 next year for an eight-year term. It will be surprising if that term in office does not stretch beyond Osborne and David Cameron.

A lot will happen between now and 2021. The successful candidate will have powers and responsibility denied any previous holder of the post. The new governor will do most of the heavy lifting in steering the economy, and the banking system, back to health. The prosperity of citizens, not to mention the City, will be in their hands.

The Bank paused in its £375 billion quantitative easing programme on Thursday and, one hopes, has put the policy to bed. Under the new leader’s term, the judgment will have to be made about when to raise interest rates - as go up they surely will - and sell back the gilts acquired under QE.

In the meantime, and rather too conveniently, the chancellor has raided the £35bn QE interest pot to improve the look of the public finances in the short term.

There are checks and balances. Sir Mervyn King often reminded us he had only one vote on the nine-member monetary policy committee (MPC). That will remain true, as on the recently-created 11-member financial policy committee.

But Alistair Darling, with his killer description of Sir Mervyn as “some kind of Sun King”, reminded us of the governor’s power within the Bank. It is unlikely to diminish much with a change at the top.

Who will it be? When I say nobody knows, I think it is true. There is a short-list of about six. The panel - Treasury officials Sir Nicholas Macpherson, Tom Scholar and John Kingman and Sir David Lees, who chairs the Bank’s court - is seeing candidates and will make a recommendation (or a choice of two) to the chancellor.

Who is on the short-list? Certainly Paul Tucker, Bank deputy governor for financial stability, the bookies’ favourite. Certainly too Lord Adair Turner, chairman of the Financial Services Authority.

Sir John Vickers, former chief economist at the Bank and head of the Osborne-appointed banking commission, must be there. The bookies think, in spite of his repeated denials, Mark Carney, Bank of Canada governor, is in the frame. Lord Terry Burns is a possibility for another career change, even at 68. Lord O’Donnell, another ex Treasury permanent secretary, has apparently ruled himself out.

There are potential women candidates, including DeAnne Julius and Kate Barker, former MPC members and Rachel Lomax, a former deputy governor. Sharon Bowles, the Liberal Democrat MEP , has applied.

Lord Green and John Varley are frequently mentioned ex bankers, though suffer from a toxic brand. There may be exotic names. The Economist has suggested Arminio Fraga, a former Brazilian central-bank governor, and Leslek Balcerowicz, former Policy central bank head.

I don’t rule out a dark horse possibility. The thing about them is that they surprise you by streaking ahead at the finish. In their absence, the front-runners are Tucker, Turner and Vickers.

Tucker, the favourite, having had his baptism of fire over Libor and his pally relationship with Bob Diamond, has the advantages and disadvantages of incumbency. He has been much more willing to admit to Bank errors and shortcomings than King.

There is little doubt he would have been more proactive when the crisis broke in 2007, and more responsive to the cries of anguish from banks when liquidity dried up. He recognises the importance of the City remaining a big global player, though one better regulated than in the past.

Tucker knows where the bodies are buried in the Bank, with an insider’s knowledge of how to improve things. But critics will say he is the continuity candidate, who should have been more aware of the financial iceberg looming before the crisis.

Turner joined the FSA late enough - in September 2008 - to be absolved of that criticism. In letting it be known he is keenly interested in the job, he has irritated some. A recent speech by King was seen by many as a public slapdown for Turner.

He does not suffer self-doubt. A joke doing the rounds in the City asks why the FSA chairman is covered in love bites, to which the answer is they are self-inflicted. His big aberration was aggressive advocacy of euro membership for Britain, and I remember him telling me I had got it entirely wrong on the euro. But he has recanted and he has upped his game.

Recent speeches show that he is putting in a lot of homework. In South Africa a few days ago, he cited the doyens of the Chicago School of Economics, as well as other ancient and modern economic texts. His attacks on the City’s “socially useless” activities and the failure of the banking system to support the real economy have struck a chord. He would be a good front man.

Turner would be the change candidate, but the fear is he would seek to shake things up too much. The City would see him as the WTM (worst than Mervyn) choice, while banks would be sent into a huddle of uncertainty. In his speech he debated whether fractional reserve banking - the basis of Western banking for centuries - should continue. That and the prospect of a mass exodus from the Bank if he got the job would make it risky.

Vickers, whose job application is his commission’s report, is ideal on paper. He knows about banking and he is a renowned economist, though not a macro-economist. He is known to the chancellor. He would be a safe pair of hands.

And yet he would suffer, like King, from being seen as too academic. He made no great waves when chief economist at the Bank and was not happy there. He was a low-key director-general of the Office of Fair Trading from 2000 to 2005. Chairing a commission on banking is not the same as dealoing day-to-day with the detail of complex and volatile markets and the new regulatory landscape, which has been Tucker’s role in the years since the crisis.

Because of this, the bookies are probably right to have Tucker as favourite. He remains the one to beat. But a credible dark horse, a genuine outsider, might be better.

My regular column is available to subscribers on www.thesundaytimes.co.uk This is an excerpt.

George Osborne is knee deep in preparations for his autumn statement, on December 5, in between wondering what to do about the European Union budget.

He will have to decide how to respond to Lord Heseltine’s “No Stone Unturned” growth report. The former deputy prime minister, who brings a touch of showbiz to everything he does, has come up with a curate’s egg of a report.

Some of it looks like a bit of throwback to the patchy industrial interventionism and regional policy of the past, though menaingful devolution of economic power from London and the south-east would be welcome. His National Growth Council has echoes of “Neddy” (the National Economic Development Council), which was finally put out of its misery after three decades of existence in the early 1990s.

Other bits of the report: speedy decisions on airport capacity, and better planning, infrastructure and skills make a lot of sense. The question is whether a government that finds it difficult to pull any policy levers can manage to do so to implement some of these ideas.

The big issue for the autumn statement is, of course, the state of the public finances and whether Osborne can still meet his fiscal rules. There will be time for a more detailed look at that in three weeks’ time, following the November 21 release of the important October public borrowing figures.

In the meantime, let me whet your appetite. The chancellor will be under pressure on December 5 to boost government spending to accelerate growth, even after the welcome 1% bounce in gross domestic product in the third quarter.

Lying behind such calls are, I think, two pieces of conventional wisdom. The first is that public sector workers are being squeezed as never before, their pay frozen indefinitely even as inflation has stayed stubbornly above the official 2% target.

The second is that the economy’s struggle to grow has been made that much more difficult by cuts in government spending. The other components of output - manufacturing, energy, private services, construction - are having to work that much harder because government is getting smaller.

Today I can tell you that neither of those things are true. Let me start with public sector pay. I was alerted to this a few weeks ago by a report by Brian Reading for Lombard Street Research, described here. He suggested that public sector pay had risen by 9% over the past three years.

The response to this from readers, particularly those working in the public sector, was sceptical, so I checked the figures. Taking April 2009 as the starting point, when avarage weekly earnings in the public and private sectors were similar, I looked at the rise since then.

Sure enough, average weekly earnings in the public sector have gone up from £448 then to £491 now, a rise of 9.6%. In the private sector, in contrast, the increase has been from £446 to £469, 5.2%.

Public sector pay has risen nearly twice as fast as in the private sector in this supposed time of austerity. How can that be? One possibility is that the inclusion of RBS and Lloyds Bank employees in the public sector headcount, which happened in July 2009, bumped up the numbers. There is no evidence of that, however; no sudden jump in public sector earnings.

There are, instead, other explanations. The supposed squeeze on public sector pay provides a partial exemption for low-paid workers. In addition, public sector managers, including those in the civil service, appear to have been using other devices, including promotions withing salary bands, to deliver significant rises for their employees.

I would not pretend there has been no austerity affecting public sector workers. Public sector employment has dropped by 648,000 since the second quarter of 2009, or around 450,000 excluding the transfer of further education and sixth form colleges from the public to the private sector.

That in itself tells us something important. The strong growth in private sector employment in the past three years, more than 1m net new jobs, has a lot to do with wage flexibility. The suspicion must be that lack of pay flexibility in the public sector - and the big increase in the wage bill - has been a prime reason for the big public sector job losses.

That in turn raises the question of the role of the unions. In the public sector, 56.5% of workers belong to a union, compared with just 14.1% in the private sector. Have the unions looked after the pay of their public sector members, only to sacrifice hundreds of thousands of workers? They may well have done.

What about the second strong belief, about the effect of the cuts on growth? Those third quarter GDP figures were interesting in a number of respects but not least because they showed that 0.4 percentage points of the 1% rise in GDP was contributed by “government and other servicea”.

This component of GDP, all but a tiny bit of which is accounted for by public services, does not include benefit and pension payments, so its rise does not reflect the level of unemployment. It accounts for just over 23% of GDP. It is still rising.

Its third quarter jump was not an isolated event. Government has made a contribution to GDP growth for the past seven quarters. In the latest 12 months, while GDP has been flat, government output is up by 2.4%.

As noted here before, the “wrong kind of cuts” mean the government has been reducing capital spending. Those reductions have to be set agsinst the continued rise in government current spending. Even so, these figures show it is hard to claim that the economy is being dragged down by government.

The public spending enthusiasts will argue that you can never have enough. I would argue that we need to think a lot more about the mix of that spending and what we need, to return to Heseltine, to help medium and long-run growth. Osborne has been criticised for cutting spending too much. A more telling criticism is that he has not controlled it properly or sensibly.

PS Stranger things have happened than Andy Haldane, the Bank of England’s executive director for financial stability, turning up at a meeting of Occupy, telling it it was right, and crediting it with driving reform of the financial system. I can’t, however, think of many.

Can anything be done? The Commission has a range of proposals in all these areas. Skills, benefit reform and a living wage all come into it. But the forces that are squeezing those on lower incomes have been building for decades. Turning them around could take as long.

My regular column is available to subscribers on www.thesundaytimes.co.uk This is an excerpt.

With David Cameron’s too broad hint of good news on the way to Labour’s obvious disappointment at a better-than-expected figure, the GDP numbers have become a political football as well as the nearest thing the Office for National Statistics has to a sexy announcement.

It would be inconsistent of me not to say these preliminary figures are prone to revision. When they are unexpectedly weak, as in the second quarter, the expectation is that they will be revised up, as they were.

Given the 1% third quarter rise in GDP exceeded expectations, the risk this time is on the downside, though the ONS does not appear to have made unrealistic assumptions for what it does not know about the third quarter (most of September) and the story the figures tell is quite a logical one.

So, taking the second quarter’s 0.4% fall and the third quarter’s 1% rise together, you have a 0.6% GDP rise over six months. Part of that, 0.2%, was the ONS’s treatment of Olympic ticket sales. The remaining 0.4% splits into 0.2% underlying growth in each of the two quarters, which does not look to be stretching things too much.

In the fullness of time, of course, there will be many further revisions to the numbers. I would expect the double-dip from which we have just emerged to be exposed as phony, revised to become more consistent with far stronger job numbers. But we may have to wait years for that.

Even on the figures we have, the economy is not as weak as we thought. Since turning in mid-2009, overall GDP has risen by 3.3%, and is less than 3% below its pre-crisis level. Excluding the depressed North Sea sector, the economy is up 4.4% from its 2009 lows.

The big question, following on from last week, is whether the economy can maintain momentum after this 1% boost.

The problem for the economy so far is that it has been one damned thing after another. The coalition’s deficit-reduction strategy has coincided with a deepening of the eurozone crisis, an economy starved of credit in spite of the lowest interest rates in the Bank of England’s history and high, mainly commodity-driven, inflation.

Of these three brakes on recovery, the inflation news has been better. Even if a rise in food and energy prices pushes it a little higher over the winter, we should not get back to the 5%-plus levels of a year ago.

Oil prices have fallen from their highs, with US crude down 14%. Real incomes should pick up, maintaining the incipient recovery in consumer spending.

The eurozone crisis, in contrast, looks as though it will always be with us. Though the European Central Bank’s announcement of so-called outright monetary transactions - buying the bonds of troubled eurozone members - has removed the air of crisis, European economic numbers took a turn for the worst last week.

Following weak German surveys, the Ifo index and purchasing managers’ survey, it looks as if Germany, one of the strongest economies post-crisis, may go back into recession over the winter. Britain’s recovery is getting no help from Europe.

On the other side of the world, Japan may also be slipping into recession, partly because of a slump in exports to China due to tension between the two countries over the disputed Senkaku/Diaoyu islands.

We have to assume politicians in Washington are not stupid enough to allow the “fiscal cliff” of big emergency tax hikes and spending cuts to kick in, but the uncertainty is affecting US business sentiment.

It is not all bad news out there. China appears to be past its cyclical low. There is growth in the world economy, particularly the emerging world, the trouble being that not enough of it is close to these shores.

So can we build on the third quarter improvement? A positive sign that does not always get attention is highlighted by Simon Ward, an economist with Henderson Global Investors. Ward, who follows the monetary data closely, saw the third quarter GDP bounce as consistent with a rise in the real (inflation-adjusted) money supply. Encouragingly, he says: “With monetary trends improving further in recent months, this upswing should be sustained at least through next spring.”

Does that argue for more quantitative easing(QE) from the Bank to boost the money supply? The markets have concluded that the stronger GDP figure will mean the monetary policy committee will not do more QE next month.

I think that’s right. The veteran City economist Stephen Lewis of Monument Securities, in an elegantly written critique of his old classmate Sir Mervyn King’s speech in Cardiff last week, put it well.

“Sir Mervyn has no reason to believe the money the Bank creates through QE is as effective in stoking economic activity as the money that would have been generated through the extension of bank credit if the banks had been willing to lend,” he wrote. “Most likely it is less effective,”

After five years of inactivity, and over three years of QE, the Bank and Treasury are trying to get credit flowing through the £80 billion Funding for Lending Scheme, intended to get loans to small and medium-sized firms and mortgage borrowers by offering banks and building societies low cost funding linked to lending.

Two things, however, troubled me about the Bank governor’s speech. The first was its gloomy tone. Perhaps we have got used to a governor who talks about the “black cloud of uncertainty” coming our way from Europe, the “slow and unceratin” recovery, or that advanced economies will struggle “to get out of their current predicament”.

Maybe, like the character Mona Lott in the wartime radio comedy It’s That Man Again, it is being so cheerful that keeps him going. Perhaps he is being realistic. But when, to build on the third quarter you need consumers to spend and businesse invest, this is hardly going to do it.

The other was that Funding for Lending Scheme. It is early days – the scheme did not really get going until last month = and the Bank has high hopes for it. But my initial worries it would be another damp squib have not yet been assuaged. I keep coming back to comments by Bank officials when the scheme was floated in the summer, that in its absence there would have been a further lending fall. Maybe just stabilising it will be regarded as a victory.

King, in his speech, talking of Funding for Lending, said that “the window of opportunity which it provides must be used to restore the capital position of the UK banking system.” I thought the idea was to get credit into the economy not build up the banks’ capital buffers.

The authorities, judging by this, may more concerned about having an ultra-safe banking system than one lending enough to maintain the recovery. That is worrying.

My regular column is available to subscribers on www.thesundaytimes.co.uk This is an excerpt.

Even before gross domestic product figures for the third quarter are published at 9.30 on Thursday, the arguments are well-rehearsed.

Pessimists and the government’s critics will say any pick-up is a mere statistical blip, which does not change the picture of a flatlining economy prone to falls in gross domestic product (GDP). On this view, the double-dip will be followed by triple, quadruple and even more exotic dips.

The other is that the third quarter will mark the start of a sustained recovery. The upturn had a temporary setback, exaggerated by special factors and what the Office for National Statistics (ONS) concedes are more revision-prone data in recent years. But the economy’s firmer tone, reflected in strong employment growth, will persist.

You can, of course, never rule out new shocks. The eurozone crisis is still smouldering and America’s mad fiscal cliff of emergency tax hikes and spending cuts looms (though surely it will be avoided). But, on this view, this week should mark the beginning of better times.

Which will it be? There is a danger of counting chickens before they are hatched. Official forecasters were surprised when the ONS pronounced the double-dip in April, after the data in the early part of the year looked strong. There is always a risk the statisticians will bowl a googly again.

It would, however, be quite a surprise. Economists expect third quarter growth of between 0.4% and 0.8%, some of it merely reflecting a statistical bounce from the jubilee-depressed second quarter.

If it is near the top of the range, there will have been underlying growth since spring. A figure at the lower end, merely making up the second quarter fall, would maintain the picture of a flat economy.

What will happen after the third quarter? There is a great temptation, which the government’s critics fall for, of blaming every woe on George Osborne. I can understand it. He plays the role of pantomime villain well; not everybody could get booed at the Paralympics. He is no great communicator and, after an error-strewn budget, has work to do to inspire confidence. He gets into scrapes in first-class train carriages.

But it is nonsense to suggest that the economy has not grown because of his fiscal tightening, or that it cannot grow as long as austerity persists.

Two reports published in the past few days offered useful insights. One was from the Office for Budget Responsibility (OBR), the independent fiscal watchdog, which proved you can learn as much more from your mistakes as your successes.

After a brief interlude in which a crude exercise from the International Monetary Fund was leapt on as proof that the coalition’s fiscal tightening was solely responsible for disappointing growth, the OBR provided a more rounded picture.

It addressed the question of why, while the budget deficit in the coalition’s first two years came down in line with its June 2010 forecast, growth has fallen well short. Compared with a prediction that GDP would rise by 5.7% between mid-2010 and mid-2012, it only increased by 0.9%.

Where did the growth go? The biggest reason identified by the OBR is one frequently noted here. High inflation has eaten into real, or inflation-adjusted, consumer spending. Interestingly, consumers have been spending; the OBR’s forecast of a cash spending rise of 9.3% over two years was spot on. But it was eaten up by higher prices, leaving no room for “real” growth.

The other weak components of GDP were business investment, which the OBR attributes mainly to eurozone uncertainty and lack of credit, and exports, or net trade, similarly affected by eurozone woes.

Did it not allow enough for the impact of the fiscal tightening? Possibly, though any such effect is balanced by the fact that government spending so far has been significantly stronger than it expected.

The other useful report was from the ONS. To coincide with a seminar it held in Westminster on the great productivity conundrum - why has employment been so strong when GDP has been so weak? - it published a paper by Peter Patterson, its deputy chief economist.

Productivity is not the same as growth, though it is a key driver of it. It measures output per worker or output per hour. According to the latter, productivity was growing 2.4% a year in the decade or so before the crisis but has barely grown - a mere 0.2% a year - since mid-2009. An economy that does not generate productivity growth is in trouble.

Though most sectors of the economy are suffering from weaker productivity growth, two stand out. One is North Sea oil and gas, where output per hour has dropped more than 40% in five years.

The other is financial services, where productivity was growing by more than 4% a year, but in the past three years has been falling nearly 3% annually, as its output has plunged. Just these two sectors provide much of the explanation for the very weak productivity numbers.

So what do these reports tell us? In the case of the OBR’s assessment, it is possible the unhelpful factors that have depressed growth over the past two years will persist.

Some of them, however, are subsiding. The fall in inflation is easing the squeeze on real incomes and should support stronger consumer spending. The eurozone crisis has not been solved but has been contained. There is tentative evidence the global economy, after slowing, reached its low point in the third quarter. Any recovery will be good for exports.

As for the ONS exercise, there are signs that the plunge in output in the North Sea and in the financial services sector - which accounts for a tenth of GDP - is coming to an end. Even stable output would mean both being less of a drag on future growth.

Can we start to believe in a sustained recovery? With a fair wind, yes, and that is also the view of most economists. Consensus Economics, a consultancy, polls economists regularly. In its latest exercise, it asked for medium-term predictions.

For Britain, the forecast was for 1.2% growth next year, 1.9% in 2014 and 2.2% in 2015, election year, before settling at 2% over the medium-term. In the past that would have been regarded as so-so but it is not that much below America, which settles at 2.5%, the eurozone, which is seen as growing by 1.5% in the medium-term and Japan, which struggles to hit 1%. Britain is even seen as outpacing Germany, which grows in line with the eurozone average.

In the long-run, as Keynes noted, we’re dead. In the medium-term we can hope for better growth.

My regular column is available to subscribers on www.thesundaytimes.co.uk This is an excerpt.

It is 20 years since, in the aftermath of the ERM (exchange rate mechanism) Black Wednesday debacle, the then Tory chancellor, Norman Lamont, announced that the government was adopting an inflation target.

A young, or at least a younger, Mervyn King was, as the Bank of England’s chief economist, tasked with producing a quarterly inflation report. This enhanced role for the Bank paved the way for independence in 1997.

Had either the chancellor or the Bank’s chief economist said in 1992 inflation would average just 0.1 percentage points above the official target over the next two decades they would have been ridiculed.

But that, as an older Sir Mervyn King, now on his last lap as Bank governor, reminded us last week, was what happened. Consumer price inflation has averaged 2.1%, compared with a 2% target. Britain’s traditional Achilles heel - inflation averaged 12% in the 1970s and 6% in the 1980s - may not have been cured but for 20 years it has been strapped up.

Before getting on to whether this has been such a good thing, I should point out for the sake of purists that there was a different inflation target for more than half of the period in question. The original target, the retail prices index excluding mortgage interest payments (RPIX) was set at 2.5% and lasted well into the 2000s. The change does not, however, change the big picture of close-to-target inflation.

So should we doff our hats to Lamont and garland the Bank for its achievement? We should certainly give some credit where it is due but we should also not ignore the shortcomings. King, to be fair, took some of these on the chin in a 20th anniversary speech at the London School of Economics.

The first is that inflation has been too high over the past three years, indeed the past seven years, at the very time we needed it to be low to support consumer spending. The record for two-thirds of the 20 years was good, helped by favourable international factors, but the final third has been poor. In only 14 out of the past 84 months has inflation been at or below target.

King’s defence was that the low-inflation credibility built up earlier prevented recent inflation from being much higher. So, he said: “Since 2007 the UK has been able to absorb the largest depreciation of sterling since the Second World War, as well as very large rises in oil and commodity prices, with an increase in inflation to an average of only 3.2% over the past five years and without dislodging long-term inflation expectations.”

Fair enough, though the Bank was not merely an disinterested spectator in sterling’s fall. Quantitative easing, on the Bank’s own estimates, has boosted inflation and there has been a lot of it. The Bank was hit by unhelpful factors but also tolerated higher inflation, believing the alternative would have been much worse.

The bigger question is whether the inflation target breeds dangerous behaviour: one kind of stability promoting instability, volatility and excessive risk-taking elsewhere.

That may now be one for King’s successor, though it is also relevant to the incumbent’s record. Applications to succeed him closed last week and having Tu in your name (Paul Tucker or Adair Turner) looks to be an advantage.

King suggested there was nothing exceptionally frothy about Britain’s 2.9% growth rate in the run-up to the crisis - the International Monetary Fund (IMF) now disagrees - though admits it was unbalanced growth.

Monetary policy in Britain was not exceptionally loose in comparison with other economies. Interest rates were higher than elsewhere (and King reminds us he would have liked them even higher) and pre-crisis the pound was strong.

So what went wrong? Significantly higher interest rates - breaking Britain’s unbroken period of growth from the early 1990s to 2008 - could have changed behaviour. This is the argument that a couple of small recessions along the way could have prevented the big one.

Maybe, however, even if the Bank had deliberately aimed off the inflation target in that period and inflicted more pain on the economy, we would still have had the big one.

As King put it: “Leverage and the growth of credit may be relatively insensitive to interest rates, especially once a self-reinforcing cycle of optimism and credit expansion is underway. And this financial crisis was a global one: the UK alone could not have stopped it happening.”

So has inflation targeting done more harm than good? No, but given Britain’s high-inflation history, policymakers were guilty of giving too much prominence to it, and took their eyes off other dangers. It was a bit like the captain of the Titanic looking only at the calm waters on one side of the liner, missing the iceberg on the other.

That problem, we have to hope, has been corrected. If we ever get to a situation again where the banks are increasing their leverage too aggressively and credit is exploding, interest rates would rise whatever the inflation rate and “macroprudential” tools such as putting a cap on bank leverage would be employed. The Bank’s right hand - its monetary policy committee (MPC) - would co-ordinate things properly with its left-hand, the new financial policy committee.

Even that will not make Britain immune from the dangers. It was odd that in an era of globalisation it seemed for a time that nine members of the MPC had Britain’s economy under the tightest control; precision-guided policy.

It was an illusion then and it is an illusion now. The best monetary and macroprudential policy in the world wlll not prevent the economy being exposed to problems elsewhere, whether in the eurozone, America or other parts of the world.

Britain has been blown about and the gusts continue. The downside of inflation targeting was that it gave the impression that central banks had everything under control.

It will be a long time before we think that again, Tucker, Turner, or whoever else exceeds King, will not have gone into their job interviews preaching a doctrine of infallibility. All they can try to do is reduce the risks.

My regular column is available to subscribers on www.thesundaytimes.co.uk This is an excerpt.

George Osborne’s third speech tom the Tory conference as chancellor, this week, is probably his stickiest. In 2010, the coalition was in the first flush of optimism. The first of the four quarterly falls in gross domestic product on its watch was yet to come.

Last year was a little less comfortable but it came before the Office for National Statistics (ONS) gave us the double-dip recession.

This year’s is too early for the ONS to tell us whether there was growth in the third quarter - if not with favourable post-Jubilee and Olympic effects we might as well give up now - that will come on October 25.

But the backdrop remains a subdued one. Business surveys suggest some of the strength we have seen in the labour market may be subsiding. Purchasing managers’ surveys for manufacturing, construction and services averaged 51.1 in the third quarter, above the 50 dividing line between growth and recession but only just.

Some bits of the economy are doing well. New car registrations last month, the first for the new “62” plate, were 8.2% up on a year earlier, with sales to private buyers up 14.2%. Overall, though, this is an economy still in serious need of some oomph.

The most difficult area for Osborne is his fiscal strategy. No doubt we will hear a lot about “dealing with the debt” from ministers, when they should be saying “dealing with the deficit”.

But even dealing with the deficit is in trouble this year after a successful first two years, as discussed last week. Depending on how you measure it, borrowing is between a fifth and quarter up on last year. The fiscal strategy is in need of rebooting.

Some will say the coalition is suffering the inevitable economic consequences of trying to cut the deficit too quickly. Paul Krugman, the Nobel-winning American economist, will be over here to make that point again later this month.

I think the problem is rather a different one, and it goes back to the coalition’s early, over-confident days in the spring and summer of 2010. We had an inexperienced Treasury chief secretary - Danny Alexander only got the job when David Laws was forced to resign - and a spending review Osborne insisted was completed in time for its mid-October unveiling.

The result was an exercise intended to set the tone and the fiscal parameters for the parliament was a dog’s breakfast, hurriedly cobbled together. We have had, and continue to have, the wrong kind of cuts and the wrong kind of spending increases.

Handed a “there’s no money left” poisoned chalice by Labour and a sketch, no more, of a spending review in which the only thing slashed was capital spending - infrastructure - the coalition was silly enough to run with it.

Brian Reading, the economist, has deconstructed the errors made in a paper for Lombard Street Research, The Blunt Axe. I can do no better than sum up his main criticisms of that 2010 review.

As he writes: “Its claim to secure economic stability was made without any attempt to assess the growth consequences of spending cuts. It hid behind the fan of the OBR’s [Office for Budget Responsibility] rosy forecasts that had little regard for the uncertainty in the global economy.

“It slashed and burnt investment except on expensive prestige projects; It made no attempt realistically to identify where taxpayers’ money was to be saved.

“It made no to attempt to measure the real resources provided to its priorities, using bogus price deflators. It failed to protect front-line workers, identify them or determine what front line work they did. It made no plans for the inevitable cuts in government employment, delegating responsibility to public sector employers.”

The most egregious errors were on public investment and unemployment. Government investment has the highest “multiplier” of any fiscal action by government. Every pound spent results in at least a pound extra gross domestic product. Yet the government planned a 58% cut in public sector net investment by 2014-15.

Public sector employment, meanwhile, has fallen 300,000 more than the OBR said, mainly because the coalition’s aim, of holding down public sector pay, failed. Instead of rising just 3% since the election, average public sector pay has risen by 9%, Reading calculates. Jobs took the strain.

The problems persist. So far this fiscal year, benefit spending is 6.5% up on last, as a result of the decision to index most benefits by 5% in April. Where’s the axe there?

What should be done? Reading is clear and I agree with him. Politicians of all parties cannot be trusted to make the right decisions on spending and neither can Whitehall officials (his paper was written before the West Coast main line fiasco).

The most effective exercises in cutting public spending in the past, he points out, have been when governments got somebody in to do it. So the Liberals in the 1920s asked the businessman Sir Eric Geddes to advice on cuts, the Geddes axe.

In 1931 Sir George May, on his retirement as secretary of the Prudential, headed a committee to advise Labour, and then the coalition national government, on a programme of cuts. In 1976-7 the International Monetary Fund which oversaw cuts. We have learned a lot since those exercises. Public expenditure is still significantly too large in relation to the economy’s sustainable tax base, hence the deficit.

But we cannot afford another disaster like 2010’s spending review. Future cuts need to be planned in a way that has the minimum impact on growth and front-line services and enhances, not diminishes, Britain’s ability to grow in future.

So the next spending review, in 2013, needs to be overseen by an outside committee of experts, under a strong leader independent of politics. “A fresh start is urgently needed right now,” Reading writes. “A Geddes-style independent committee should be immediately established.” Indeed. Spending is too important to be left to politicians.

My regular column is available to subscribers on www.thesundaytimes.co.uk This is an excerpt.

It is the party conference season, when the government's economic strategy comes under attack, and ministers run some eyecatching announcements up the political flagpole.

We have already had a foretaste of this from the Liberal Democrats. Most of it boiled down to ‘if you are Lord Sugar do not expect a free bus pass and expect to pay more tax on your mansion’, though not until after the elction.

For this week’s Labour conference, in Manchester, the coalition has at least been spared the indignity of an economy that has shrunk on their watch. Two months ago that was the case: the Office for National Statistics said then that gross domestic product in the second quarter was 0.3% lower than two years earlier, when the government took office.

Now, thanks to revised figures last week, it is 0.2% larger, and one of the five quarterly falls in GDP of the past three years - in the second quarter of last year - is now recorded as a rise. The initial 0.7% GDP drop in this year’s second quarter is now put at 0.4%. There will be many more such revisions to come.

This will not, for now, save the coalition from taunts about the double-dip recession. Nor will it prevent a political narrative that runs like this: the government’s fiscal strategy has not only flattened the economy but is failing on its own terms by not reducing the budget deficit according to plan.

There is a lot to say about this. The fiscal tightening is only one aspect of disappointing growth, the others being the high-inflation squeeze on real incomes (which the latest figures suggest has eased considerably), the absence of credit growth and the eurozone crisis. In the past year the eurozone’s woes have weighed down heavily on Britain’s economy.

A bit of a myth has grown up about the public finances, which we shall no doubt hear more of this week. The benchmark for the government’s austerity plan was laid down by the June 2010 forecast from the Office for Budget Responsibility (OBR), the official fiscal watchdog.

Its forecast then was for public borrowing, estimated at £155 billion in the 2009-10 fiscal year, the last year of the Labour government, to drop to £147 billion in 2010-11 and £116 billion in 2011-12.

Latest figures show borrowing running pretty close to those projections, with 2009-10 put at £159 billion, 2010-11 £142 billion and 2011-12 £119 billion. If you wanted to stretch it you might say that a reduction from £159 billion to £119 billion is slightly bigger than from £155 billion to £116 billion, but the central point is that as far as the tightening for the first two years is concerned it is a case of so far, so good.

It gets more difficult from now on. The OBR’s June 2010 forecast was for a drop in borrowing to £89 billion this year, leaving aside any accounting shenanigans from the transfer of the Royal Mail pension fund to the public sector.

So far in 2012-13, borrowing is running a fifth about last year’s level. That should change as we move into the second half of the fiscal year - there were similar worries about a big overshoot 12 months ago - but it would take a minor miracle to get back to where the OBR said in 2010 we would be, let alone achieve the deficit reductions to £60 billion, £37 billion and £20 billion for the following three years.

Future deficit reduction has become harder because of growth in current government spending, notably benefits, which in the April-August period were 6.5% up on a year earlier. This was mainly because of the decision to uprate most benefits by 5% in April and it is why talk is now turning to freezing such benefits.

Some tax receipts, particularly corporation tax, are also very weak, down nearly 10% on a year earlier. A rise in company profits in the second quarter should turn this around somewhat, but the loss of the revenue cash cow of the business and financial sector is genuine.

The big reason for the slowing of progress on deficit reduction is, of course, the disappointment on growth. When the coalition took over in May 2010, it adopted a tight fiscal/loose monetary strategy that had worked so well in the 1990s.

With hindsight (though it did not seem so at the time) Britain bounded out of the recession of the early 1990s, with growth rates soon hitting 3% or more. The loose monetary policy of the time; lower interest rates and a sizeable sterling devaluation, more than compensated for a fiscal tightening that saw hundreds of thousands of public sector jobs cut. A budget deficit of 8% of GDP turned to surplus in five years.

Why did it work then but is so much tougher now? The 1990s model required monetary policy to do the heavy lifting in kickstarting and maintaining the recovery. This time, monetary policy has struggled to keep the economy’s head above water.

Three and a half years of Bank rate at an unprecedented low of 0.5%, £375 billion of quantitative easing and a 25% drop in the level of sterling, most of which has stuck, have failed to do what a more modest monetary relaxation did two decades ago. Either the forces pushing the economy down are even more powerful than we thought, or monetary policy has lots its potency.

We may know soon enough. The Bank of England-Treasury £80 billion funding for lending scheme (FLS) is the latest attempt to reboot monetary policy. Last week the Bank announced the first 13 banks and building societies to have signed up, between them accounted for nearly three-quarters of the stock of lending to households and firms.

Under the scheme, lenders will be provided with cheap liquidity in the form of Treasury bills for up to four years, in return for commitments to maintain or increase lending between now and the end of 2013.

Paul Fisher, the Bank’s executive director for markets, is not suggesting that the scheme will transform a weak economy overnight. But, he said in a speech last week: “I am confident that the FLS will help the supply of credit. Before its introduction, it was more likely than not that the stock of credit would contract further over the next 18 months. Perhaps it still may. But any return to positive credit growth would be a better outcome than we could have previously hoped for.”

It needs to happen Monetary policy has to work to boost the economy, and to keep the fiscal strategy on track.

My regular column is available to subscribers on www.thesundaytimes.co.uk This is an excerpt.

Another week, another puzzle. The latest figures for retail sales, out on Thursday, showed a marginally disappointing 0.2% drop in volumes in August.

Store sales were generally fine but online spending dropped, because we watched the Olympics and Paralympics on television rather than clicked and shopped.

That may be a sad indictment of the way we live but even after the 0.2% slip, retail sales volumes were 2.7% up on a year earlier. Sales in August 2011 were a little depressed because of the riots but it was still the case that non-food sales last month were a hefty 5% up on a year earlier; more of a boom than a shoppers’ strike.

I promised a puzzle. Retail sales have grown, with volumes 1.4% up on their pre-recession peak in the first quarter of 2008.

Now let us look at consumer spending more generally, which is what matters for GDP (gross domestic product). In the latest quarter, April-June, spending in real terms fell 0.4% and was down by 0.8% on a year earlier. Not only has it failed to get back to its pre-recession levels but it is still a substantial 6.3% below it.

Retail sales, covering what people spend in stores as well as petrol and diesel purchases, are not the same as consumer spending. The latter includes gas and electricity and other household bills, bus and rail fares, and expenditure on housing, recreation, culture, hotels and restaurants.

Some of those, like nights out or tickets to sporting events, we like spending money on. Others, like household bills, insurance and train fares, we do not.

You could argue the current mix of rising retail sales and depressed consumer spending, is on balance better: people are spending less on things they would prefer not to spend on, and more on goods in the shops.

Even so, it is odd. Retail sales and overall consumer spending are usually closely correlated. It is unusual for them to be moving in opposite directions.

As far as the Bank of England is concerned, it is the wider picture for consumer spending that matters and, according to the latest minutes of its monetary policy committee (MPC), we are heading for another disappointment. Despite last week’s drop in consumer price inflation to 2.5%, the MPC fears - again - it will disappoint on the upside in the coming months.

“Any sustained recovery in output would probably need to be accompanied by a pickup in consumption...,” it said. “The prospective rises in prices for petrol, household energy and some foodstuffs would dampen real income growth in the second half of the year.”

It is not all one-way. Since the MPC met, oil prices have slipped, and this may feed through into lower petrol and diesel prices.

The read-across from above-target inflation to real income growth is not as direct as you might expect. People have other sources of income. In the 12 months to the first quarter of this year real incomes fell only 0.1%, even though inflation topped 5% during that period.

Even so, the most basic building block for a rise in spending is that earnings from employment go up more than prices. Normally it happens. In the eight years before the recession, earnings rose 39%, prices 15%. There was a real income bonanza.

But not now. The relationship has broken down. Pay, in the latest figures, is rising an annual 1.5%, well below inflation. Even adjusting for depressed bonuses, pay is rising less than 2%.

Nor is this just the result of the squeeze on public sector pay. It is rising by 1.2% but earnings in the private sector are only increasing by a slightly faster 1.8%.

There is now an official debate about how inflation is measured. Following a report from the Consumer Prices Advisory Committee, the national statsitician will consult on changing the methodology for calculating the retail prices index (RPI).

People will suspect a trick but certain aspects of the RPI, particularly clothing and footwear prices, have looked odd for a while. The so-called formula effect gap, which gives higher retail price inflation (currently 2.9%) than consumer price inflation (2.5%) may be removed.

That will not change the underlying reality, however, of prices rising more rapidly than pay. How can it be tackled? One way is for the Bank to aim, not merely for 2% inflation - its target - which it has struggled to hit, but to go for something lower. With wage growth so depressed, even 1% inflation is not too low for this economy.

The other is to look for a return to normal earnings growth. Before the crisis, allowing for what was then regarded as trend productivity growth of about 2% a year, 4% earnings growth was both consistent with the inflation target and good growth in consumer spending.

Can we return to such growth? One is tempted to say that if firms are worried about demand in the economy, as they say, part of the solution is in their own hands, in the form of more generous pay awards.

Looked at from a macro perspective, a new paper from the Resolution Foundation by Professors Paul Gregg and Stephen Machin, ‘What a drag: the chilling impact of unemployment on real wages’, does as its title suggests.

It finds that while unemployment has not risen as much as feared, at more than 8% of the workforce it has had a crushing impact on the growth in real wages.

Building on changes that were in place even before the recession - the economists think the greater sensitivity of wages to unemployment can be traced back to 2003 - Britain is a buyers’ market for employers.

The implication is that only a sharp fall in unemployment will change this. As they put it: “Real wage growth for low and middle earners will not return to significant positive territory until unemployment starts to fall significantly – probably below the levels (of between 4% and 6%) recorded in the period from 1999 to 2007.”

That is not going to happen for some time. The Bank can help by getting inflation down further. But the days when strong growth in real wages generated across-the-board rises in consumer spending are a fading memory.

My regular column is available to subscribers on www.thesundaytimes.co.uk This is an excerpt.

We should celebrate and nurture good news. In the past few days there have been three sets. In Europe, the eurozone has moved further back from the brink, thanks to the German constitutional court decision to back, with strings, the rescue fund for its troubled members and the rejection by Dutch voters of eurosceptic parties. There is a long way to got but the sense of imminent euro collapse has gone.

Then, not for the first time, came excellent job numbers, with a rise of 236,000 in employment to 29.56m, within a whisker of its pre-recession peak four years ago.

The composition of employment has changed in that time, with a drop in full-time workers and a rise in part-timers. But these were very good numbers and, as before, hard to square with a stagnant economy, let alone a shrinking one.

It is gratifying to see some things going exactly according to plan. I expected private sector job creation to easily outstrip public sector job losses, as in the 1990s, and so it has. In the past three years, the private sector has added 1.36m jobs while the public sector has cut by 689,000.

There is a distortion to the figures from the reclassification of roughly 200,000 people who work in further education from public to private sectors. Adjusting for that still leaves 1.16m additional private sector jobs, against 489,000 public sector cuts.

It is the third bit of good news I want to concentrate on today. This was the sharp narrowing of Britain’s overall trade deficit in July to £1.5 billion, from £4.3 billion in June, with the deficit on goods dropping from £10.1 billion to £7.1 billion.

Exports rose by 9.3% in value in July, while imports dropped by 2.1%. Proof that the great rebalancing of the economy towards exports is under way?

Maybe not, or at least not yet. As was suspected a month ago, the June figures were heavily distorted by the Jubilee bank holidays, which hit exports harder than imports. It is always unwise to draw conclusions from one month’s data, particularly when the distortions are so obvious.

There is still something to celebrate in the figures. The three monthly picture, shows the overall trade deficit narrowed to £8 billion in the May-July period from £10.5 billion in the previous three months.Export volumes rose 0.9%, excluding oil and erratics, while imports fell 0.8%.

Exporters are being hit by the eurozone crisis, while doing better in non-EU trade. So in the latest three months goods export volumes to the rest of the EU edged up by 0.3% but were down by 4.4% on a year earlier. Non-EU exports, in contrast, rose by 4.5% and were 12.5% on a year earlier.

The weakness of Britain’s EU markets is one reason why it is too soon to celebrate the improvement in Britain’s trade position. The fact that, even after July’s improvement there was a £7.1 billion deficit in trade in goods is a rather bigger one.

Britain’s deficit in goods, the so-called visible trade deficit, has been on a deteriorating trend for decades; Britain’s last manufacturing trade surplus was in 1982.

In 1997 the deficit was £12.2 billion, rising to an alarming £94.1 billion in 2008. You might expect it to have fallen in the recession, and it did in 2009 to £82.8 billion. But then it rose again, hitting £100 billion for the first time in our history last year.

There are two worrying things about this. One is that the trade deficit is running at these record levels despite what should have been a huge boost from sterling’s 25% fall in 2007-8, most of which has stuck.

The second is that it has occurred despite the depressed level of consumer spending, still more than 6% down (in real terms) on pre-recession levels. If we have a £100 billion deficit with consumer spending subdued, heaven knows what will happen if it starts growing strongly.

Most of the time, the growing deficit on goods has been disguised by a rising surplus on services. Britain is second only to America as an exporter of services and the surplus on services has been almost a mirror image of the deficit on goods.

The services surplus, £18 billion in 1997, reached £76.4 billion last year. Services are keeping Britain afloat. The fear is that they may be less effective at doing so in future.

Michael Saunders, an economist with Citi, the bank, has used Eurostat data to show that while the volume of Britain’s total exports (of goods and services) is up a marginal 0.1% compared with the recession’s eve in early 2008, this is well below the growth achieved by America, 12%, Ireland, 9.7%, Germany, 9.5%, the Netherlands, 9.2%, and Spain, 7.4%. One reason is service sector exporters, particularly in financial and business services, are finding life tougher as a consequence of the crisis.

What do we need to do? People often ask me why the trade figures no longer seem to matter much anymore. The markets did not bat much of an eyelid either when the very poor June trade figures came out a month ago, nor when the much better July numbers came out last week. These days capital flows, rather than trade, drive the currency markets.

Trade does matter, however. The trade gap remains a useful barometer of this country’s economic health, and of the ability of companies based here to compete in global markets.

Vince Cable, the business secretary, has begun to sketch out an industrial strategy, focused on “sector strategies” for key parts of the economy. The fact that industrial strategy carries connotations of Labour in the 1970s and that targeting sectors sounds suspiciously like picking winners has had some on the right foaming at the mouth.

That is silly. The Thatcher government in the 1980s had an industrial strategy of attracting inward investment, mainly from Japan, to revive Britain’s car industry. I remember Lord Young, her business secretary (he preferred enterprise secretary) being mocked for predicting an eventual return to a trade surplus in cars.

But it has happened. Britain is this year heading for the first trade surplus on cars since 1976, with 80% of vehicles assembled in Britain intended for export If it can happen for cars, it can happen for a range of other products, and it is the ultimate test of the success of an industrial strategy. We really should mind the trade gap.

My regular column is available to subscribers on www.thesundaytimes.co.uk This is an excerpt.

David Cameron has returned to work with a new ministerial team and, instead of freshly-sharpened pencils, some freshly-sharpened policies. In a week in which Britain’s growth was downgraded by the Organisation for Economic Co-operation and Development (OECD), the question is whether they will make a difference.

That downgrade, to a 0.7% drop in gross domestic product this year, is not all it seems. The OECD chose not to assume a statistical bounce this quarter from the Jubilee-affected second quarter, though that was the strong message from Friday's industrial production figures.

Even so, the economy is in serious need of some oomph. The question is whether it will get it. First we need to know what the government is doing.

There will be a new body to make funding and advice more accessible for small firms, probably modelled along the lines of America’s Small Business Administration; not so much a business bank as a one-stop agency.

Most of the flurry concentrated on the beleaguered construction sector, particularly housebuilding. So, on top of the £40 billion of infrastructure guarantees announced in July, there are £10 billion of housebuilding guarantees, to be used for homes for the private rented sector.

Why guarantees? The government believes it cannot reverse the capital spending cuts of the past two years without losing credibility. Though the worst of those cuts is over, it is relying on privately-funded, publicly-guaranteed spending for a boost in coming years.

There will be some tweaks to a planning system that was only recently put into place in March after what the Home Builders Federation describes as a two-year “policy hiatus”. But, while homeowners will now be able to build bigger structures in their gardens without planning permission than before, this is no planning free-for-all.

Housebuilders should get local authorities off their backs when its comes to onerous so-called Section 106 requirements to include a high proportion of affordable homes in new developments. They will be hoping the Community Infrastructure Levy, payable on new developments, is not used as a cash cow by local politicians.

Talk to housebuilders, however, and you get a simple message. Without mortgage availability, the industry will remain in the doldrums. Since the financial crisis fired an Exocet five years ago, cutting off two-thirds of new loans at a stroke, housebuilders and sellers of existing homes have been struggling under this handicap.

While builders welcome anything that makes planning less burdensome, mortgages matter most. The £280m extension of the government’s FirstBuy scheme for first-time buyers is welcome.

Most hopes lie with the £80 billion Treasury-Bank of England Funding for Lending Scheme. If it gets mortgages flowing, building will follow. If not it will remain very depressed. In the 12 months to end-June, new housing starts in England were just 98,670, 10% down on the previous year. Far from building its way to recovery, the industry has been digging into recession.

Three months ago I quoted a paper from the think tank CentreForum by the economic historian Nick Crafts. It stressed the role of housebuilding in Britain’s 1930s’ recovery, on the back of cheap money and an absence of planning controls.

Could history repeat itself? Crafts suggested perhaps an additional 3m new homes are needed, and rolling them out an extra 150,000 a year could generate 750,000 more jobs. I do not disagree with his numbers, though they would require the industry to more than double its output.

The question of whether construction can lead to stronger growth has to confront the fact that, important though it is, it is small relative to the economy as a whole.

Construction accounts for 6.8% of GDP, according to the Officed for National Statistics. New homes are only part of the eector, accounting for under a fifth of construction output last year, just over 1% of GDP.

This arithmetic means even a very substantial boost in construction has only a muted impact on overall economic activity. Let me demonstrate. Construction output in April-June was over 16% down on its pre-recession peak in early 2008.

Suppose, instead of sliding, construction had been flat. Would it transform the GDP picture? No, GDP would be a modest 1.3% higher than current figures suggest.

If all government initiatives doubled housebuilding next year (which is highly unlikely). It would be to boost GDP by a little over 1%. A similar result would be achieved with a 20% rise in output - again unlikely - for construction as a whole.

The point is not to knock initiatives to boost construction and housebuilding. I hope they work. But recoveries have to be rounded. They cannot rely on one sector.

If more housebuilding encourages consumers to spend more, over and above the multiplier effects of additional construction employment, then good. The 1930s, as well as a housebuilding boom, was the age of the consumer, with cars, electrical products, confectionary and cosmetics contributing to a sustained spending upturn.

If the promise of more airport capacity, however distant, persuades businesses that this is a time to invest, then good too.

And if. perhaps above all, the international environment improves, it is possible the government’s flurry of announcements will not fall on stony ground.

One discovery in recent years is that policymakers in Britain are powerless in the face of global events. We like to maintain the fiction that everything is the result of decisions by the chancellor or the Bank of England’s monetary policy committee.

As far as the short-term outlook for Britain’s economy is concerned, though, the big announcement was not from Cameron or George Osborne but Mario Draghi, president of the European Central Bank.

Many are concerned about his pledge of “unlimited” bond buying of eurozone countries’ debt under the new outright monetary transactions(OMT) programme. But if it boosts a shrinking eurozone economy and stabilises volatile markets, most will have reason to be grateful. The eurozone crisis has cast a long shadow. Anything that lets in a bit of sun will be welcomed.

My regular column is available to subscribers on www.thesundaytimes.co.uk This is an excerpt.

The Bank of England’s monetary policy committee (MPC) meets this week, and quantitative easing will be on the agenda.

Though it is probably too soon for the Bank to add to the £375 billion it has already sanctioned - not all of which has yet been done - the City thinks there is more to come, probably in November.

If £375 billion of quantitative easing (QE) sounds a lot, equivalent to a quarter of Britain’s annual gross domestic product, some think it has not gone far enough.

Adam Posen, who left the MPC on Friday, said in an interview one of his biggest regrets was not persuading the rest of the committee to do more in 2010 and 2011.

So QE is a hot topic. Every time I give a talk, I get questions on it. People are engaged, and sometimes enraged.

What the Bank may have thought was a technical exercise has people interested, puzzled and worried. Many see it as an exercise in propping up undeserving banks, while others cannot understand why £375 billion, £6,000 a head, is not simply handed out to the public, or used for something worthwhile, like infrastructure or housing.

Others think QE is the kind of policy associated with dodgy dictatorships. When a central bank buys the debt of its own government, is it time to stock up on gold bars or move to Switzerland?

Most of these questions are quite easily answered. The Bank prefer to call QE asset purchases. It involves expanding the Bank’s balance sheet - electronically creating money - and using it to buy assets, overwhelmingly government bonds (gilts).

So far the Bank has bought just under £350 billion of gilts, nearly 39% of the total of so-called conventional stocks in issuance. It does not buy index-linked gilts.

The clue to why that money could not just have been handed out is in the name, asset purchases. The new money is used to buy gilts from pension funds, insurance companies and overseas institutions (the banks do not hold many). When QE has done its work, the assets will be sold back.

Unless households had assets to hand over, say a share of their property, there could be no equivalent policy for them. It would be a massive, unfunded tax cut.

The same applies, with a little qualification, to the arguments about infrastructure, housing or small businesses. It would have been possible for the Bank to buy infrastructure bonds, bundles of new mortgages or packaged small business loans, directing money to parts of the economy where it is needed. But the Bank is a conservative institution, and chose the least risky assets.

Buying gilts may be low risk, but is it dodgy? The figleaf of propriety is preserved by the fact that the Bank’s gilt purchases are not direct from government, or its Debt Management Office, but private holders.

It is, however, a figleaf. Many private holders of gilts are very short-term owners. There is no doubt funding a record budget deficit has been made infinitely easier by QE. A new buyer for gilts has come on to the scene when the government needed it.

Desperate times call for desperate measures, however, which is why I backed the first £200 billion of QE in 2009, though not the second round launched last autumn. The question is whether the policy has been as successful as the Bank claims.

In its most recent research, last month, the Bank looked at the effects of QE on different groups, largely to deflect criticism that it has hurt pensioners.

It identified four potential boosts to the economy. Gilt purchases give sellers money to move into other assets, including corporate bonds, equities and property.

They boost market liquidity, send a signal that interest rates are likely to remain low for longer (the Bank will not raise rates while doing more QE) and, it suggests, could boost consumer confidence.

Adding all this up, it concluded: “Without the Bank’s asset purchases, most people in the United Kingdom would have been worse off. Economic growth would have been lower. Unemployment would have been higher. More companies would have gone out of business.”

In earlier research, endorsed in its latest publication, it suggested that the first £200 billion of QE boosted the level of GDP by between 1.5 and 2 percentage points. The second round. launched last October, is not yet complete but, allowing for that, and the fact that the policy operates with a lag, suggests a total GDP effect so far, according to the Bank, of 2.5 to 3.5 percentage points.

Is this plausible? Latest official figures suggest the economy is only 2.1% above its recession low in mid-2009. The Bank’s numbers imply all that growth - and more - is due to QE. Without it, it seems, the economy would have shrunk. Tied to the fact that on current data it has shrunk in the past nine months, and the growth benefits look to be exaggerated.

In 2010, for example, Britain benefited from a strong rebound in the global economy, which grew by more than 5%, and by the turnaround in inventories - stocks - that always follows the worst phase of a recession. Every other economy began to recover in the middle of 2009, whether or not they adopted QE.

For me the simplest test is to look at what QE is supposed to do: boost the money supply. Since 2009, M4 money supply measure has risen around 5%, adjusting for financial sector deleveraging.

Though the relationship between money and other economic variables is never perfect, that does not cover the 10%-plus rise in prices in the past three years, leaving no room for a growth boost.

The Bank would say it is impossible to know what would have happened in the absence of QE. The same applies, however, to claims of its effects on other asset prices. Financial markets are international. Ascribing those rises to QE is pushing it.

If scepticism about the growth benefits of QE is in order, is it harmless? Not necessarily. At some stage the Bank will have to sell the gilts it has acquired, an exit strategy that might not be easy.

There is an inflation risk, though not a big one with the money supply so depressed. My argument has been that, though sterling is higher than when the policy first started, regular QE hints or announcements have kept it from rising more, contributing to higher imported inflation than necessary. Disappointingly, we may be seeing a re-run of that now.

The biggest problem is that markets are addicted to QE, in the way they used to be addicted to low interest rates before the crisis. If there is a bond market bubble, the Bank is helping to keep it inflated. We should be sceptical of the claimed benefits of QE. The sooner it ends, the better.

My regular column is available to subscribers on www.thesundaytimes.co.uk This is an excerpt.

A year ago, amid the fall-out from the riots, turmoil in the eurozone and the stunning loss of America’s AAA debt rating, George Osborne looked to be in fiscal trouble.

Net borrowing in July 2011, initially reported at £20m, added to a picture of a deficit stubbornly refusing to come down . The deficit reduction programme, it seemed, was stuck.

Things changed. July’s small deficit was eventually revised to a surplus of £2.8 billion. Borrowing did come down significantly over the course of 2011-12, to £125 billion, from £148 billion in the previous year, 2010-11. The strategy survived.

Whether history is repeating itself remains to be seen. Public borrowing in the first four months of the current fiscal year is not just failing to come down, it is up.

Adjusting for two distortions - the transfer of the Royal Mail pension plan to the public finances and a payment to the government at the end of the Bank of England’s Special Liquidity Scheme - April-July borrowing was £47.2 billion, £11.6 billion higher than a year earlier.

Though the fiscal task this year is less onerous - on an underlying basis borrowing only has to drop by £5 billion to £120 billion - things are heading the wrong way.

There will be data revisions for all the usual reasons, and the fact the Treasury is running in a new computer system for monitoring spending. A North Sea shutdown artifically depressed tax receipts.

Nor was a July deficit quite as rare as it was painted when the figures were released. The government was £557m in the red in a month in which corporation tax payments are concentrated but this was better than two years ago, when the deficit was £3.4 billion, or three years ago, when it was £6 billion. Every year from 1993 to 1996, July was a deficit month.

Not only that but a glance at the details shows how complex working out what the government’s fiscal position is. It is a minefield, making the accounts of the messiest individual or business look like child’s play.

Perhaps because of this, both the Office for Budget Responsibility and the Institute for Fiscal Studies say it is too early to say this year’s fiscal target will be missed. There is time to make up lost ground.

Does this mean the chancellor’s garden is rosy? Not a bit of it. In fact, the more you look at it, the more of a mess it is.

Some readers will be too young to remember the Margaret Thatcher year. In her first term as prime minister, 1979-83, almost the entire nation believed Britain was reeling under the impact of “the cuts”.

Labour, the unions, most economists and the majority of voters believed it, and ministers did nothing to disabuse them of it. The reality was rather different.

Whie capital spending, on infrastructure, was indeed cut sharply, by more than half, the lion’s share, current spending, rose strongly, increasing by 13% in real terms over four years.

Some of this was the effect of recession, pushing up the bill for unemployment and other benefits. Much of it was public sector pay, after the government agreed to honour the recommendations of the Clegg commission (no relation).

Only in its second term did the government start to get to grips with spending.
It is happening again. Current spending is rising under the coalition, and is intended to carry on doing so until beyond the end of the parliament.

Capital spending, as then, is being slashed, from £48.5 billion in 2009-10 to £26.1 billion in 2011-12, Osborne having taken the plans he inherited from Alistair Darling and run with them. These are the “cuts”. As under Thatcher three decades ago, the coalition has failed to put a brake on the recurring items of spending.

So last month, current spending was up 5.1% on a year earlier. Welfare payments, (officially net social benefits), were up 6.2% year-on-year last month, and an even more worrying 7% in the April-July period.

This is not a temporary phenomenon. Cash cuts in current spending are not planned this year, next year nor the year after. By 2016-17, the government expects current spending to be £709 billion, £80 billion or 13% above the cash total for 2010-11.

In later years the hope is this spending bill will rise more slowly than inflation. The evidence so far is discouraging.

Why is it happening? Though some payouts such as child benefit and the working tax credit are being frozen, a government that has a reputation for slashing spending is being rather generous.

Most benefits rose by 5.2% in April, in line with last September’s inflation rate. It was a kick in the teeth for workers, who these days are lucky to get a 2% pay rise. It was not the action of a government determined to bear down hard on spending.

We may have to await Iain Duncan Smith’s reforms for better control of welfare spending, though they will not be fully effective until 2017. Osborne’s efforts, such as the cackhanded initial attempt to limit child benefit to basic rate taxpayers, have been unimpressive and ineffective.

In opposition, Tories talked about following Canada, which cut public spending by 20% over three years in the 1990s. In truth the gulf between British and Canadian policy is as wide as the Atlantic.

So far deficit reduction has come from two things: those deep cuts in capital spending and the hike in Vat to 20%. It is obvious why the Treasury wanted the Vat hike: it did not trust the politicians to cut spending. But higher taxes and cuts in infrastructure spending are bad for growth, short term and long-term.

Failing to tackle the current spending bill, by the same token, is bad for the economy: leaving us with a size of state that reflects the overblown Blair-Brown years rather than the current reality.

Some of the weakness in corporation tax revenues - down 19% in July compared with a year earlier - is temporary. But the OBR thinks some will persist. The days when the City was a giant cash cow for the Exchequer are over. The days when booming profits allowed ministers to play Lady Bountiful are gone for some time.

So, even though the latest numbers for the public finances are not quite the disaster portrayed last week, Osborne is in a deep bind. Strongly rising current spending and weak corporation tax leaves him little room for fiscal manoeuvre.

The boost to infrastructure spending business wants cannot realistically be achieved without cuts elsewhere. Getting such cuts past his coalition colleagues is likely to be impossible. He has made his choice. Like the early Thatcher, he has a reputation as a cutter that is undeserved. That may be where the comparison ends.

My regular column is available to subscribers on www.thesundaytimes.co.uk This is an excerpt.

Normally, even when economists fall down on forecasting they are pretty good at explaining things after the event. Now they are just left scratching their heads.

The latest very good job market figures has them scratching even more. How can economy that is supposed to be back in recession have generated 201,000 new jobs in the April-June quarter?

We will get the Office for National Statistics’ second take on that quarter this week, amid expectations that the initial 0.7% fall in gross domestic product will be revised. That alone will not solve the puzzle.

Nor will apparently simple explanations relating to the Olympics. Though there was a 99,000 rise in London employment in the second quarter, there was a proportionately bigger 69,000 increase in the smaller north-west region. Unemployment fell in most parts of the country.

The answer, I think, is in three parts. Gross domestic product is not as weak as current official figures suggest and will be significantly revised. There is no way GDP in the second quarter of this year was lower than two years ago.

The composition of GDP is also important. Even on unrevised data, service sector output has grown in the past two years, while manufacturing has been flat. The average has been dragged down by a 27% drop in “mining and quarrying” (mainly North Sea oil and gas), an 8% drop in construction and falling electricity output.

The 499,000 rise in employment over the past two years thus partly reflects those parts of the economy that are growing, including much of the service sector, combined with what seems to be an absence of job cuts in those that are shrinking.

Maybe the North Sea is a genuine example of fast-falling productivity, in that the oil and gas becomes progressively harder to get out but the numbers of people involved in doing it do not fall.

Second, as some labour economists point out, the job market may just be more efficient: better at getting people in to the available vacancies that is used to be. From the start of the crisis five years ago, the labour market has shown its flexibility. Employment, at just under 29.5m, is within 100,000 of its pre-crisis peak but its composition has changed in favour of part-timers and the self-employment.

Third, for employers, weak wages - and falling real wages - may have enabled them to keep people on when in a different environment they would have cut back. It has meant that they have recruited when at another time they might have held back. For firms, the wage bill is often as important as the headcount, if not more so.

The puzzle will not be fully resolved for some time but in the meantime there is another concern. The employment figures were not the only strong numbers last week. The weakness of demand has been the big obsession yet the latest retail sales figures suggested it is coming back.

Retail sales rose by 0.3% last month, which was better than expected. More interesting was that June’s apparent washout, initially reported as a 0.1% sales rise, was revised up to 0.8%.

Retail sales volumes in July were up by 2.8% on a year earlier, or 3.3% excluding petrol and diesel. Not only are they strong, but they are exactly following the script.

My argument has always been that the biggest reason for weak consumer demand was the unintended squeeze on households from high inflation.

That squeeze is easing fast - even a small upward blip in July did not prevent inflation, at 2.6%, being half its rate last September - and spending is picking up in consequence. Consumers have been late to the party but they now appear ready to join it.

Why the concern? Because the political debate is dominated by the very weak data, notably GDP. This is not entirely a bad thing. Some things being urged on the government because the economy is apparently not growing are sensible.

If it can find room within its broad fiscal plans to spend more on infrastructure and boost housebuilding that would be good. If funding for lending restores credit growth to small and medium-sized firms and home-buyers, that will be good too.

When they were asked recently to suggest ways of boosting growth, these were the suggestions of some of the signatories to a letter to The Sunday Times in February 2010, which supported deficit reduction.

But some of the things being urged on the chancellor from others, such as a fully-fledged Plan B of abandoning deficit cuts, would not be sensible at all and are a direct product of the apparent “no growth” economy.

The same is true of the Bank of England and quantitative easing. Would there be a case for greatly expanding the QE programme, as the Bank is doing with its near-doubling to £375 billion, in the context of a more rounded picture, taking in the strength of employment and retail sales, as well as the weakness of GDP, construction and parts of industry?

I think not. The Bank is aware of the problems with the GDP data - or should be - but is still rather too willing to use them as its guiding light.

Most of all, the risk is that the gloomy “double-dip” view undermines business and consumer confidence. That does not appear to be happening to firms as far as recruitment is concerned, but it may be constraining investment.

Consumer confidence has been weak in recent months even as retail spending has risen, so perhaps we can make too much of a gloomy mood. But it does not help.

One day, all this will be resolved. Norman Lamont, chancellor in the early 1990s, suffered when his “green shoots of recovery” of autumn 1991 were apparently snuffed out by a drop in GDP in early 1992. He was asked to step down in May 1993, with the economy seemingly struggling in vain to get up to cruising altitude.

The latest official figures show, however, there was no drop back in GDP in early 1992 and that the economy grew by a strong 3.1% in 1993. The numbers change, but usually too late.

My regular column is available to subscribers on www.thesundaytimes.co.uk This is an excerpt.

Let me start today with a simple statistical point. When the Bank of England came out with its new “zero” growth forecast for 2012 last Wednesday it was widely reported, particularly by broadcasters, that we can say goodbye to growth for the rest of this year.

But zero growth for 2012 in fact implies quite a lot of growth in the coming months. How so? The Office for National Statistics’ index of gross domestic product for 2011 was 102.6.

In the first half of this year it averaged 101.9, and in the Jubilee-affected second quarter only 101.5, pending revisions. We need an average of 103.3 in the second half just to achieve 2011’s average. By my calculations that requires 1% or so growth in both the third and fourth quarters.

It is, as they say, a tough ask and may not be achieved. But it is not a forecast of flatlining until 2013.

What does zero growth in 2012 mean in a wider sense? It means, however you slice it, and whatever data revisions come along, this is a disappointing recovery. Five years on from the “official” August 9 2007 start of the global financial crisis and credit crunch, the economy remains crunched.

Things have changed enormously in those five years, and it would be wrong to compare what people in authority were saying pre-crisis and now. But it is reasonable to look at how things have evolved since we knew the extent of the damage, at the economy’s low point in 2009.

Back then, in its August 2009 inflation report, the Bank predicted 3% growth for 2012. Its famous fan charts, which now tell us that in three years the economy could be growing by nearly 6% or shrinking by 1%, had a similar range back in 2009. As an aside, that range makes them next to useless for businesses and other users as a guide to what might happen.

To be fair to the Bank, when introducing that report, Sir Mervyn King warned that “recovery could be slow and protracted”.

The Treasury was even more upbeat with its numbers, predicting growth of between 3.25% and 3.75% for 2012 in the autumn of 2009, even as the economy appeared to be struggling to escape recession, and even when Alistair Darling, the then chancellor, was warning of the huge uncertainties that lay ahead.

When the coalition took over in May 2010, David Cameron and George Osborne lost no time talking of the huge challenges. But they also had a reassuring official forecast to draw on, the Office for Budget Responsibility predicting 2.8% growth for 2012. This was a forecast made after Osborne’s June 2010 budget, which announced the 2011 hike in Vat.

This is not to heap all the blame on the official forecasters, most non-official forecasts falling into the same trap. Maybe politicians, and the Bank, had to offer hope, for fear of making a bad situation worse.

Undoubtedly, however, the management of expectations could have been better. If people had been warned that things were so difficult we would be lucky to get any growth at all, the outturn would have been less disappointing.

By the same token, if back then the Treasury and Bank had believed the economy would be struggling to grow in 2012, maybe they would have put in a greater effort to prevent such an outcome.

By that I do not mean the necessary reduction of the deficit. We should not believe party propaganda on fiscal policy. Darling recognised Britain’s record budget deficit was unsustainable and began the task of cutting it. In 2010 he reversed the temporary Vat cut, increased the top rate of income tax and started drastically cutting public sector capital spending.

Osborne stuck with the capital spending cuts, raised Vat again but softened one planned Labour rise - employers’ National Insurance - and raised the personal income tax allowance. Growth may have been a touch stronger under Labour’s slower deficit reduction but not so you would notice.

Part of the reason for the growth disappointment has been that it has been one damned thing after another. Just as the uintended squeeze on households from high inflation begins to ease, so the impact of the eurozone crisis intensifies.

The latest trade figures show second-quarter exports to the rest of the EU were down 9.9% on a year earlier, even as non-EU exports showed an impressive 9.7% rise.

A credit crunch is, however, a credit crunch. Perhaps Osborne is too deferential towards King. Maybe the Treasury and Bank believed in a “creditless” recovery. Maybe they believed the forecasts.

The fact is, however, the response to the continued lack of credit in the economy, for small and medium-sized firms and households, has been piecemeal and mostly ineffective. We have had Project Merlin, credit easing, the NewBuy and other mortgage schemes, all attempting to get around the basic problem.

At no stage during this period have I had the impression that Osborne and King, sleeves rolled up, have been working together in a determined way to get credit flowing. The governor’s lack of enthusiasm has at times been palpable.

One thing the Bank has ploughed on with enthusiasm is quantitative easing (QE), launching a second round last autumn. I think we are entitled to more than a little scepticism about it.

Apart from the economic weakness that followed the latest round, QE is supposed to boost the money supply. Yet the Bank is honest enough to admit that in the nine months to June, £125 billion of QE only led to a £30 billion money supply boost.

Now all hopes lie with “funding for lending”, the £80 billion scheme launched last month to provide cheap funding for the banks as long as they maintain or increase lending.

Funding for lending is late, roughly by four years, and while I agree with it principle, the risk is of another damp squib. The Bank says its success will be hard to assess, and that it may only prevent lending from falling further over the next 12-18 months.

That would be yet another huge disappointment. Five years on, the economy is still in the grip of the credit crunch. We may be in its deadly embrace some time.

My regular column is available to subscribers on www.thesundaytimes.co.uk This is an excerpt.

Think today about two countries, both in Europe but not in the euro. They should, in theory, be facing very similar circumstances.

But one country, having performed strongly since the worst of the global financial crisis, surprised the markets a few days ago with a 1.4% jump in gross domestic product in the second quarter.

The other, having struggled since the crisis, shocked markets with a 0.7% second quarter GDP fall. In July, one country’s purchasing managers’ index for its manufacturing sector rose from 48.4 to 50.6, while the other’s slumped from 48.4 to 45.4, its lowest for more than three years.

To end the suspense, the first country is Sweden and the second, as you may have guessed, Britain. For Sweden, to quote Abba, it is a case of The Winner Takes It All.

Though Sweden’s latest GDP figures were a surprise, and have resulted in a hurried upward revision of 2012 growth forecasts, they were no flash in the pan.

After slumping 5% in 2009, Sweden’s economy surged 5.8% in 2010 and 4% last year. Britain shrunk a little less in 2009, 4%, but grew only 1.8% in 2010 and 0.8% last year. Leaving aside the vagaries of the data, the maths suggest any growth this year will be difficult. Sweden’s economy is well above pre-crisis levels of GDP, while Britain’s is more than 4% below it.

What is Sweden’s secret? It helps to have had a banking crisis in the past. The Swedish crisis of the early 1990s was used as a template in the wider crisis of 2008-9.

Bust banks were nationalised and assets sold off. Taxpayer funds were injected at considerable cost. The banks were later privatized and, on some measures, at no overall cost to government of the rescue.

The episode did not make Sweden immune to the crisis in 2008-9, as the GDP figures show. But, unlike in Britain, there has been no prolonged banking hangover.

Some Swedish lessons are water under the bridge. In Britain, the Bank of England and Treasury were happy to condone a sharp fall in sterling, around 25%, as the mechanism for rebalancing the economy in favour of exports and manufacturing.

Maybe the policy needs more time to work but you would have to say the evidence so far is discouraging. Britain’s manufacturers are struggling and export success has been balanced by rising imports.

In Sweden, in contrast, the currency has stayed strong but exporters have done well and conrtinue to do so. Ben May, who follows the Swedish economy for Capital Economics, notes that its exports of high-technology capital equipment, which is in demand all over the world, do not appear to need a devaluation boost. Britain has a current accountb deficit of 2%-3% of GDP, while Sweden has a 6%-7% surplus.

The fall in the exchange rate has, of course, had other negative effects on Britain’s economy, pushing up inflation via higher import prices. Officail figures last week showed that real incomes per head in the first quarter dropped to their lowest level since 2005, with high inflation the main culprit.

Some people think consumers are not spending in B ritain because of high levels of household debt. There is, however, no evidence of that. Sweden has similar levels of household debt as a percentage of GDP and income as Britain. It also had a similar pre-crisis rise in house prices.

Yet consumer spending has recovered much more strongly - up 3.6% in 2010 and 2.1% in 2011 - the absence of an inflation squeeze on real incomes being a big factor.

The final factor is fiscal policy. David Cameron used to talk about fixing the roof while the sun was shining. Sweden, having had awful public finances in the 1990s, went into the crisis with healthy ones, a budget surplus of 3.6% of GDP in 2007. Britain, in contrast, had deficits of similar size on comparable figures from the Organisation for Economic Co-operation and Development.

The result of what the OECD describes as “steadfast fiscal discipline in the past” is that Sweden has not needed the tax hikes and spending cuts Labour and the coalition were forced to introduce in Britain. With a budget close to balance, Sweden has room for a fiscal stimulus, if needed.

What can we learn from the Swedish experience? The most fundamental lesson is that, logical though it seemed, devaluation is no short cut to export success.

The route is a longer and more arduous one, having enough firms with the right products that other countries - particularly emerging economies - want. Britain has some - and is the world’s third biggest exporter of services - but not enough.

Second, inflation matters. Falling inflation is the main hope for a sustained recovery in consumer spending, as the growth in real incomes is restored. The Bank lost control of inflation - it would argue because of factors outside its control - and the ecnomy has suffered in consequence. At the very time low inflation was needed, it was not achieved. We have to hope things will be different from now on.

What about fiscal policy? Going into the crisis with a budget deficit was an error. Is trying to fix too quickly the bigger deficit that resulted from the crisis also an error?

The National Institute of Economic and Social Research examines this in its quarterly review. Nitika Bagaria, Dawn Holland and John Van Reenen, sensibly acknowledge that fiscal consolidation - deficit-cutting - “is essential for debt sustainability”.

Research in America by Bradford DeLong and Larry Summers suggests deficit-cutting when the economy is depressed - and monetary policy has little further room to respond by cutting interest rates - is more damaging. So the National Institute authors examine the case for delaying further deficit cuts until after 2014.

The effects, unsurprisingly, are that economy would grow more. What surprised me was that these effects are quite small. So next year the National Institute expects Britain to grow by 1.3% with deficit cuts but only 2% without them. In 2014, the numbers are 2.4% and 2.6% respectively, while in 2015 2.7% and 2.9%. After that, growth is weaker under the “delayed tightening” scenario than under existing plans.

So is it worth delaying? Even the International Monetary Fund has suggested next year’s fiscal tightening might have to be postponed, so it is a reasonable question.

More growth now is the economists’ equivalent of a bird in the hand worth two in the bush. Unemployment would be lower now - ameliorating some corrosive effects of long-term unemployment, particularly for the young - but higher later.

The big question is whether the government could get away with fiscal delay, in the markets and with ratings agencies. If the short-term growth benefits were more striking, ministers would no doubt be more willing to risk it. As it is, I suspect they will stretch “Plan A” as far as they can but stick with it. They must envy the Swedes.

My regular column is available to subscribers on www.thesundaytimes.co.uk This is an excerpt.

On Wednesday we will get figures for gross domestic product in the second quarter. Everybody is braced for a third successive decline and a fresh outbreak of gloom.

The National Institute of Economic and Social Research and RBS, both of which track the components that make up GDP, predict a 0.2% fall, following drops of 0.4% in the final quarter of last year and 0.3% in the first quarter of this year.

It is anybody’s guess what the Office for National Statistics (ONS) will come up with, though the recent pattern has been for it to come in well below independent predictions. If the number is down, expect some “triple-dip” headlines, though they should be reserved for a new recession, not a third successive quarterly decline.

I don’t want to repeat word for word what I said a month ago but the GDP figures still cannot be squared with the strength of the employment data.

Latest labour market statistics show in the most recent three months for which the ONS has data, March-May, employment rose 181,000 to 29.35m, its biggest rise since the three months to July 2010.

Unemployment fell by 65,000 to 2.58m, or 8.1% of the workforce. Though unemployment is higher than a year ago, and the figures may have been flattered by an extra day’s work in May (the late spring bank holiday was shifted to June), these figures were inconsistent with even a mild recession. They speak of a growing economy.

Isn’t the strength of employment just a London effect, an Olympic effect, which will disappear as soon as the five-ringed circus has moved on? Well, no, even apart from G4S’s recruitment woes.

While 62,000 of the 181,000 rise in employment in the March-May period was in London and the south-east, this is broadly in line with the region’s share of the national economy. It is hard to detect much of an Olympic effect in a 64,000 rise in employment in the north-west.

If not the Olympics, isn’t it all part-timers? Again, no. In the March-May period full-time employment rose by 133,000, part-timers by 48,000.

Let me make one thing clear. I am not suggesting we are enjoying a normal recovery. Last September, when the eurozone’s lurch into more serious crisis added to the headwinds, I said the best we could hope for was a flat economy until the middle of this year, after which consumers should get a boost from falling inflation.

It does not take much to tip a broadly flat GDP figure into a negative number, particularly on initial ONS data. For reasons frequently set out here - the inflation squeeze on real incomes, the government’s fiscal tightening, weak credit growth and the eurozone crisis - growth is much harder to come by than in a normal recovery.

The International Monetary Fund’s Article IV assessment of the UK economy, available on its website (www.imf.org) is a good summing up of constraints on growth. Its downward revision of growth this year to just 0.2% arose from the arithmetic of the GDP figures described above.

The labour market figures show us, however, that since the double-dip recession apparently began, in the early autumn of last year, the economy has added a quarter of a million jobs. Unemployment has come down by 100,000 (not as much as the rise in employment because the workforce continues to grow) and total hours worked in the economy have risen by 2%.

Let me put these numbers into perspective. The rise in employment, just since September, is more than in the entire growth years of 2002, 2003, 2006 and 2007, of which only the latter was affected by the crisis.

The rise in hours worked, again only since September, is more than occurred in any year during the economy’s long and undisturbed upturn from 1992 to 2008.

So what is happening? The labour market figures could be wrong, though they include data from different sources. Another measure, workforce jobs, rose by 471,000 between autumn and spring.

It could be employers are having to recruit because productivity - output per worker or output per hour - is so dire. While the University of Cambridge report on “productivity pessimism” by Bill Martin and Bob Rowthorn cited here recently argued that much of the growth in jobs has been in low-productivity sectors, a productivity collapse still looks implausible, not least because a shift from public to private sector jobs should boost productivity.

What can we take away from this? The GDP figures will eventually be revised higher, as always, after they have ceased to be of relevance. Even the battered Bank of England has fallen under their spell, launching another £50 billion of quantitative easing this month, despite its earlier scepticism about the official figures.

The Bank’s own regional agents report growth in the economy in all the sectors they monitor with the exception of construction. Growth appears to have moderated but this is not the same as recession.

What is really happening? Most people do not trouble themselves about the details of GDP figures, and subsequent revisions, though they may respond to the gloomy headlines when the figures are reported.

Headlines are not good at distinguishing between magnitudes. If this week’s figures show a 0.2% fall in the second quarter, GDP will have dropped by a little under 1%, pending revisions, over the course of nine months. That is less than half of the fall that was happening each quarter in the most intense phase of the 2008-9 recession.

People should also focus on the bigger picture. As well as the fall in the unemployment rate to 8.1%, we had an unexpectedly large drop in inflation to 2.4%. Unemployment and inflation are the two most important variables affecting households.

Unemployment, or the fear of it, keeps households from spending. Inflation, when it is too high, squeezes the income needed for that spending. Arthur Okun, the legendary American economist, famously combined the two - the unemployment and inflation rates added together - into his misery index.

Britain’s misery index hit a peak of 13.7 in September last year, made up of an 8.5% unemployment rate and a 5.2% inflation rate. Thanks to gently falling unemployment and rapidly falling inflation, it has now dropped to 10.5. It was last lower in November 2009 when, as we now know, the economy was pulling quite strongly out of its 2008-9 tailspin.

The mood may be gloomy but misery is easing, as far as most households are concerned. The test for the economy, and ultimately the recovery, will be whether this translates itself into spending in the second half of the year.

My regular column is available to subscribers on www.thesundaytimes.co.uk This is an excerpt.

The Libor scandal has given us a new perspective on Sir Mervyn King. The governor has become The Guv’nor, the genteel grandee of the Square Mile as a bit of East End muscle.

In telling Marcus Agius, the Barclays chairman, Bob Diamond had to go, we saw not so much the governor’s eyebrows as the governor’s headbutt.

Maybe he had to be blunt because, judging from Agius’s circumlocutions in front of the Commons Treasury committee, he wanted to be sure it had sunk in.

This is not, of course, the first time the authorities have ordered the banks to do things they would have preferred not to. Fred Goodwin, the former RBS chief executive, memorably described being forced to take a huge chunk of taxpayer-provided capital as a “drive-by shooting”.

The banks are having the Vickers Commission proposals imposed upon them, which will ring-fence their commercial and investment banking operations.

The point is that the banks are being told to do a lot. There can be no greater official interference in the business of a private company than telling its chairman to sack his chief executive. This is not to say King was wrong, far from it, but it gave the lie to the idea of the banks being free agents.

This, for me, raises a bigger question. Why, if the authorities can order the banks to do so much, can the Bank and the Treasury not just tell them to lend? The Bank’s role is as much to ensure an adequate flow of credit into the economy as it is to prevent that flow from being excessive. Why is it failing in that task?

On Friday we had details of the latest official wheeze, “funding for lending”, unveiled at the Mansion House last month. Under it, the banks will be offered official funding at below market rates, probably at about 0.75%, in exchange for maintaining or increasing lending.

It is the latest in a long line of initiatives, including the Project Merlin deal with the banks on small business lending and the credit easing plan unveiled by George Osborne at last year’s Tory conference.

There is nothing wrong with funding for lending in principle, which has the potential to get £80 billion more into the economy. But the banks are required only to "maintain" their lending to get the cheap funding, and there is no guarantee they will pass the low funding costs on to customers. Business groups have welcomed it, but are sceptical about whether it will transform small firm or consumer lending. And I cannot help thinking that it and the other schemes are a roundabout way of proceeding.

If there is genuinely no appetite for borrowing, as the banks often say, even cheap funding will make little difference. If loans are only viable because they are made on the back of such subsidised funding, then maybe they should not be made at all.

But if, on the other hand, the banks are simply holding back, as I believe in large part they are, then a bit of the muscle directed at Agius over Bob Diamond ought to be enough to unleash more lending, rather than dancing around the problem with fancy and complex schemes.

The banks will say, when they are not blaming lack of demand for loans, that regulators are to blame for a credit famine that has seen small business lending fall almost continuously since early 2009.

Andy Haldane, the Bank’s executive director for financial stability, responded in The Times, saying it is not a bunch of “risk nutters” stifling the recovery. The Bank’s financial policy committee recently issued guidance that liquid assets can be used to support credit and growth, “not stuffed under banks’ mattresses”.

All well and good, but if the banks are under the impression that they are under regulatory pressure to de-risk themselves rather than lend, which they are, credit availability will continue to be a problem.

What does the Bank do when faced with a weak economy? It prints money. This month’s announcement of a further £50 billion of quantitative easing (QE) will take the total to £375 billion, analysts predicting an eventual £500 billion of asset purchases, mainly gilts (UK government bonds).

My position on QE is straightforward. I had no problem with the first round of £200 billion, launched in March 2009. The economy was falling off a cliff and the kitchen sink was needed. Stopping the slide was essential, and there was a genuine fear that prolonged deflation - falling prices - was a serious risk.

The second round, launched last October, was different. Growth had slowed but there was no collapse. Though inflation is now falling, deflation did not come into it. What should have been an emergency tool became an everyday instrument.

The Bank would say QE proved itself in 2009, boosting both growth and inflation. But we only have its assessment to rely on, and it is not an independent witness. I am not aware of a rigorous independent investigation of QE

I am not the only one concerned about the use of QE in these circumstances. Pensioners’ groups point out that, by depressing bond yields it has hit annuity rates, as well as widening pension fund deficits. There is something inherently uncomfortable about a central bank buying so much of its government’s own debt.

Such discomfort has reached the Bank for International Settlements, the central bankers’ bank. Ultra low interest rates and large-scale asset purchase programmes such as QE run serious risks, the BIS said in its annual report.

They could, paradoxically, damage the banking system, distort financial markets and put off necessary tough decisions, it warned. They have boosted commodity prices worldwide, pushing up inflation.

And, it added: “Failing to appreciate the limits of monetary policy can lead to central banks being overburdened, with potentially serious adverse consequences. Prolonged and aggressive monetary accommodation has side effects that may delay the return to a self-sustaining recovery and may create risks for financial and price stability globally.”

We should listen to the BIS. It was prescient in warning of the strains that resulted in the global financial crisis. It is worried that central banks are getting hooked on the drug of printing money.

There is also the question of what QE is for. To be fair to King, from his first BBC interview on the policy in March 2009, he has insisted it was not a scheme to boost banking lending, but pump up money supply directly. That is fine, but over a prolonged period the money supply measure the Bank follows, M4, will not rise much if there is no increase in bank lending.

QE, like the other schemes, is a roundabout and potentially risky way of going about things. An economy starved of credit self-evidently needs more credit. The governor should use his newly-discovered muscle to get the banks to lend. And he should not take no for an answer.

My regular column is available to subscribers on www.thesundaytimes.co.uk This is an excerpt.

The Bank of England, never very cheery, found much to be gloomy about in announcing a further £50 billion of quantitative easing (QE) on Thursday.

“Output has barely grown for a year and a half and is estimated to have fallen in both of the past two quarters ...,” it said. “Business indicators point to a continuation of that weakness in the near term.”

The lights have gone out at the Bank. As recently as April it was saying the weakness of some official data was “perplexing” and the growth of activity was “likely, if anything, to have picked up” since the second half of last year. Now it appears to accept even the perplexing figures.

There may be a crumb of comfort in the fact that, given its dodgy forecasting record, the Bank’s gloom now could be a harbinger of better times ahead. But it is not much of a reassurance.

As for QE, the analogy is with adding petrol to a damp bonfire. Eventually it will explode into life and take your eyebrows off. But whether it fires up into growth or inflation is an open question.

The Bank is not the only central bank trying to inject a bit of oomph. The European Central Bank, with its rate cut to an all-time low of 0.75%, and the People’s Bank of China, cutting to 6%, acted last week.

Gloom is also affecting the government. Nothing reflected more badly on George Osborne than his obvious glee that, amid economic woes and budget U-turns, he thought he could pin the Libor-fixing scandal on Ed Balls, his Labour shadow. His attempt to do so, clumsy and evidence-free as it was, did him no good at all.

Why are things so gloomy? We are, as Sir Mervyn King has told us, affected by the “large black cloud of uncertainty” emanating from the eurozone. But there is also a specific British disappointment, which will be explored by Price Waterhouse Coopers (PWC) in its UK Economic Outlook to be published this week.

John Hawksworth and Yong Jing Teow of PWC split the past 15 years into three periods, the growth years of the “great moderation”, 1997-2007, the great recession of 2008-9 and the post-crisis “recovery” since 2009. They compared Britain’s performance, on a range of measures, with other G7 economies (America, Japan, Germany, France, Italy and Canada).

Not to spoil the surprise too much, the headline verdict is that Britain was close to the best in the G7 from 1997 to 2007 but was close to the worst in the recession and subsequent recovery.

The period 1997 to 2007 - Gordon Brown’s chancellorship - may have been unsustainable, debt-fuelled and ultimately irresponsible, as Osborne and others frequently say. Looked at purely in terms of the numbers, however, it was also something of a purple patch for the economy.

So growth, which averaged 3.1% a year, was second only to Canada in the Group of Seven (G7), and thus faster than America and the rest. Britain’s growth rate was nearly double Germany and more than three times the rate in “lost decade” Japan.

Inflation, traditionally our Achilles’ heel, averaged 1.6%, the same as Germany and well below America. Only Japan, suffering deflation, was lower.

Britain did OK on unemployment but spectacularly well on labour productivity, which at 2.2% a year was the highest in the G7. The weakest bit of Britain’s performance over the 1997-2007 period, which is not a surprise, was on the fiscal side.

The cyclically-adjusted budget deficit widened by 2.6% of gross domestic product over the period, while Germany and Japan narrowed their deficits. America, however, pushed the boat out even more than Britain, widening its deficit by 3.1% of GDP.

Combining these measures, Britain comes very near the top of the G7 league over the 1997-2007 period, doing particularly well on growth, inflation and productivity, all of which makes the subsequent performance all the more disappointing.

In the 2008-9 recession, for example, Britain’s GDP felly by 6.3% and only Italy and Japan did worse. The 5.1% of GDP widening of the underlying budget deficit was exceeded only by America’s 5.8%.

It is the past three years, however, that Britain’s performance has taken on seven-stone weakling proportions. Only Italy, with 0.4% annual growth, has done worse than Britain’s 0.9% since mid-2009. Germany tops the G7 with 2.9%, followed by Canada, 2.8%, America, 2.4%, and even Japan, 2.1%.

The inflation story has been horrible, Britain’s average of 3.6% being more than a percentage point above anybody else. Labour productivity has gone from the G7’s best to the worst. Is there anything we have been good at? The budget deficit has dropped by 2.6% of GDP, the same as France and more than anybody else in the G7.

Why, overall, were we close to the best, and are now nearly the worst? It is not hard to think of reasons why growth has been weak, including the high-inflation squeeze on real incomes, the fiscal consolidation - tax hikes and spending cuts - and the credit famine.

PWC’s Hawksworth sees some of the recent underperformance as payback for the good years. From 1997 to 2007 Britain was, on the numbers, a 3%-plus growth economy. Maybe it was never genuinely more than a 2% economy. Feast to famine on public spending and credit are symptoms of the shift. Some growth over 1997-2007 was stolen from later years.

What of the future? Is Britain condemned to be the poor relation of the G7, or for the current poor performance to persist into a lost decade?

PWC says not, and I agree. Growth, it thinks, will settle at just over 2% in future, below America (2.8%) and Canada (2.3%) but above Japan (1.5%), France (1.4%), Germany (1.2%) and Italy (0.1%).

Inflation will remain relatively high, though not particularly troublesome. Britain’s projected rate to 2016, 2.1%, is the highest in G7. But with the exception of Japan, most other countries are quite close.

A 2% economy - 2% growth and 2% inflation - would once have been considered dull and disappointing. Given the all-pervading gloom around at present, it now looks like Nirvana. If we can get there.

My regular column is available to subscribers on www.thesundaytimes.co.uk This is an excerpt.

The government is on the back foot over its fiscal strategy again, partly because of its curious approach to policy.

George Osborne, having railed against the unfunded tax cuts proposed by Labour, managed to come up with one himself, postponing the 3p a litre fuel duty rise planned for August 1 until January.

The cost, £550m, will apparently be met through savings in spending by government departments, though the Treasury says it will take until the autumn statement to work out what they will be.

Osborne’s announcement, on the day poor public finance figures were revealed, may have merit in itself, as did the u-turns on the pasty tax, caravans, skips (yes) and tax relief on charitable donations.

They create an impression, however, of a chancellor who bends under relatively modest pressure. Is the cut in the 50p rate safe? What about the “granny tax”, another controversial element of the budget?

Would we be entirely shocked if, one say, Osborne was to stand up and say that in the light of events he had decided to suspend his deficit reduction programme? The Treasury insists these u-turns are minor adjustments and the big picture remains resolutely intact. But it makes you wonder.

The significance of the latest numbers for the public finances was not only the disappointing May figures. which showed borrowing of £17.9 billion, nearly £3 billion up on a year ago.

No, it was the trend over the past few years. The Office for National Statistics now thinks public sector net borrowing, the government’s preferred budget deficit measure, peaked at £158.6 billion in 2009-10, falling to £140.6 billion in 2010-11 and £127.6 billion for the fiscal year recently ended, 2011-12.

The 2011-12 figure was disappointing, representing an upward revision of more than £3 billion, but remained consistent with what looks like a successful deficit reduction strategy.

Except that the detail is rather less encouraging. The current budget deficit is important in this context. This represents the recurring elements of government spending - public sector pay, pensions and benefits, and so on - less current receipts, the majority of tax revenues.

The current budget deficit, adjusted for the economic cycle, is what the government aims to eliminate. Progress, however, is painfully slow.

From its peak of £110 billion in 2009-10, this deficit only fell to £99.5 billion a year in 2011-12. At a £5 billion a year pace of reduction you do not need a calculator to work out that it will take 20 years to eliminate it.

Why is the overall deficit down more than £30 billion since 2009-10, while the current deficit is a mere £10 billion lower? The answer is that the coalition persisted with the reductions in capital spending - on schools, hospitals, roads, and so on - it inherited from the Labour government.

So net investment by the public sector fell from £48.5 billion in 2009-10 to £28 billion in 2011-12. Take away that reduction and you barely have any drop in the overall budget deficit. Other things being equal, the deficit would be stuck at close to levels the coalition inherited two years ago, and the AAA rating would be long gone.

That is one reason why, despite ultra low gilt yields, the government resists calls to boost capital spending. Reductions in net investment have driven deficit reduction.

The task gets harder from now on because deficit reduction will have to be through reducing current spending and hoping for higher tax revenues. It would be greatly complicated if, at the same time, capital spending was being increased.

There is another reason. Listen to the debate on the British economy and you could be forgiven for thinking that, so sapped is business confidence if the government does not invest, nobody will.

That is not true in general. Business investment in the first quarter was up by 14.8%, in real terms, on a year earlier. Firms may be downbeat but they are spending.

It is also not true of infrastructure spending. The national infrastructure plan, updated at the end of last year, set the numbers out. Over the period 2005-10, £113 billion was spent on the infrastructure.

From 2011 to what it described as “2015 and beyond”, £250 billion of such spending is planned. There are a couple of caveats. There is many a slip between plans and delivery and “and beyond” offers a get-out.

To check, I contacted the Construction Products Association (CPA). In some of the key areas of infrastructure spending, there is indeed a boom, according to Nobel Francis, the CPA’s economics director. Spending on rail is on course for a 57% rise by 2014, and is exceeding spending on roads for the first time in many decades.

There is also high spending on water and sewerage and, in particular, energy, where electricity investment will treble by 2016. So it is plausible that, far from being starved of infrastructure investment, the economy is experiencing something like a doubling compared with 2005-10.

Could more be done? Spending on roads is falling. The £550m fuel duty postponement could have been used to fill potholes. It would have generated more jobs and, I suspect, kept motorists happier, though still have been unfunded.

There is, as discussed here many times, undoubted weakness in housebuilding. Most of the solution lies with the private sector, and restoring mortgage funding. It remains to be seen if the Treasury-Bank “funding for lending” scheme will do it.

There may also be a bigger role for the public sector. Whether you call it council housing or social housing, building now is less than 10% of its 1967 peak. We are not going to see a return to the building of the 1960s, but more could be done. The chancellor has pledged to use what he described as the strength of the government’s balance sheet to support infrastructure.

One way is to offer enhanced guarantees on bonds for building issued by housing associations, Another, suggested by the IPPR (Institute for Public Policy Research) in a new report, Together At Home, would be for the government to follow the practice of other countries, exempting local authority housing funding - which has a stream of rental income to offset its cost - from its deficit measures.

There is, as I say, a lot of infrastructure spending going on. The public finance numbers suggest the government could not afford a conventional boost in capital spending. But there is scope for the use of guarantees and other devices to bring forward more spending, on housing and on roads. We may hear more about this soon.

My regular column is available to subscribers on www.thesundaytimes.co.uk This is an excerpt.

We have become suspicious of good news. Analysts poke at any encouraging data, convinced either that it will not last or that it does not change the gloomier big picture.

Maybe that is the way it should be. There have been so many disappointments in the past few years perhaps downbeat should be our default position. You can see it in the stock market. Every time it gets a bit of wind in its sails, too often it is because another storm is approaching, usually these days from the eurozone’s direction.

There is also the old rule about not taking one month’s figures in isolation. Sometimes we should look a gift horse in the mouth; next month it will throw us.

Having said all that, the latest clutch of economic numbers were remarkably good. It started with a drop in consumer price inflation from 3% to 2.8%, and in retail price inflation from 3.5% to 3.1%.

Nor was this a one-month flash in the pan. Inflation came in below expectations (including those of the Bank of England) in both April and May.

It is hard to overstate the importance of this fall in inflation. High inflation, unusual in the aftermath of recession, has given us the unintended squeeze on real incomes that provides the biggest reason for the weakness of consumer spending. Spending has never been as depressed at this stage of a recovery as it is now.

The squeeze has not gone away. Regular pay is rising by an annual 1.8%, according to official figures, a percentage point below the annual rise in prices. But the gap is closing. In September inflation was 5.2% and regular pay was rising by 1.7%.

Back then, unless you were a FTSE 100 chief executive or in another favoured minority, your pay was almost certainly rising by less than prices. As the inflation hurdle falls, the bigger the proportion of people who can peer over it, in the happy position of having a rising real income.

Indeed, some of this may be showing through in another bit of upbeat news. Retail sales volumes jumped 1.4% in May compared with April. Some of that was due to the unwinding of the distortion due to panic buying of petrol and diesel a few weeks ago but, even adjusting for that, sales volumes rose by 0.9%.

In the latest three months, leaving aside petrol purchases (which is how the retail numbers used to be reported) there was a 0.9% rise compared with the previous three months and 1.9% compared with a year earlier. In May alone, sales volumes were 3% higher than in May 2011.

The dreadful June weather may give us a temporary setback but the evidence is of a bit of spending power creeping back in, and not before time.

There is other mildly encouraging news. The CBI said that manufacturers’ order books had improved, as had industry’s output expectations. The latest trade figures had raised fears of a collapse in exports but the CBI reported both a strengthening of export order books and that they are well above their long-run average.

There was also a pick-up in mortgage lending, with the Council of Mortgage Lenders reporting gross advances of £12.2 billion last month, 24% up on April and 11% higher than in May last year.

I have saved the best until last. Ever since Britain dived into recession more than four years ago, there has been a puzzling discrepancy between the statistics for the whole economy - gross domestic product - and for the labour market.

Employment fell by far less than expected in the 2008-9 recession, by 2.5% as GDP dropped by 7.1%, and it recovered as the economy returned to growth. Currently, while GDP is more than 4% below its pre-recession peak, employment is less than 1% below its pre-crisis peak.

The mystery has deepened with the latest figures. In the latest three months (February-April), employment rose by 166,000 to 29.28m, according to the Office for National Statistics, and this was the biggest three monthly rise since August 2010.

In the first quarter of the year, for which the ONS has a breakdown between public and private sector employment, there was a 205,000 rise in private sector jobs, only partly offset by a 39,000 drop in the number of people employed in the public sector.

The gap between private sector job creation and public sector cuts was dramatic in the first quarter but it was part of a longer-run trend. In the past two years there has been an 843,000 rise in private sector jobs, against a 424,000 private sector fall.

Those who scoffed at the idea that the private sector would compensate for public sector job losses were wrong. They have, by as near to two for one as you will get.

The first quarter, of course, was when - measured by GDP - Britain officially went back into recession, a 0.3% fall following a similar drop in the final three months of 2011. The economy has shrunk, on the GDP figures, by 0.1% over the past year and grown by a mere 1.4% over the past two.

I have been trying to resolve this discrepancy. Part of the weakness in the recent GDP figures has been due to energy: the gas and electricity we as households use (which fell as a result of the mild winter) and North Sea output. It is plausible such weakness does not have many employment implications.

A bigger reason for the apparent return to recession was falling construction output. Construction is a big employer, just over 2m people working in the industry. But the employment numbers do not speak of a sector in freefall. Employment in the first quarter, 2.04m, was fractionally down but it was higher than a year earlier.

In manufacturing , the EEF, which represents the sector, points out that manufacturing employment rose 38,000 or 1.5% in the first quarter, its biggest percentage rise since records began in 1978. Yet GDP figures suggest this is another struggling sector.

Of course it is possible to argue that productivity growth has slumped to the point where even in a non-growth environment employment grows. Is that remotely plausible? I can accept productivity growth is weak. I cannot believe it is negative, particularly when a shift from public to private sector employment should boost it.

The truth is that a 320,000 rise in private sector employment and a 1.9% increase in hours worked in the economy over the past 12 months is not consistent with a shrinking economy. A rise of 843,000 in private sector jobs over two years is inconsistent with economic growth of just 1.4% over that period.

In the past, governments have struggled to convince voters growth is happening when employment is weak. Now it is the other way round. I fear we are once more being led astray by the GDP figures and by the economy’s increasingly implausible slide into a double-dip recession. These numbers do not add up.

My regular column is available to subscribers on www.thesundaytimes.co.uk This is an excerpt.

Sometimes the eurozone feels like a Horizon holiday brochure from the 1970s: last week Spain, this week Greece. Horizon went bust, and the question is whether one or more eurozone members will suffer a similar fate.

I shall come to Greece in a moment. First, let me offer my take on Thursday’s Mansion House announcements by George Osborne and Sir Mervyn King.

Having been banging on for longer than I can recall about the need to boost bank lending, including last Sunday, I welcome these initiatives. The £80 billion “funding for lending” scheme, the additional liquidity of at least £5 billion a month under the extended collateral term repo scheme and giving the Bank’s new financial policy committee an additional growth mandate add up to a reasonable package.

I do not believe this initiative will lead to a rush of risky lending. We can also dismiss the tired old “pushing on a piece of string” cliche: weak credit is holding back demand.

The dangers are on the other side, that the banks have locked them into a mindset in which they genuinely believe there are few creditworthy borrowers out there.

Many banks, indeed, appear to have adopted the approach of the old shop sign: “Please do not ask for credit, as refusal often offends. The ultimate sanction against them, if they refuse to play ball, is direct lending by the government, perhaps via state-owned Royal Bank of Scotland.

The truth is that Thursday’s scheme has been much too long in coming. The economy has been starved of credit for nearly five years.

The governor defended quantitative easing (QE) at the Mansion House, as he was obliged to, but something like the new scheme - or the purchase by the Bank of a wider range of private sector assets (rejected by King again) - should have been in place alongside QE when it was first launched in March 2009.

One thing is clear. This was not the response to fears of “Panicos”: renewed eurozone turmoil. It will take more than this to insulate Britain from what Europe could throw at us. If the eurozone goes badly wrong, other emergency banking and liquidity measures will be needed.

It is clear eurozone shocks are far from over, with bond markets unconvinced by the 100 billion euro Spanish banking bailout, its bond yield hitting 7%. Today’s second Greek election in as many months risks fresh turmoil.

Irrespective of party support, most Greeks want to stay in the euro, perhaps preferring the slow grind of years of austerity to the sudden and shocking collapse in living standards suffered by Argentina when it defaulted and devalued a decade ago. But is it in Greek hands?

Many Greek scenarios that have come my way. Aviva Investors sees a 40% chance of no exit/muddling through; 40% of a managed exit; and 20% of a disorderly departure, after which European equities drop a third. One of our biggest fund managers, in other words, sees only a 40% chance of Greece staying in the euro.

Berenberg, the German bank, has a set of scenarios linked to today’s election. If pro-bailout parties win, led by New Democracy's Antonis Samaras, the “troika” of EU, European Central Bank and IMF could agree a modest relaxation of austerity and there would be a 75% probability of Greece being in the euro by the end of the year.

If, instead, there is a victory for Alexis Tsipras's Syriza party and allies, he could renege on pledges and fall into line, or forced to negotiate an exit — Greece leaves chaotically. Under Syriza Berenberg sees only a 30% chance of Greece staying in.

Maybe we should expect, as on May 6, an inconclusive election, leaving the country and its euro membership in limbo, albeit with the EU keen for clarity before the June 28-29 summit of EU summit leaders.

The world can only wait so long for Greek voters. To paraphrase Lady Bracknell, one messy election is a misfortune, two looks like carelessness. Greece would begin to look ungovernable. Holger Schmieding, Berenberg’s chief economist, sees the probability of Greece staying in the euro in these circumstances as 50% or less.

You can see where this is going. There are circumstances in which Greece can stay in the euro but plenty in which it will not. The chancellor gave voice recently to a view expressed here, which is that a Greek exit may be the only way to break the log jam and persuade Germany to support remaining members of the eurozone.

The assumption is that a Greek exit is manageable, not just in the technical sense of replacing euros with a new drachma but also in ring-fencing other eurozone economies, halting the contagion that, left unchecked, would run from Athens to Lisbon, Dublin, Nicosia, Madrid, Rome and even Paris.

Given the EU’s record so far, however, and its apparent inability to organise a drink-up in a Belgian brewery, a managed “Grexit” may be hoping for too much.

How bad could the alternative be? On the Baseline Scenario website (baselinescenario.com), Peter Boone and former IMF chief economist Simon Johnson and Peter Boone sketched it out. Their piece, The End of the Euro: A Survivor’s Guide, makes for scary reading.

“Some form of new currency will soon flood the streets of Athens,” they write. “It is already nearly impossible to save Greek euro membership: depositors flee banks, taxpayers delay tax payments, and companies postpone paying suppliers — either because they can’t or because they expect soon to be able to pay in cheap drachma.”

Then, say Johnson and Boone, trouble really starts. “Europe’s electorate will be rudely awakened to the large financial risks foisted upon them in failed attempts to keep the single currency alive. If Greece quits the euro this year, its government will default on approximately 300 billion euros of external public debt ...

“More importantly and currently less obvious to German taxpayers, Greece will likely default on 155 billion euros directly owed to the euro system (the ECB and the 17 national central banks in the eurozone).”

Capital flight from other peripheral euro members increases in intensity, the euro plunges, inflation soars, financial turmoil increases and the single currency is pulled apart by forces it cannot resist.

“A disorderly break-up of the euro area will be far more damaging to global financial markets than the crisis of 2008,” they write. “Europe’s rich capital markets and banking system, including the market for $185 trillion in euro-denominated derivative contracts, will be in turmoil.

“It is almost certain that large numbers of pensioners and households will find their savings are wiped out directly or inflation erodes what they saved all their lives. The potential for political turmoil and human hardship is staggering.”

Will it happen? One would hope not. Europe’s political establishment used to talk about the eurozone as a haven of stability. In the coming months they will have their work cut out to stop it becoming a source of massive instability.

My regular column is available to subscribers on www.thesundaytimes.co.uk This is an excerpt.

A week can be a long time. A plunge in May manufacturing activity nine days ago, measured by the sector’s purchasing managers’ index, had prompted some City economists to predict dramatic action from the Bank of England on Thursday.

The Bank’s monetary policy committee (MPC), however, had other ideas. Despite a call from the International Monetary Fund for it to consider cutting interest rates, it left Bank rate unchanged at 0.5%, as it has since March 2009.

This was not too surprising. Anything is possible but the Bank thinks it has good reasons, partly to do with the operation of the money markets, for having 0.5% as a minimum official interest rate.

The debate over whether to add to the existing £325 billion of quantitative easing (QE) was no doubt closer, with some votes in favour. But the Bank, like the European Central Bank the day before, decided to keep its powder dry.

With so much uncertainty around, including next Sunday’s Greek elections and the on-off rescue of Spain and her banking system, discretion was seen as the wiser option. You may say that uncertainty adds to the need for central bank activism but there is an announcement effect as well as a practical impact as far as monetary policy is concerned.

The Bank, in other words, had it announced more QE on Thursday, would have been under pressure to announce even more in a month, should the aurozone be deteriorating further at the time.

As it was, better-than-expected data for services and construction, in their purchasing managers’ surveys, and for May retail spending, allowed the Bank to stay its hand. The economy is far from strong but it is not collapsing either.

That said, it is badly in need of some monetary “oomph”. I apologise for taking readers on a journey that to some will sound like an excursion along the motorway network, and to others will sound like an echo of the monetarism, as in monetary targeting, under Margaret Thatcher in the 1980s.

M4, the broadest measure of the money supply, is the one to think about in the context of efforts by the Bank to get the economy moving again by monetary means. On the face of it, those efforts are so far failing very badly.

In April, the M4 money supply measure was down nearly 4% on a year earlier, having been falling on an annual basis since autumn 2010, the time official figures say the economy stopped recovering.

To put this into perspective, M4 growth never turned negative in the early 1990s, while the problem for the Thatcher government in the early 1980s was too much, not too little, broad money growth.

The crude number may overstate how weak the money numbers are. The Bank prefers to adjust M4 for lending to so-called intermediate other financial corporations (OFCs). Think of it as banks’ lending to off balance sheet and other subsidiaries, which boomed in the years leading up to the crisis - the financial sector lent huge sums to itself - but has since gone into sharp reverse.

Adjusting for this has M4 up by 3.8% on a year ago, a significant acceleration on the spring of last year, when it was rising by just 1.5%. The latest bout of QE, it seems, has made a difference.

We should not, however, get carried away. The Bank’s rule of thumb was that you needed annual M4 growth of 9% for trend growth of 2.5% or so and inflation at the 2% official target. Even adjusted, M4 is growing less than half that rate.

Not only that but alongside adjusted M4 figures, the Bank produces statistics for adjusted M4 lending. These show, when you take out the financial sector distortion, lending into the economy is currently rising by 1.3% on an annual basis. That is better than a year ago, when it was not growing at all, but it is still pitifully weak. Both the money supply and bank lending are too weak to support recovery.

So what should the Bank do? One route is just to continue what it has done so far, implementing QE overhelmingly through the purchase of UK government bonds (gilts) but do so on an even greater scale.

David Miles, now the most aggressive proponent of QE on the Bank’s MPC, said in a recent speech that “exceptionally expansionary monetary policy” was the right course in current circumstances.

Michael Saunders of Citi, the bank, believes that there is much more to come - up to an eventual £500 billion - from the Bank in the form of conventional QE.

Or perhaps, I would argue, the Bank could do things differently. One thing that jumped out at me from the IMF’s recent assessment of the British economy was its recommendation that “options to further boost demand through credit easing measures that utilize the government’s balance sheet should be explored”.

It suggested purchasing private-sector bonds, on a significant scale, to support a greater volume of both mortgage lending and loans to business, particularly small and medium-sized firms. It also urged the Bank to provide longer-term bank funding facilities against a broader range of collateral, to ease funding pressures and get more lending into the economy.

This, to me, is what the Bank should be doing, suitably indemnified for any losses by the government. Adam Posen, soon to leave the MPC, suggested some months ago that the Bank should be buying securitized (bundled) small and medium-sized enterprise (SME) loans, a cry taken up by the British Chambers of Commerce.

We have just passed the fourth anniversary of my first suggestion that the Bank should buy new mortgage-backed securities - bundles of mortgages - to overcome the crisis’s abrupt loss of wholesale funding that continues to restrict housing activity to recessionary levels.

The government has just launched its £20 billion credit easing schemes for SMEs. It is a step in the right direction but does not go far enough. The global financial crisis saw many things go from feast to famine but nothing as dramatically as the availability of credit. And, to repeat a previous message, an economy starved of credit will always struggle to grow. Smarter monetary easing is needed.

My regular column is available to subscribers on www.thesundaytimes.co.uk This is an excerpt.

After ‘Black Friday’, in which manufacturing in Britain and the eurozone slumped and America’s job market stalled, the search for growth is as urgent as ever.

Gilt yields are at record lows, along with US treasuries and German bunds. The 10-year gilt yield is under 1.5%. So why doesn’t the government do what Paul Krugman, the nearest thing to a rock-star economist, advocates?

Krugman, on a visit to Britain from America, put it in his usual colourful way, in a lecture at the London School of Economics and in numerous BBC interviews.

“If you want to worry about debt and deficits, fine, but this is the time, to quote St. Augustine, to say ‘Oh Lord, make me chaste and continent, but not yet,” he said at the LSE, adding: “The bond market is saying borrow, borrow.”

It is a view with many advocates here. Gilt yields are at record lows. Government borrowing is cheap. Why not follow the advice of a group I could call Keynesians but to avoid labels will call the borrowers?

Many people get confused in this debate, because there is a lot of confusion around. Jon Moulton, the venture capitalist, thinks the government should cut spending even harder. I shall leave that for another week.

The first confusion is over the causes of weak growth. Some borrowers imply it is all due to austerity, notably coalition austerity. But it is due to a range of factors, including austerity but also high commodity inflation (squeezing real incomes), the eurozone and the credit crunch.

I asked the Ernst & Young Item Club, which uses the Treasury model, to compare growth under coalition plans with Labour’s plan for slower deficit reduction.

The results are interesting. The economy grew 2.1% in 2010, 0.7% in 2011 and Item projects will grow 0.4% this year. Under Labour’s plans, assuming nothing else changed, growth would have been marginally higher in 2011, 0.8%, and in 2012, also 0.8%, but at the cost of around £24 billion additional government debt.

Item suggest, however, it is realistic to assume gilt yields would have been 0.5% higher under Labour’s plans. They fell this much between Labour’s March 2010 budget and George Osborne’s June 2010 budget.

Plugging this in to the model gives 2011 growth of 0.7% (as under the coalition), and 0.7% in 2012, only slightly faster than currently expected, though with an additional £37.5 billion of debt.

Yes, I hear you saying, but what if there was no austerity at all? Let me turn to the National Institute of Economic and Social Research, which is in the borrowers’ camp.

In May last year, it predicted 2% growth for 2012. Now it predicts zero. There has been no “news” on 2012 fiscal policy in the past year; the IMF suggests a modest loosening relative to previous plans. So other factors explain the shortfall.

The second confusion is over historical precedent. You might think cutting the deficit is some mad, ideological experiment. There is an excellent new Centreforum pamphlet, Delivering Growth While Reducing Deficits: Lessons from the 1930s, by the economic historian Nick Crafts .

Starting from much lower budget deficits than now — roughly 2% to 3% of gross domestic product - the then coalition acted to restore budget balance.

“Over fiscal years 1932/33 and 1933/34 the structural budget deficit was reduced by a total of nearly 2% of GDP as public expenditure was cut and taxes increased, the public debt to GDP ratio stopped going up while short term interest rates stabilized at 0.6%,” Crafts writes. “Yet from 1933 to 1937 there was strong growth such that real GDP increased nearly 20% over the period.”

As in the 1930s, so in the post-1976 period, the 1980s and 1990s. This is no laboratory experiment. It is what has worked every time before, combining fiscal consolidation - cutting the deficit - with loose monetary policy and a devaluation of the pound. If there was a UK economic policy textbook, this is page one, chapter one.

The borrowers, on the other hand, suggest something for which it is hard to find a British precedent. Public borrowing is close to peacetime records. Borrowing in 2011-12, 8.2% of GDP, would have been a record if not for even higher figures (11.2% and 9.3%) for the two previous years.

Labour had a time-limited fiscal stimulus worth about £25 billion in 2008-9, when the deficit was 6.9% of GDP. But I can find no example of a British government, faced with very high borrowing and having embarked on a fiscal consolidation, reversing it.

Things might be different if, as discussed last week, everybody agreed most of the deficit is cyclical not structural. They might be different if the eurozone produces a second collapse, though the deficit consequences do not bear thinking about.

None of this means the borrowers are necessarily wrong. The case for a stimulus does not rest on whether austerity caused the weakness. The lack of precedent may be because this time it really is different.

But what they are proposing is risky. A ratings downgrade is not the end of the world but Moody’s, in its January warning on the AAA rating, said a “discretionary fiscal loosening” would be a likely trigger.

Markets see Britain as a safe haven but that is not guaranteed. They can turn on a sixpence. Pimco, the bond firm, once had gilts “resting on a bed of nitroglycerine”.

The Office for Budget Responsibility, having pushed the government into a further fiscal tightening, would find it hard to condone a loosening, even one that focused on capital/infrastructure spending. The government has two fiscal rules, on the current deficit but also on debt.

I urged the Treasury last year to find room for more infrastructure, within existing plans - without borrowing more - and it did in the autumn statement. The IMF wants more of the same, by squeezing some current spending. I agree, though planning delays mean it is hard to get projects up and running quickly. “Shovel-ready” projects are not lined up in Whitehall waiting for the go-ahead.

What makes me most uneasy is government debt. Some borrowers say anything borrowed now would be strictly temporary. But clawing it back later would be hard, with the government already needing to find substantial extra welfare savings.

Public sector net debt is 65% of GDP, excluding direct support for the banking system, or 148% including it, says the Office for National Statistics. Eurostat, the EU statistical agency, puts the figure of 87%. Whichever measure you use, it is rising strongly and those banking liabilities may yet return to haunt us.

When does it become unsustainable? An influential paper by Carmen and Vincent Reinhart and Kenneth Rogoff, Debt Overhangs: Past and Present, argues that tempting though borrowing may be, governments should tread carefully, particularly those with sharply rising debt.

Once debt gets to more than 90% of GDP, the “overhang” consequences can become severe: annual economic growth more than a percentage point lower, sustained for an average of 23 years. As they say, “the cumulative effects can be quite dramatic”. This is something to avoid.

What should the government do instead of more borrowing? A lot more to ease the impact of the credit crunch on business lending and mortgage markets. Freeing up credit provides demand. The great housebuilding boom of the 1930s was built on easily-available credit and an absence of planning. I shall return to this.

My regular column is available to subscribers on www.thesundaytimes.co.uk This is an excerpt.

Plenty of people have been giving advice on the British economy, including the International Monetary Fund, the Organisation for Economic Co-operation and Development (OECD) and others.

The IMF exercise was a bit odd. Pleasing though it is to have the elegant Christine Lagarde, its managing director, breezing through London, this kind of detailed dispensing of advice, in public, is normally reserved for countries in IMF programmes.

Yet Britain is giving the IMF money, not the other way around. I can’t remember Dominique Strauss-Kahn, her predecessor, doing this kind of thing. Maybe he had other things to think about.

Anyway, the IMF says the Bank of England should act now, and the government not too long afterwards. Not doing so could consign the economy to permanently weak growth. Grow slowly too long, and you get used to it. People who do not work for long periods may never do so.

Many of these ideas have been around for a long time. The Bank of England, which is urged to cut interest rates even further from the current ultra-low 0.5% level, considered and rejected this last October.

As for more quantitative easing, it is now plainly back on the agenda, but the monetary policy committee (MPC) voted 8-1 against it this month. Another idea, that the Bank should buy private sector assets rather than government gilts, has been debated for more than three years.

On fiscal policy, the IMF praised the government’s approach, Lagarde reacting with horror to what might have happened in the absence of the coalition plan.

But it also said that some things could be done better. The government could cut public pay and welfare harder, and raising more from unspecified property taxes, to pay for more infrastructure spending.

The other recommendation was a more explicit “Plan B”, including temporary VAT and national insurance cuts, though only if “downside risks materialize and the recovery fails to take off”. Not yet, in other words, but certainly in the event of a messy eurozone outcome hitting Britain hard.

Some will be delighted by this prospect, having argued for a Plan B even in the absence of a eurozone accident. Others will be horrified, pointing to the fact that Britain is already running a budget deficit of more than 8% of gross domestic product.

Last week saw a downward revision of public borrowing for 2011-12 but only to £124 billion. The deficit may be gradually coming down (from a peak of £156 billion in 2009-10) but debt, as conservative commentators keep pointing out, is rising strongly. Any minister wanting to cause mass apoplexy has only to confuse debt and deficit.

The big question, whether the government’s response is to cut the deficit more slowly or is forced to unveil explicit economy-supporting measures is how much deficit-cutting work that will leave to do later.

Debt and the deficit matter in cash terms. What matters most, however, is the structural deficit, that which is left if and when the economy recovers.

The Office for Budget Responsibility, the government’s fiscal watchdog, thinks some three-quarters of the budget deficit, about 6%, is structural. That is why it said last year the chancellor would need further measures, which he interpreted as spending cuts beyond the next election.

Any temporary fiscal stimulus, on this view, would have to be followed by even bigger cuts, or tax hikes, later.

But what if the underlying picture is better than the OBR, the Bank of England, Treasury, IMF and OECD believe? This is what Bill Martin and Robert Rowthorn of the University of Cambridge claim.

Martin, who had a long City career with UBS and Philips & Drew, published a paper in July last year, called Is the British Economy Supply Constrained? Now he has returned to the them, with Rowthorn, in a paper to be published this week: 'Is the British Economy Supply Constrained II? A renewed critique of productivity pessismism', available from Cambridge’s Centre for Business Research.

Since the first paper, productivity pessisism has become more ingrained in official circles. So they take on the pessimists.

The economy is 14% below where it would have been had growth continued at its pre-crisis pace, suggesting plenty of spare capacity. But policymakers are operating on the basis that it is only operating about 2.5% below capacity limits.

I have a great deal of sympathy with this. Spare capacity, the “output gap” is an elusive concept in a largely service-based economy. You do not need to build a new factory to expand output. The labour market has spare capacity, the 2.6m unemployed, as well as migrant workers.

Martin and Rowthorn take on the argument that growth in private sector employment over the past couple of years means employers have given up on productivity. Otherwise, why would they not squeeze more output out of existing workers?

The answer, they say, is that the higher-productivity sectors of the economy are behaving exactly as you would expect in a weak growth environment. They are not recruiting. The growth in jobs has been in low-productivity, low-wage sectors.

What about high inflation? Though the rate dropped to 3% last month, it is high for an economy with plenty of spare capacity. But inflation has mainly been due to import price shocks, they say, not an economy running into supply bottlenecks.

The most striking conclusion that emerges is that rather than a “structural” deficit of 6% of GDP, the true figure is nearer 2%. The authorities could safely expand knowing that most of the deficit will disappear as recovery persists.

It is a potentially game-changing verdict. Martin agrees with the IMF on more quantititative easing and, if possible, even lower interest rates than the current 0.5%.

On fiscal measures, he is less attracted to temporary tax cuts than measures that preserve the government’s fiscal credibility while increasing the flow of finance to the private sector - if necessary bypassing the banks - and investing in public investment projects with, as he describes it, “non-imaginary rates of return”.

The Martin-Rowthorn thesis is that policymakers have locked themselves into a gloomy mindset, in which the economy can only grow very slowly in what they call a narrow “corridor of stability”. If they are right, we could be liberated from at least some of the austerity of the coming years.

The productivity pessimists should respond. The hope has to be that they are indeed too pessimistic.

My regular column is available to subscribers on www.thesundaytimes.co.uk This is an excerpt.

The European Union is turning into a very dysfunctional family. Greece, now combining deep economic pain with political instability, is the troubled teenager threatening to leave home for good. Spain, having a few years ago won praise for the way the authorities oversaw its banking system, is starting to look as if it might need the rest of the family to club together and help it out.

France, the flamboyant uncle whose disco days are over, is trying to relive the glory days when it could tilt the Franco-German axis towards growth.

Even Germany, the fatherland figure, is not immune from the mood change. Though Berlin looks resolute against any hint of a generalised fiscal relaxation, the Bundesbank is open to German inflation in future being above the eurozone average.

Though that is a logical requirement if other eurozone economies to regain their lost competitiveness, it would once have been sacrilege for the Bundesbank.

Where will it all end? Willem Buiter, chief economist at Citi, the bank, has raised his probability on a Greek exit from the euro, a “Grexit”, to 50%-75%. He thinks it most likely it would be combined with a massive EU/European Central Bank exercise to ring-fence other eurozone members from being forced out by the market backlash, though concedes that other more damaging scenarios are possible, including “uncontained” euro contagion.

As for France and its new president Francois Hollande, financial markets are relaxed about austerity being combined with more growth-friendly measures, including additional infrastructure spending. As noted last week, they see the new president working with rather than against the eurozone consensus.

That is unlikely to satisfy those who voted against austerity. The euro project was always as much political as economic. Politics will decide whether and in what form it can survive.

Where does that leave Britain, the black sheep of the family? Two things have happened since the Greek and French elections. One is that gilt yields have hit record lows, with the yield on 10-year government bonds, dropping below 1.9%.

This would be extraordinary at any time but for a country borrowing £126 billion with an inflation rate of 3.5% it is phenomenal. “Safe haven” is overused but gilts are clearly a port in the eurozone storm.

The other development has been that the pound, which has been looking perky for a while, received an extra fillip from euro woes. Sterling has been trading at close to 1.25 euros, a far cry from the days when the global financial crisis almost pushed it below one-for-one parity with the single currency. Even tourists have been getting more than 1.20 euros, welcome news for many ahead of the summer holidays.

Is it, however, very bad news for exporters, the great white hope for Britain’s recovery and rebalancing? Will it mean firms will lose their advantage in overseas markets just at the time the economy needs it most?

A few facts. At 1.25 sterling is a lot stronger than it was 2-3 years ago. It is still, however, considerably weaker than in the early months of 2007, the eve of the crisis, when it averaged nearly 1.50 euros. A 16%-17% depreciation is still worth having.

What is true against the euro is also true against other currencies. As recently as July 2008 the pound traded at more than $2; now it is in the low $1.60s. The sterling index, which measures its average value against currencies, is some 19% below pre-crisis levels. Britain’s exporters still have a big exchange rate advantage.

They have been using it, though it is customary to register disappointment about Britain’s export performance. Export volumes, excluding oil and so-called erratic items of trade, are up by around 23% from their recession low in the spring of 2009.

The trouble is that imports, on the same basis, are also up, by 20%. Because of the pound’s fall those imports have increased significantly in price, leaving Britain with a large trade gap.

Will the pound’s revival continue? Against the euro I have always had in mind a “fair value” level of 1.30 to 1.35 euros, so there is a little way to go to get there.

David Bloom, currency economist at HSBC, says that as well as benefiting from eurozone woes, the pound is gaining as a result of M & A (mergers and acquisitions) flows into Britain resulting from the takeover of British firms. The government, despite its political woes, is also hanging on to its reputation for fiscal discipline.

The level of the pound is important. Its long period of strength from autumn 1996 to autumn 2007 was instrumental in shrinking Britain’s manufacturing sector and the loss of 1m jobs in industry.

Some firms could not live with an overvalued exchange rate, while others shifted production overseas. In that period Britain lost a lot of suppliers of components, so-called semi-manufactures, a loss we are paying for in the trade figures now.

For sterling, how much is too much? I would argue that the pound moved from clear overvaluation before the crisis, buoyed by flows of international money into Britain’s banking system, and then went to an undervalued position when those flows stopped and it fell very sharply.

Its recovery now, bearing in mind how far it remains below those overvalued levels, need not do much harm. Indeed, some firms have been waiting for the bounce (which always happens) to assess what level of sterling they will be dealing with in the long term, and before planning their export strategy. They are naturally cautious about betting the firm on what might only be temporary weakness.

Some of the fall was temporary but much will stay, as is commensurate with the country’s changed economic position. That leaves plenty for exporters to go for.

In the end, of course, it is not just the exchange rate. Demand, strong in non-EU markets, weak in most of Europe, is the prime factor affecting export demand. Design, quality, reliability and service are other key determinants of export success. Get them right and a bit of perkiness for the pound should not be a problem.

My regular column is available to subscribers on www.thesundaytimes.co.uk This is an excerpt.

This weekend is a big one in the eurozone saga, with both the second round of the French presidential election and Greece’s parliamentary elections.

In both we are likely to see a vote against austerity and, by implication, eurozone bailout plans. It could be make or break.

And yet the markets have been eerily and surprisingly calm, with no repeat of the kind of panic we saw last autumn, either in eurozone sovereign debt markets or currencies. The European Central Bank, which decamped to Barcelona for its regular meeting last week, sat on its hands.

Markets reacted adversely to the first round of the French presidential elections but that passed. What about this time?

The key question, assuming the polls are right and Nicolas Sarkozy is replaced by Francois Hollande as French president is what kind of relationship he strikes up with Angela Merkel, the German chancellor. Will the end of “Merkozy” be followed by a Paris-Berlin stand-off?

I suspect not. Some of Hollande’s pre-election bark, even his tax plans, may be worse than his bite. When he talks about reorientating the eurozone towards growth, he is reviving a familiar argument.

The eurozone, you may remember, was originally governed by a stability and growth pact, though today there is not much of either. The Germans insisted on stability, fiscal discipline, while France pushed for growth as well, to avoid the eurozone turning into an austerity zone.

Despite apparent differences now, it is likely Merkel and Hollande will find a way of working together. It is also likely that there will be enough figleaves for the new French president in growth-friendly measures built around infrastructure measures and job-creation schemes. Hollande wants to rock the euro boat but not make it sink.

A potentially bigger risk comes from Greece. Holger Schmieding, chief economist at Berenberg Bank, sees a 40% chance of a Greek euro exit this year because of what he describes as “austerity fatigue in Greece or donor fatigue in Berlin”.

A Greek exit, should it occur, would eventually be good for Greece and remaining eurozone members, Getting there, however, without triggering a domino effect, and without a hugely damaging impact of the banking system, is the difficult part.

So, as it has been for two years, the eurozone remains the key global economic threat. It is back in proper recession and eurozone unemployment, at 10.9% (22.1% for young people), is at record levels.

My sense is that while we will see a strong vote against austerity this weekend, this is not yet the pivotal moment. Such are the eurozone’s problems, and so far are we from a permanent solution, that those who vote against austerity in the belief that their lives will be immediately transformed are bound to be disappointed.

How does this feed back to Britain? There are two routes. One is that today’s elections will usher in a period of renewed instability in the eurozone which will further undermine Britain’s recovery.

That could happen directly. Already the volume of exports to the rest of the European Union is down 3.3% in the latest three months compared with a year earlier, compared with 1.7% growth over the same period in exports to non-EU countries.

Or it could happen indirectly. The main effects of the eurozone crisis have been in the financial system, adversely affecting the cost and availability of funding.

This effect, pronounced in the second half of last year, was reversed by the European Central Bank’s 1 trillion euro long-term refinancing operation (LTRO), launched in December. There are signs this is wearing off. Many home-owners are receiving news of mortgage rate hikes, even with official interest rates un changed.

The other effect is on confidence, particularly among businesses that part of the weakness in business investment due to eurozone uncertainty.

That brings me on to the second route from the eurozone to Britain? Is anti-austerity catching, and could it force the coalition to releax or abandon its fiscal strategy?

The government is suffering serious mid-term blues, as shown by Thursday’s council elections and the opinion polls. Austerity is unpopular and Labour leads the polls.

Interestingly, however, if we take our own YouGov polling, voters are not yet ready to trust Labour again with the economy. David Cameron and George Osborne still enjoy a lead of several points over Ed Balls and Ed Miliband on this key question of trust in running the economy.

Only when Labour is decisively ahead on this, as after the Tories’ ERM (exchange rate mechanism) debacle in September 1992 should the coalition get really worried.

In the meantime, ministers need to do better explaining. Most people. I find, are ready to accept that the economy’s weak growth is entirely due to “the cuts”.

Official figures suggest otherwise. We do not yet have the detail for the first quarter, but gross domestic product numbers for the end of 2011 show government spending grew 0.5% in real terms compared with the final three months of 2010, following growth of 0.8% over the course of 2010.

The picture is a bit more complicated because the coalition inherited big cuts in public sector capital spending from its predecessor: it fell 5.1% during 2010 and 6.7% in 2011. Capital spending by government is, however, only a tenth of other spending, so the overall effect of government on the economy is still broadly neutral.

If not the cuts, then what? The big shift has been consumer spending, which grew in 2010 but fell in 2011. Some of that was Vat and national insurance hikes. Mostly it was unexpectedly high inflation.

Exports are contributing to growth, as is business investment, though modestly. One big reason why growth slowed in 2011 compared with 2010 had nothing to to with austerity, confidence or inflation. The economy was boosted initially by firms rebuilding stocks after the recession. This was always going to be temporary.

Even if they do not defend it very well, I think ministers will stick with the fiscal strategy, even if the politics gets more difficult. They will be hoping they are not trying to stick with it through a period of renewed eurozone chaos. Today’s elections will have some say in that.

My regular column is available to subscribers on www.thesundaytimes.co.uk This is an excerpt.

What can I say about Britain being “officially back in recession”? Apart from the fact that no quantity of salt is big enough to be applied to these preliminary estimates, I am not going to spend too much time on them.

I have done it before, most notably three weeks ago, and so have plenty of others since the gross domestic product figures came out. The hope has to be that pinches of salt are being liberally applied by others.

After the figures, the CBI said manufacturers were at their most optimistic for two years, while Nationwide building society said consumer confidence was its strongest for nine months. Will this survive the headlines?

Even if it does, the economy is plainly weak. One way of looking at it is with reference to the GDP numbers. In 2009, the third quarter was initially reported as a 0.4% fall and the fourth quarter a 0.1% rise.

Now the data shows rises of 0.2% and 0.7% respectively, a big shift, partly because of technical changes to the calculations. It is not certain the latest GDP figures will undergo a similar revision.

Were they do so, however, the drop in GDP in the fourth quarter of 0.3% would become growth of 0.3%, while the latest quarter’s would go from minus 0.2% to plus 0.4%. The point is not whether the numbers will be revised precisely this way.

It is that even if they are, they will point to an economy growing only weakly. By this time in a normal recovery growth would be 3% or so. The underlying growth most economists think is happening now is much weaker, perhaps only 1%.

The government’s fiscal tightening is a factor. You cannot hike taxes and cut spending without impacting growth. But a deficit of 11% of GDP had to be tackled.

Labour’s so-called balanced plan for deficit reduction would not have survived the scrutiny of the ratings agencies and the markets, as was clear at the time of the May 2010 election. It cannot be regarded as a viable alternative.

To the extent it would have pushed sterling down further, inflation would have gone up more, further squeezing household real incomes and condemning the economy to even weaker demand.

Not everything George Osborne did on the fiscal side was right, as was clear long before the unforced errors of the March 21 budget. There was too much “it is going to be brutal” bravado when the coalition took office. The hike in Vat to 20% was an in your face, “we’re all in this together” tax hike at a time when some Gordon Brown stealth taxation might have been better.

The solution to weak growth does not, however, reside with fiscal policy. It does lie with a supply of credit that is woefully insufficient to support a decent recovery.

Last week the Bank of England produces its latest Trends in Lending report. It showed that bank lending to businesses was down 3% over the latest 12 months, continuing a fall that began in the early part of 2009. Lending to small businesses is down roughly 10% in the latest 12 months. Figures from the British Bankers’ Association show a similar picture.

It is not unusual for lending to firms to be weak in the aftermath of a recession. Banks become risk-averse. After the recession of the early 1990s, when they suffered large losses on their small firm loan books, business lending was also negative.

We have, however, now gone beyond the point at which business lending should be turning positive. In the 1990s it was two and a half years into the recovery. This recovery is now near its third anniversary and business lending continues to fall inexorably.

It is not just business lending. A good proxy for mortgage lending is the number of mortgage approvals for house purchase. Once it seemed this was one thing we did not have to worry about. From their low point in the final three months of 2008, approvals soared by 92% by the end of 2009.

Then, however, they dropped back and are now 8% below late 2009 levels and 58% below the pre-crisis peak. Some would say this is no bad thing. But an active housing market supports consumer spending and employment. Its absence is a significant drag on the economy.

Why is this happening? Some of it reflects the banks’ usual switch to risk-aversion after a recession. Some of it is due to the loss of some players, notably foreign (including Irish) banks. which were active in the small firm and mortgage markets.

Much of it, however, is due to the official response, from the government, the Financial Services Authority and the Bank of England. When the crisis hit, the authorities recognised credit was the lifeblood of a modern economy. Allowing banks to fail, and credit collapse, would have made the recession we had look like a tea party.

Unfortunately, the same logic was not applied to the recovery. Instead of ensuring an adequate supply of credit for a sustained upturn, the response has been to lock the stable door on the crisis after the horse has bolted. The authorities have been so busy acting to prevent the next crisis they ignored the need to shake off this one.

So we have had the Bank winding down its special liquidity scheme and the recommendations of the Vickers commission speedily reported and officially accepted. Last month the financial policy committee, the new “macro-prudential” regulator in the Bank, urged Britain’s banks “to raise external capital as early as feasible”.

We need a stable and safe banking system. But the authorities’ actions, together with evidence that Britain is going further than international counterparts, adds up to what banking analysts call “regulatory overkill”. It is an important reason for chronic lending weakness.

“Policy made without reference to the impact of its implementation is highly likely to deliver sub-optimal economic outcomes – in this case, costing the UK significant economic growth without any material uplift in financial stability in return,” says Alastair Ryan, banking analyst at UBS.

“The UK now has a well-capitalised, well-funded banking system that is raising prices and shrinking lending – and will need to keep doing more of both as the regulatory agenda expands.”

So we have a situation in which the Bank has undertaken £325 billion of quantitative easing, an exercise in monetary easing notable for its entire lack of impact on credit growth. The Treasury’s credit easing plan for small firms looks too small to make a difference.

Unless somebody in authority gets to grips with the conflicts between regulation and growth, and realises a credit-starved economy will always struggle, we can only expect more disappointing GDP figures.

My regular column is available to subscribers on www.thesundaytimes.co.uk This is an excerpt.

Once Sir Mervyn King, the Bank of England governor was master of all he surveyed, the King of Threadneedle Street, showered with new powers by the coalition government.

Now he has become the governor everybody loves to criticise. If there was a City TV show about him it would be called “Everybody Hates Mervyn”. The debate over his successor used to be couched in terms of who could possibly replace him. Now people are talking about the need for a new broom to sweep up after the mistakes of recent years.

You also have to feel a bit sorry for Adam Posen. The American member of the Bank’s monetary policy committee (MPC), and until now its most aggressive proponent of quantitative easing, was rash enough to say in an interview last year that if inflation did not drop to 1.5% or thereabouts this summer, he would not seek a second term.

I don’t know whether Posen was getting used to the London life and planning for a second term. But Paul Tucker, the Bank’s deputy governor, says inflation will not drop below 3% this summer. If that turns out to be the case Posen, in all conscience, cannot stay on. He now says the Bank has serious concerns about inflation. His term expires in August.

The Bank is getting it in the neck because some people have old scores to settle. Many of the criticisms of King, his downplaying of financial stability in the Bank before the crisis and the Bank’s initial slow and very unhelpful response to it, have been around for years. So has the fact that, unlike his predecessors, instead of rubbing shoulders with bankers, he has always rubbed them up the wrong way.

The renewed outbreak of criticism, however, has followed the latest inflation figures, together with the fact that a decision on the governor’s successor will have to be made in the next few months, even though his term does not expire until the middle of next year.

Consumer price inflation was 3.4% in February. Had the March figures, published last week, shown a fall to 3.3%, the reaction would have been that the pace of the fall was slow but nonetheless happening. An unchanged figure would have been disappointing but nobody would have got too excited.

The fact that inflation rose to 3.5%, however, and that the deputy governor described it as “bad news on the inflation front” and effectively tore up the Bank’s forecasts.

These were indeed bad figures. Two years ago the Bank predicted, not for the first time, that we would now be in a period of sub-2% inflation, which if true would have allowed Posen to stay on.

Even when that proved too optimistic, the Bank’s big story for this year was supposed to be a drop in inflation to 2.5% this summer, as a prelude to dropping below 2% before the end of the year. Anything is possible but most forecasters, and apparently now the Bank, think that is not going to happen. Whether King will see a rate of 2% or below before he steps down from the Bank in a year or so has become an interesting debate.

There are 12 broad components to the consumer prices index (CPI), ranging from food and non-alcoholic drinks through to clothing and footwear, transport and domestic bills. Only one of those 12, recereation and cuture, where prices are actually falling, has an inflation rate below 2%.

Since July 2005, when inflation rose above the 2% target, we have had 81 monthly readings. The overwhelming majority, 64, had inflation above target, with only 17 at or below it. Every monthly reading since December 2009 has been above target.

Since 2005, despite the worst recession in the post-war era, inflation has average one percentage point above target. There is a pattern here. What is it.
When King tackled the issue of the inflation overshoot in a speech in Newcastle in January last year, he set out a theme that has since become familiar.

Inflation was high because of factors outside the Bank’s control, including Vat hikes, the pass-through in import prices from sterling’s fall and global energy and commodity prices.

The first of these is no longer valid: inflation excluding the effects of indirect tax changes is 3.5%, the same as overall inflation. Give that sterling has been stronger in recent months, the second effect should have come to an end.

We are left with commodity and energy prices, and domestically-generated inflation. “Core” inflation, excluding food, energy, alcohol and tobacco is running at 2.5%.

This is all rather uncomfortable. The only time over the past few years when inflation fell decisively, if briefly, below target was when the global financial crisis hit commodity and energy prices hard. The Bank only hits its target, it would appear, when the world economy is in trouble.

Credit where it is due, and a lot of credit should go to Andrew Sentance, who left the MPC last year and is now with Price Waterhouse Coopers, for his perceptive analysis of this. Inflation would not come down to target but would be uncomfortably sticky, he said in an interview with me on leaving the Bank.

The Bank, he said repeatedly while on the MPC, gave too much weight to spare capacity at home - the output gap - and not enough to global inflationary pressures which, as we have seen, are no flash in the pan.

The majority on the MPC rejected Sentance’s call for a hike in Bank rate and, to be fair, raising rates against the backdrop of a weak economy may have been a step too far.

Not only did the MPC not raise rates, however, it then moved dramatically in the other direction, launching what turned out to be a further £125 billion of QE last autumn, against the backdrop of 5% inflation.

My argument against it at the time was that QE was a weapon to be used only in emergency conditions and when there was a real fear of deflation. MPC members countered by predicting that inflation was going to fall like a stone. So confident were they I thought surely this time they were right. Sadly not.

Some will say inflation a point or so above target is neither here nor there. But, at a time when total pay is increasing by 1.1% (1.6% even excluding bonuses), the fall in inflation was essential for the economy. Only by that means would the growth in real incomes needed to boost the 62% of GDP accounted for by consumer spending. We can only hope that inflation fall has been delayed, not cancelled.

As for the Bank, its reputation has taken another battering. There will be more letters from King to George Osborne explaining the inflation overshoot. And with each one, confidence in its ability to keep inflation on target will diminish.

My regular column is available to subscribers on www.thesundaytimes.co.uk This is an excerpt.

It could have been the horrendous traffic jams I encountered over the Easter weekend. Maybe it was a clutch of relatively upbeat data. Or was it one or two anecdotal reports of very strong spending in recent weeks?

The upshot is that I have wondering whether the British consumer, perhaps against the odds, is making a bit of a comeback. Consumer spending, as I have noted before, has never been as depressed at this stage of a recovery as now.

Both consumers and businesses need to spend to turn a weak upturn into something more meaningful. The question this week is whether the consumer side is starting to spring into life.

Those traffic jams, in the face of record petrol and diesel prices and the fear of a tanker drivers’ strike, were on the face of it surprising. The latest Department for Transport figures suggest car traffic is about 3% below its all-time high, achieved in the final three months of 2006.

Even so, we drive 243 billion car miles a year, and the figure is rising. Maybe it is boosted these days by forced staycationers. People drive for all sorts of reasons, of course. One of them is shopping.

The British Retail Consortium’s March retail sales monitor showed retail sales value up by 3.6% on a year earlier on a total basis or 1.3% “like-for-like”; adjusted for additions to floor space.

The increase was due to non-food sales and the BRC attributed part of the rise to the warm weather during the month, which boosted purchases of clothing, footwear and outdoor products. Online non-food sales were up by 13.9% on a year earlier.

The BRC remains cautious, particularly over the willingness of consumers to splash out on big-ticket items. For some such items, however, people are spending.

New car registrations in March, the month of the new ‘12’ plate, totalled 372,835, up by 1.8% on a year earlier. What was striking about the figures however, from the Society of Motor Manufacturers and Traders, was the strength of sales to private buyers, up by 7.4% on a year earlier in one of the two key sales months of the year. New car sales to private buyers in the first three months were 5.8% up on the equivalent period of 2011.

The biggest ticket item of all, for most people, is the house. No sector has provided more mixed messages over the past two 2-3 years, around a generally stagnant overall picture, than housing.

Even here, though, there are more signs of life than one might expect. Tomorrow Rightmove, the property website, will report a big monthly increase in asking prices for properties, taking them to record levels.

Most other price measures are not as buoyant. But the latest LSL-Acadametrics house price index, derived from Land Registry data, was prices up by 0.2% last month, the fourth rise in a row and the seventh in the past nine months.

Last month was also, according to the LSL index, the first March since 2008 when housing transactions in England and Wales exceeded 60,000, There is a stamp duty effect in there: the end of the sub-£250,000 holiday for first-time buyers.

There may also be something else happening, however, if the latest survey from RICS (The Royal Institution of Chartered Surveyors) is to be believed. It has seen a pick up in sales and its members are more optimistic than for a long time about the outlook for house prices.

“There is growing evidence in the RICS survey of a more fundamentally driven market improvement,” it says. “It is possible that surveyors are now beginning to factor in less economic downside risk going forward.”

What does all this add up to? Consumer spending recorded a rare rise in the final three months of 2011, given its recent history. The evidence we have points to a second successive rise in the first quarter of 2012.

It is too soon to talk of the return of the rampant British consumer, still less the pre-2007 housing market, neither of which would be welcome anyway. The pain at Mothercare, as well as some other retailers, speaks of the battle for scarce shoppers’ pounds.

Perhaps the latest Ernst & Young Item Club report, out tomorrow, has it right. Professor Peter Spencer, its economic adviser, says: “For the first time in years, the gap between wage growth and inflation should start to close. This will feed through to the tills on the high street and will be given an additional boost by the Olympics.”

But the Item Club forecast is for a rise of just 0.8% in consumer spending this year and, as Spencer adds: “Make no mistake; consumers can’t lead this recovery.”

The contribution of consumers to the recovery depends on two things, both of which we will learn more about this week when official figures are released.

The first is employment. The Report on Jobs from KPMG and the Recruitment and Employment Confederation suggests job vacancies hit an eight-month high last month, with permanent job placements similar to February’s strong level.

The official unemployment figures may show an easing of the pace of increase but it is too early - and growth is too weak - for a significant drop in the jobless total yet.

The other key factor is inflation. As Alan Clarke of Scotiabank points out, whether it is petrol or stamp prices (a 30% increase in the price of a first-class stamp), most of the recent news has been inflationary.

It may mean that the March figures show no improvement on February’s 3.4% consumer price inflation, while retail price inflation could be only marginally lower than the 3.7% recorded then.

This needs watching. Falling inflation, to restore the growth in real incomes, is an essential part of the consumer story. If inflation does not fall much from here, that story will be very considerably weakened, if not snuffed out entirely.

The spring signs of a consumer revival are, like certain bedding plants, still very delicate. It would not take much of a frost to kill them off.

My regular column is available to subscribers on www.thesundaytimes.co.uk This is an excerpt.

Sometimes, and not just to get another reference to Charles “bicentenary” Dickens into the column, I feel Britain resembles a tale of two economies.

I am not talking here about north versus south, or the City versus manufacturing. Rather, it is the very different picture presented by the official data, from the Office for National Statistics, and private surveys of economic activity.

The difference is not always one way. Retailers have often been left scratching their heads by the buoyancy of the official data for high street sales.

Mostly, however, gloomy official numbers have been at odds with much more buoyant surveys. Why is this, and what is really happening to the economy?

Let me take you back 10 days to the latest update from when the Paris-based Organisation for Economic Co-operation and Development (OECD). The headline-grabber was a prediction of a 0.1% drop in Britain’s gross domestic product (GDP) in the first quarter, following a 0.3% drop in the final three months of 2011.

It is probably the most arbitrary definition in economics, and one we should not really take too seriously, but every schoolboy knows that two consecutive quarters of decline equals a recession.

No matter that it was a forecast from the OECD, which does not have a great forecasting record, it spawned many “Britain back in recession” headlines. Then, however, something surprising happened.

The OECD’s pronouncement, rather than sparking deep gloom, was followed by a series of upbeat surveys on the economy. They included the monthly purchasing managers’ surveys, produced by Markit, for manufacturing, construction and services.

After the last of these was published, showing the service sector expanding strongly, Chris Williamson, Markit’s chief economist, declared that “UK economic growth picked up in March to round off the strongest quarter for a year”.

The three Markit surveys, indeed, were consistent with 0.5% growth in the first quarter. It may not sound much but it is a far cry, economially and politically, from the OECD’s 0.1% drop. The fact that in all three cases the March surveys showed growth strengthening through the quarter boded well for activity in the second quarter (which has just started) too.

It was not just the purchasing managers’ surveys. On the back of the British Chambers of Commerce’s latest quarterly survey, David Kern, its chief economist, prodicted 0.3% first quarter growth.

The BCC, which surveyed manufacturing and services in a sample of 8,000 firms, found both sectors were more upbeat and reporting stronger output, orders and employment. Manufacturing was stronger, suggesting Britain’s factories are shrugging off eurozone gloom and weak demand at home to take advantage of export opportunities further afield.

The surveys may not exactly have been a champagne moment but they were a welcome antidote to the gloom. Andrew Sentance, the former Bank of England monetary policy committee member, now with Price Waterhouse Coopers, kept a running score which reached OECD 0 Surveys 6.

Then, as is its wont, the Office for National Statistics, threw an almighty spanner into the works on Maundy Thursday. From its Newport lair, it published figures showing industry back in the doldrums. Its numbers are less timely than the surveys, so covered February, slap bang in the middle of the first quarter.

In that month, it said, manufacturing output fell by 1%, dropping below any month in 2011, and was 2.3% down on February 2011. Overall industrial production rose 0.4% thanks to a cold-weather boost to energy output. But it was 2.3% lower than a year earlier. Recovery, what recovery?

There was nothing in the surveys to suggest the weakest manufacturing numbers in over a year. Kern of the BCC said the numbers raised “serious questions” about the official data. I tend to agree.

The purchasing managers’ survey for construction has been growing since January last year and in March reported its fastest rate of expansion for 21 months.

Now consider the horror story unfolding in official construction numbers. They suggest output fell off a cliff in December and January (23% combined), so even a sprightly recovery in February and March may not stop the sector reducing GDP in the first quarter. Given industrial production is also likely to be negative, all the weight is on the shoulders of the service sector. After conceding a hatful of goals, the OECD could yet turn out to be right.

I can tell you at this point the official figures will be wrong. This is despite the ONS telling me all its statistics are produced using internationally recognised methods.

I know they will be wrong because a former national statistician, Len Cook, explained why in a paper a few years ago. Revisions to official data are “expected and inevitable”, he said. The ONS gets its figures out as soon as it can, knowing further information will change the picture.

Even “final” estimates of economic data can never be regarded as the truth because there will always be an element of statistical uncertainty in them. I know, from conversations with him, he was keen to attach reliability “star” ratings to official statistics, though it never happened.

Why do the surveys often appear to present a more realistic picture than official data? The ONS, despite the resources at its disposal, produces numbers that may be statistically pure - on the basis of the information available - but often jar.

The surveys, in contrast, build up a broader, internally consistent picture of business activity by asking a series of questions, covering orders, employment, investment intentions and the rest. Of course we need both official data and surveys. But we should acknowledge the limitations of the former and the usefulness of the latter.

The big picture looking at data and surveys in the round, is an economy growing at a modest rate which has been doing so for nearly three years. An economy that was “flatlining” as Labour keeps saying, would not have added nearly 700,000 private sector jobs in the past two years.

That picture of modest growth is true now, and will still be true whatever surprises the ONS has for us when it publishes its initial estimate of first quarter GDP on April 25. The challenge, as discussed last week, is to achieve stronger growth.

My regular column is available to subscribers on www.thesundaytimes.co.uk This is an excerpt.

My natural instinct when confronted with unexpectedly weak growth figures is to question them.

Nobody doubts that this is a subdued recovery but the downward revision of gross domestic product in the fourth quarter of 2011 to show a fall of 0.3%, coupled with small, mainly negative changes for earlier quarters, had me asking questions again.

The GDP figures are out of line with surveys they usually track closely, notably the monthly purchasing managers’ index. Not only that but long experience has taught me it takes years to get the full picture.

The recession of 1990-92 was barely more than half as bad as first reported. I was wrongfooted in late 1998 and early 1999 when the statistics showed Britain flirting with technical recession, compared with the strong growth the numbers now show .

More recently, the economy’s apparent failure to recover in the second half of 2009, while Britain’s competitors were doing so, became a big issue for the last Labour government. Now we know the economy was recovering, thanks to data revisions.

The figures, however, are the figures, and they set the tone. It is on the basis of them that the OECD suggests Britain is in a mild double-dip recession. When they are revised, as they will be, few will notice.

Even so, as noted above, even data revisions will not turn this into a strong recovery. Britain’s emergence from the crisis and recession is hesitant and bleary-eyed. It is not as weak as the official statistics suggest but it is far from strong.

Britain, according to the OECD, is performing similarly to a weighted average of the three largest euroland economies; Germany, France and Italy (though Germany, in almost every respect, looks healthier).

Where there is much clearer divergence is in respect of America. While Britain will struggle to show any net growth in the first half of this year, the US economy will grow at an annual rate of nearly 3%.

This will maintain the post-crisis pattern. A US recovery that is disappointing by historic standards is much stronger than Britain’s. From its recession low-point in mid-2009, the trough, Britain has grown by 3.2%, an average growth rate of little more than 1%. America, in contrast, is more than 6% above its recession lows.

The US economy has surpassed its pre-crisis level while Britain is more than 4% smaller than before the crisis hit. Since the crisis originated in America, while exposing vulnerabilities elsewhere, some might consider that rough justice.

Why is this? I have dealt before with the crude “Keynesian stimulus versus coalition austerity” argument. The great experiment some wished for, of Obama pumping in spending and cutting taxes while Osborne was sucking the lifeblood out of Britain’s economy, was never there.

There were, however, important differences, and some of them relate to fiscal policy. By coincidence, even before the latest ONS numbers and the OECD, they had been addressed by Adam Posen, a member of the Bank of England’s monetary policy committee.

Posen, in a speech ‘Why is their recovery better than ours?’ (though confusingly he is American), listed several reasons why America has shown Britain a clean pair of heels. The two striking weaknesses in Britain are in business investment, which fell by 3.3% in the final quarter of 2011, and consumer spending.

Business investment rebounded much more in America, he said, because firms had a wider range of financing options. They were much less dependent on banks. If credit rationing has been a factor in Britain, and many small and medium-sized firms would say it has, this goes some way to explaining investment weakness.

The lending caution of British banks, meanwhile, has become entrenched because they are more exposed to eurozone risks than their US counterparts.

What about the weakness of consumer spending? The astonishing thing about this recovery is that the consumer has been a bystander. Though consumer spending perked up in the final quarter of 2011, rising by 0.4%, it was 1% down on a year earlier.

Consumer spending is less than 1% above its recessionary trough and 5% down on pre-crisis levels. Never before have we had a recovery in which spending has stayed so weak.

Posen, and this is where fiscal policy does come in, said part of the explanation is that there has been a bigger tightening in Britain than America, which is true.

Some of it is due to the nature of that tightening. George Osborne’s first big announcement, in June 2010, was a hike in Vat to 20% the following January. It was a conscious break with the stealth taxes of the Brown years, a big up-front tax hikes which showed that we were all in together.

But Vat, as the chancellor is discovering with pasties, is a bit too visible. People notice it. Retailers make sure they notice it, so price rises get blamed on the government. Three months after Vat went up, so did employees’ national insurance, a tax hike bequeathed by Labour. There was barely a squeak.

The biggest reason for weak consumer spending, and the fact that real incomes fell more last year than in any since 1977 (the year when the 1976 International Monetary Fund rescue hit home), was the unintended squeeze from high inflation.

Posen says the main reason British consumers fared worse than their US counterparts was that the rise in energy costs was amplified by the weakness of sterling; its 25% depreciation. An open economy blown around by international developments can be unhelpful.

There are other reasons why consumer spending is so weak. In 2007, when the crisis hit, the houssehold saving ratio was less than 3%. Now it is nearly 8%. Borrowing constraints and caution about employment have changed behaviour.

Will this change? Posen thinks the differences between America and Britain will subside. On consumer spending, the best hope remains a fall in inflation and a restoration of real income growth, with oil the biggest threat to that scenario.

As for business investment, a report from RBS notes the £754 billion corporate cash mountain but also warns that it could be next year before we see a decisive rise in investment. Jefferies, the investment bank, also cites the corporate sector as “the best hope for a stronger UK recovery”. Either way, whether corporates or consumers, there is some catching up with America to do.

My regular column is available to subscribers on www.thesundaytimes.co.uk This is an excerpt.

A chancellor who cuts the 50p top tax rate, reduces corporation tax to 22% (with an ambition of getting to 20%), and takes 840,000 people out of tax by raising the personal allowance, might expect to be garlanded.

Instead, George Osborne finds himself lambasted by the Tory press, criticised by the think tanks and scared of going out at night for fear of being pelted with Werther's Originals by irate pensioners.

Many people have asked how the Treasury could have found itself in this pickle. Why leak all the eye-catching announcements in the budget, while leaving the £3 billion “raid” on pensioners by taking away age-related allowances to grab all the headlines on the day itself? When even Labour accuses you of stealth taxes, you know something’s up.

I think, without giving away any trade secrets, there were two reasons. One was that the pre-budget leaks were not part of some carefully-planned Treasury strategy.

Treasury people are naturally secretive: left to them the most that would have come out in advance would have been localised public sector pay bargaining, relaxing Sunday trading for the Olympics and a 100-year gilt (government bond).

But budgets these days are collegiate affairs. Gone are the days when Gordon Brown kept it secret from Tony Blair until the day before. And the more people that know, from the prime minister through his chatty Liberal Democrat colleagues, the more likely things are to get out.

I also think the Treasury, and in particular Osborne’s key adviser Rupert Harrison, did not see the pension changes as very controversial. As an alumnus of the Institute for Fiscal Studies, he probably agreed with its verdict of “a relative modest tax increase on a group hitherto well sheltered from tax and benefit changes”.

So was it a good or a bad budget and what did it tell us about the government’s fiscal strategy and the economy?

Let me get two things off my chest. Unless things improve suddenly, I owe the Office for Budget Responsibility an apology. Since November, when it revised up its projection for public borrowing this year from £122 billion to £127 billion, I have been calling that decision into question.

The monthly numbers, which were pointing to a significant undershoot - the talk was of £120 billion or below - backed my judgment. Then, as it is wont to do, the official statisticians bowled a googly on the morning of the budget.

Thanks to a splurge of spending by government departments, borrowing hit a record £15.2 billion in February, more than £6 billion up on a year earlier and double City expectations.

A nice chart in the Treasury’s budget document shows the 12-month rolling total for borrowing neatly trending down to £120 billion from a peak of nearly £160 billion at the time of the election.

Unfortunately it did not include the February numbers, which have that rolling total jumping back up to £128 billion. Some of that may be unwound in the March data. But as it stands there is no undershoot of any significance: a token downward revision by the OBR of £1 billion to £126 billion.

There is a big drop in borrowing on the way, with a predicted £92 billion for the coming year, 2012-13. It would, however, be £28 billion higher if not for the transfer of Royal Mail pension fund assets to the public sector. Borrowing for 2013-14 goes back up to £98 billion. Borrowing over this parliament is officially put at £528 billion. It is moving in the right direction but averages more than £100 billion a year.

Borrowing is proving more intractable than the last time Britain was faced with budget deficits on anything like this scale; in the early 1990s. The virtuous circle then, of rapid recovery leading to a quicker fall in borrowing, is not happening yet.

I still do not see that the answer to uncomfortably high borrowing is more of it. The government’s critics offer two versions of the fiscal stimulus story. One is the temporary tax cut through Vat or National Insurance. The other is infrastructure spending, perhaps funded by issuing special bonds.

Neither stacks up. A temporary tax cut adds more to borrowing than it would add to gross domestic product and, because it was temporary, would reduce growth in future when reversed. Issuing infrastructure bonds to fund capital projects is a nice idea but it would still represent more government borrowing. Growth will come but there is no easy way of forcing it.

That brings me to the second thing to unburden myself of. A lot of commentary on the budget was that none of the tax cuts, whether for corporation tax, the 50p rate or raising the personal allowance, can amount to much because the official forecast is barely changed from November.

Apart from the fact it is a minor triumph to have had no forecast change since the autumn, this is not how forecasting works. The budget was broadly fiscally neutral, a £1.9 billion giveaway in 2012-13 and just under £1 billion the following year, clawed back in later years. A neutral budget, if plugged into an economic model, unsurprisingly does not affect growth much.

It is disappointing business investment is so weak. The OBR forecast of just 0.7% growth this year because of eurozone uncertainty compares with nearly 8% at the time of the budget. But it is ridiculous to say this reflects a failure of the corporation tax cut, which is singled out as factor likely to raise investment over the medium term. The OBR still expects a 40% rise in business investment over the next 4-5 years.

What are we left with? Even the chancellor’s best friends would not describe what we had as a bold, tax-reforming budget. Coalition budgets, as well as being leaky, will always be messy compromises.

But the signals it sent out were nevertheless important ones. Anti-business sentiment has threatened to take over in recent months. Osborne’s third budget was a corrective to that, in words and in some deeds. As a means of levering the economy into stronger growth in the short term, it made little difference. As a budget to provide a platform for stronger, business-led growth in the medium and long-term it might yet prove its worth.

My regular column is available to subscribers on www.thesundaytimes.co.uk This is an excerpt.

Wednesday’s budget provides an opportunity for the chancellor to set out a course for the economy and to send some important signals on tax, including the future of the 50p rate - if it has a future - and the level of corporation tax.

For George Osborne, it is an opportunity to clear up the tax confusion. In the absence of a clear lead from the chancellor, talk of mansion taxes and tycoon taxes has been free to take wing. If he revived William III’s window tax people might be surprised but not necessarily astonished.

I wrote on March 4 about how hard it has been to work out Osborne’s tax strategy. Paul Johnson, director of the Institute for Fiscal Studies, puts it better than I did. “Annual speculation in a vacuum is damaging and costly,” he wrote.

To paraphrase Oscar Wilde, for the IFS not to get your tax strategy smacks of carelessness. We need to know where the chancellor stands. This week is his opportunity.

Budgets are great theatre. They are important in setting the direction of taxation and the economy. This week should see the chancellor with the luxury (for him) of not having to revise down growth and revise up the borrowing numbers.

Though you can never say never with the Office for National Statistics, risks of a double-dip have eased. Osborne is on a firmer footing than a few months ago.

But businesses want a reason to be confident. Good budgets provide such reasons, for both firms and individuals. The EEF, the manufacturers’ organisation, says the clear targets set out in the government’s fiscal strategy should be matched by a growth plan with equally clear objectives.

Firms, it says, are fed up with talk of new taxes and the coalition debate over 50p. Osborne should be leading a growth drive with targets this parliament of increasing the number of firms bringing new products and services to market; attracting more globally-focused companies; lowering business costs and making the workforce more flexible and productive.

We shall see. It is fairly clear the budget will not have a big fiscal giveaway. With a deficit of roughly £120 billion, the ratings agencies hovering and the chancellor trying to get investors interested in 100-year gilts, this is a non-starter.

Indeed, much of the pre-budget debate has been stuck in a time warp. For many years leading up to the crisis it was understood that monetary policy, by which was meant merely changing interest rates, was the economic policy lever of choice.

Fiscal activism, cutting taxes or boosting spending to give the economy a short-term stimulus, had fallen into disuse. It had a brief revival in 2009, when the world was falling off a cliff. Since then governments, including America’s, have been implementing deficit cuts.

Pretty well all the stimulus action has been via monetary policy, with near-zero official interest rates, quantitative easing in Britain and America or the European Central Bank’s successful long-term refinancing operation (LTRO). Fiscal activism came and went very quickly though, as I say, nobody seems to have told those pushing for it to be used again this week.

A big fiscal giveaway would be £20 billion, roughly Alistair Darling’s 2009 stimulus package. But the Bank is in the middle of a monetary boost six times that, £125 billion, through quantitative easing (QE), on top of £200 billlion it did three years ago.

The two types of stimulus are not directly comparable. A fiscal giveway is for keeps, or at least until the governent reverses it, while the QE boost is intentionally temporary: at some stage all those gilts the Bank has purchased will be sold back.

How has the Bank been doing stimulating growth? The Times has run a series on Sir Mervyn King, including an interview in which the governor’s main defence was that history will be kind to him.

As far as monetary policy is concerned, the Bank was slow to cut when the crisis hit but acted quickly when the storm raged in 2008-9 and, for a conservative institution, embraced “unconventional” QE.

Some would say King is too gloomy - I know people who await his downbeat pronouncements with dread - but his supporters would say if ever there was a time you needed a dovish governor this was it.

What the Bank does matters a lot. Its senior officials are aware it has not yet responded adequately to criticism from pensioners and savers groups of the current round of QE.

Paul Tucker, King’s deputy and a strong candidate to succeed him, knows the Bank has to get supervision and regulation right, through its financial policy committee and prudential regulation authority. London’s role as a global financial centre means the Bank has to set an example to the world.

Perhaps the biggest economic challenge for the Bank, though, is how to return to normality for interest rates. Many see the Bank as so constrained by a weak economy and the fiscal tightening it will have no option buit to leave Bank rate at 0.5% and periodically pump in more QE, for years.

Some in the Bank are starting to think, however, of the exit strategy. Ben Broadbent, a member of the monetary policy committee, makes the sensible point that the financial crisis in Britain had little to do with the build up of household and corporate debt. It was mainly the banks, and in particular their overseas balance sheets.

Britain’s households, while they increased debt substantially, added to their ownership of financial assets at least as much. Household assets are several times liabilities (debt).

This means, he argues, the Bank will not have to tiptoe too much for fear of driving households and businesses over the edge. Most are strong enough to take higher rates, particularly if market conditions mean a lowering of margins between Bank rate and the rates people and firms actually pay, in contrast to the recent pattern.

Higher rates are usually reported as bad news. But when they do go up, even if not under the current governor (he has until mid-2013), it should be a sign that the long nightmare of the crisis is coming to an end.

The chancellor has a tough task this week combining good politics, good economics and some confidence-building but cheap measures. Most budgets, however, are soon forgotten. The Bank’s task in the coming months and years is arguably much harder and more important. Enjoy the budget, but remember the Bank.

My regular column is available to subscribers on www.thesundaytimes.co.uk This is an excerpt.

When the unemployment figures come out on Wednesday, expect to hear about it. They will be anticipated, discussed in phone-ins and be the subject of questions in the House of Commons. The Westminster and media villages will go into overtime, as they always do.

Even when the figures are not bad, as last month, they will be reported as gloomy. They are programmed that way. The Office for National Statistics’ February release showed the broader measure of unemployment as 2.67m, fractionally lower than in its January announcement.

Because the figures are announced by the ONS as a rolling three-month total, however, that small fall was reported as a 48,000 rise over the latest three months.

The beauty of the statistics is that there is always some bad news for those looking for it, whether high youth unemployment, the proportion of long-term jobless or the numbers forced to work part-time because not enough full-time jobs are available.

Maybe this is at it should be. We can never have zero unemployment but we should not be satisfied with higher than necessary unemployment. The lowest the Labour Force Survey measure of unemployment got to during the long recovery from the recession of the early 1990s was just under 1.4m in September 2004, after which it rose by 300,000 in the following two years in the absence of recession.

Unemployment is a million or so higher than its recent minimum. Behind that bald statistic is a waste of effort and talent and stories of personal disappointment.

Even when there is good news on jobs, such as 20,000 additional posts at Tesco and 2,000 jobs to be generated by the new Nissan Invitation in Sunderland, there is usually something to balance it.

In the north-east it was at least 300 jobs lost from the closure of the Lynemouth aluminium smelter. Nationally, it was the threat to 1,700 jobs for people with disabilities from shutting Remploy factories.

So we should not be complacent. What we should not do either, however, is overdo the gloom, in a way that does nobody any good. As I have noted before, there was a welcome disconnect in the recession between the drop in gross domestic product and the fall in employment.

GDP fell by more than 7%, employment by 2%, in sharp contrast to previous recessions, where the fall in employment was equal to or greater than the drop in GDP. GDP is still 4% lower than its pre-recession peak, while employment is 1.5% down.

One of the enduring narratives of recent months has been that the private sector is not generating the jobs to offset cuts in the public sector. Fortunately it is not true. Since December 2009 public sector employment has fallen by 365,000 while jobs in the private sector have risen by 630,000.

Though employment weakened at the end of last year, recent evidence, notably from the Recruitment and Employment Confederation survey, carried out with KPMG, is that it is strengthening again.

Two new contributions support my belief there is too much gloom around about the labour market. Goldman Sachs examines claims that headline figures conceal a large rise in “hidden” unemployment, such as the TUC’s recent estimate that true unemployment is 6m.

Statistics for hours worked and labour force participation (whether workers are “discouraged”) do not support the argument that a relatively small rise in recorded unemployment disguised a big increase in hidden unemployment, Kevin Daly and colleagues find. There are always people operating on the fringes of the job market but there is no evidence relationships between their numbers and those for recorded unemployment have changed.

The Goldman report draws comfort from a surprising source: low wage increases. The time to get worried about unemployment is when it is “structural”; it stays high even as the economy recovers. Low wage rises suggest a significant slice of unemployment is “cyclical”: it bears down on wages because people are available and have the skills to start work immediately.

The other contribution was John Philpott, chief economist at the Chartered Institute for Personnel and Development. Philpott, dubbed Dr Doom by The Sun, might not be the obvious person for reassurance.

In a recent speech, however, he provided it. Though the number of people unemployed for a year or more has increased from a quarter to a third of the total, this compares favourablly with the last time unemployment was close to current levels in the 1990s, when the proportion of long-term unemployed was 44%.

Talk of a “lost generation” of young people is misplaced, he said, because “core” (difficult to tackle) youth unemployment is 10%, not the 22% headlined in the official figures. The proportion of unemployed who are young people, just under 40%, is lower than it was, and the percentage of the young who are long-term unemployed, 25%, is in line with past experience.

The common theme is that there is nothing permanent about the higher unemployment we have now. As growth recovers, so employment will strengthen. Unemployment will come down.

Does that not argue for a big, employment-generating public spending boost in the March 21 budget? No. There are things the chancellor could do on infrastructure spending, which he is attempting. There is more that could be done to boost housebuilding, as Vince Cable said in his now notorious leaked letter last week.

But a short-term boost to public spending to generate jobs, in the knowledge that spending has to come down over the medium-term, would be a feeble, make-work plan, however, and ultimately a cruel deception on the unemployed.

It has to be the private sector. If the budget tries anything, it should be to encourage private employers to recruit and expand. There may be tax incentives to assist with that. Not increasing the national minimum wage for young people will help. In the end it has to be about giving firms confidence in the outlook.

Nobody pretends it is easy. Even 600,000 additional private sector jobs over the past couple of years has not been enough to offset the combined impact of public sector job losses and a growing workforce, which includes a rising number of migrant workers. But it can be done. Britain’s private sector job machine is working. It just needs to run a bit faster.

My regular column is available to subscribers on www.thesundaytimes.co.uk This is an excerpt.

This should be a good time for George Osborne. In the run-up to his March 21 budget fears of a double-dip have eased and consumer confidence has picked up.

The government borrowing numbers have come good for the budget, which should enable him to declare a deficit undershoot for this year. It is too early to say but the hope among the chancellor’s advisers, that the Office for Budget Responsibility (OBR), the independent watchdog, may have overdone the gloom for later years is not just wishful thinking.

Economic forecasters, against the pattern of the past two years, have begun to eye the possibility of revising up their growth forecasts for this year and one or two have done so.

The OBR may not go that far but there is no reason why it should change its forecasts of 0.7% growth this year, 2.1% in 2013.

And yet, Osborne finds himself assailed from all sides, particularly on tax, to the point where the budget can only be a disappointment. Unless he can simultaneously abolish the 50p top rate of income tax, cut Vat and raise the personal tax allowance to £10,000 some of his critics will claim he has under-delivered.

He is being pushed to cut tax despite the fact, as he made clear in interviews attending the G20 finance ministers’ meeting in Mexico, the scope is not there.

“Any tax cut would have to be paid for,” he said. A government that “has run out of money”, as he put it, is in no position to splash the cash, despite the prospect of a borrowing undershoot. The word from the Treasury is that with the budget deficit still well above £100 billion, this is no time to declare victory and hand taxpayers some of their money back.

So why the pressure on him to do so? Some of it is deliberately mischievous: Labour’s call for a temporary Vat cut is more about forcing a humiliating U-turn than helping the economy.

Much of it, however, reflects a genuine uncertainty about what Osborne stands for. What is his tax philosophy? Does he think that if he keeps saying he is an instinctive tax-cutter, while at the same time hiking taxes, people will not notice the rises? Gordon Brown tried something similar but it did not work.

Consider the record. Osborne’s coup de grace was in the autumn of 2007. An audacious plan to raise the inheritance tax threshold to £1m - a big cut in capital taxation - was so well received that Alistair Darling was forced to announce his own inheritance tax cut and Brown scrapped his plans for a snap election.

We have not heard much about inheritance tax since the May 2010 election. The only notable change in capital taxation was a rise in capital gains tax from 18% to 28%. Was Osborne ever committed to lowering capital taxes, or was it just a piece of political opportunism?

What about direct and indirect taxation? The Tories have been habitual hikers of Vat, beginning in 1979 with Sir Geoffrey Howe’s increase to 15% (from rates of 8% and 12.5%) and continuing with Norman Lamont’s hike to 17.5% in 1991. In each case, however, it was a hike with a purpose. Howe did it to cut income tax, Lamont to reduce local taxation. Osborne, when he raised Vat to 20%, just did it.

Not only are indirect taxes going up but so are direct ones. A chancellor who was philosophically opposed to higher direct taxes would have blocked the hike in National Insurance he inherited from Labour, rather than just easing its impact on employers.

Most chancellors stamp their authority on the tax debate. The noises off we are getting now would be ignored because people would know what was possible and what was pie in the sky. The strategy would be clear. MPs putting their two pence worth into calls for lower taxes would be given short shrift; junior ministers doing so - let alone deputy prime ministers - would be given a carpeting.

Instead, Danny Alexander, the Treasury chief secretary and Nick Clegg, the deputy prime minister, openly call for a big increase in the personal tax allowance in the budget, with Alexander saying it should be funded by abolishing pension relief for higher rate taxpayers.

I would be astonished if this relief was abolished - indeed there are no easy tax-raising hits to fund cuts elsewhere. I would be equally astonished if the 50p rate were to bite the dust this year. The “scrap the tax” campaign risks using all its ammunition up early.

But the fact is that any increase in the personal allowance beyond the planned rise to £8,105 in April will be seen as a Liberal Democrat measure, despite a long Tory history of taking people out of tax this way.

Osborne does not engage very well in the debate. On tax he is seen a blank page. The political opportunism tag sticks because he spends a significant amount of his time as the Tories’ chief election strategist. The risk with stretching yourself between two jobs is that you do neither well.

His allies would say that is unfair. He began with clear ideas about making Britain a lower tax economy. When he and David Cameron talked about “sharing the proceeds of growth”, they meant that any room for fiscal manoeuvre should be split between higher public spending and lower taxes.
The deficit changed all that, as did the compromises of coalition. As for a tax philosophy, he set one out in his last budget.

“Our taxes should be efficient and support growth,” he said. “They should be certain and predictable ... simple to understand and easy to comply with. And our tax system should be fair, reward work, support aspiration and ask the most from those who can most afford it.”

That philosophy is set out clearly in what he has done on corporation tax, his supporters say, with a cut to 23% over the next three years and a well-received clarification of the rules on controlled foreign companies. The general anti avoidance rule (Gaar) to be unveiled in the budget is intended to make sure that by making everybody pay their fair share, tax rates can be lowered for all.

One day, maybe, that will happen and our tax-raising chancellor turn himself into a tax cutter. So far, however, he gets good marks for cutting the deficit, low ones for most other aspects of the job. It remains to be seen whether that verdict is any different after March 21.

My regular column is available to subscribers on www.thesundaytimes.co.uk This is an excerpt.

In the 21 months since the coalition government has been in office, a narrative has been developing.

It is that George Osborne’s fiscal strategy is not only crippling the economy but failing in its own right by missing its targets for cutting the deficit.

Every time the chancellor stood up to announce an increase in the official borrowing projections, it seemed like a nail in the coffin for the strategy.

For Labour, a cumulative upward revision of £158 billion in borrowing over the parliament by the Office for Budget Responsibility, provided a stick to beat Osborne.

Well, unless January turns out to have been an aberration, the tide looks to be turning. Last month’s £7.8 billion budget surplus put the government on course for an undershoot of the OBR’s £127 billion projection for borrowing this year, 2011-12.

You may say that is no big deal. After all, did not the OBR revise up that forecast as recently as November? Yes it did, from £122 billion. It will be disappointing, however, if borrowing is not below that figure too.

Indeed, if the optimistic forecasters are right, the deficit could undershoot by £10 billion. “A simple extrapolation of the data over the last ten months suggests that borrowing is on course to come in at around £116 billion,” says the IFS.

There is many a slip twixt cup and lip. The OBR is not yet ready to throw in the towel on its forecast and there are two months' figures to go. But this is rather interesting. Just over three years ago the Treasury under Alistair Darling predicted a budget deficit of £176 billion for 2010-11 and £140 billion for 2011-12.

In June 2010, when Osborne presented his emergency budget, the interim OBR predicted deficits of £149 billion and £116 billion respectively.

The £149 billion was far too gloomy (as was the earlier £176 billion), the outturn for 2010-11 being just under £136 billion. But that £116 billion for 2011-12 appeared to fall foul of weak growth in the economy.

Until now that is. If it turns out that borrowing is close to those initial June 2010 projections, in spite of a weaker recovery, some of the OBR’s gloom about future years may have to be revised. The fiscal strategy looks to be much more on track than it was given credit for. The deficit is still with us but is coming down faster than feared.

As an aside, the latest numbers makes the decision to put Britain’s AAA sovereign debt rating on negative watch look even more curious. It would have made a lot more sense to wait for the data from the key tax-raising month of the year.

Myths abound about fiscal policy and its impact on the economy. One is that the American economy is doing better because it has had a fiscal stimulus while Britain is doing exactly the opposite, inflicting unnecessary pain on a sickly economy.

Not true. The International Monetary Fund’s fiscal monitor shows fiscal policy in America was tightened by 0.8% of gross domestic product last year.

This was not as much as Britain’s tightening, 1.5%, but Britain’s was smaller than Germany, 2.3%. Germany, in spite of this, grew by a robust 3%. The relationship bewteen growth and fiscal policy is not simple.

Another myth worth exploding is that we have barely scratched the surface of the fiscal tightening, so that all the pain lies ahead. While it is true that the squeeze on spending will last for years, Treasury numbers, updated by Goldman Sachs, suggest the biggest single-year hit is behind us.

That was in 2010-11, a combination of the measures the coalition inherited from Labour, its own “in-year” cuts and the Vat hike in January last year. Policy, measured by the cyclically-adjusted primary balance, was tightened by a substantial 2.6% of GDP. This year’s tightening, by contrast, is 0.9% of GDP, roughly what it will average in future years.

Where does this leave Osborne as he plans his March 21 budget? He will be spared the embarrassment of having to present upwardly-revised borrowing forecasts and downwardly-revised growth.

He is being pressed by the Tory right to announce aggressive tax and spending cuts. The Liberal Democrats want the rich to be soaked more, by scrapping higher rate pension tax relief or introducing a mansion tax. I have an image of Ed Balls, the shadow chancellor, wandering up and down Oxford Street with a “Cut Vat now” placard around his neck.

I may have misread it but I would be surprised if he were to do any of this. The usefulness of the Tory right to the chancellor is that they make his plans look moderate. Neither the abolition of higher-rate pension tax relief nor a mansion tax are likely to see the light of day, for now at least. An emergency cut in Vat is about as likely as Elvis turning up at the Commons on budget day. Osborne will make a virtue of “steady as she goes”, banking the undershoot rather than spending it.

What about the 50p tax rate? Though self assessment receipts were disappointing in January, suggesting the absence of any revenue bonanza from the tax, the question of whether the 50p rate raises any net revenue is not yet cut and dried.

We await the verdict of Her Majesty’s Revenue and Customs (HMRC), which will be published with the March 21 budget. The politics of early abolition of the tax are awful. Even if it is a revenue loser, many people would want to keep it.

Osborne can, however, give a pointer to future abolition. He can also, and I feel bound to mention it given how many readers got in touch, tackle an absurd anomaly in the income tax system.

This is the 62% (combined tax and National Insurance) rate that kicks in when incomes hit £100,000 and continues to £114,950, after which it drops to 42%, until the 50p rate takes effect at £150,000. It happens because of the withdrawal of the personal tax allowance above £100,000.

The numbers caught in this anomaly are hard to come by but must be at least a couple of hundred thousand. As importantly, it introduces a powerful distortion and disincentive into the system. It needs to be changed.

My regular column is available to subscribers on www.thesundaytimes.co.uk This is an excerpt.

On February 21, the Office for National Statistics will publish figures for public finances in January.

These figures, which the chancellor of the exchequer will get a day early, are important in their own right. January is one of the big months for tax receipts, so they will tell us whether the government’s deficit reduction programme is on track, overshooting or undershooting.

The January numbers will also give us the first solid indication of the impact of the 50p top rate on incomes above £150,000. If they are strong, in what is the key self-assessment month, it will at least suggest that the tax is in some decent revenue. If they are weak, it will add to the sense of anticipation over the second piece of information heading Osborne’s way.

This is the exercise he commissioned from Her Majesty’s Revenue & Customs (HMRC) in order to provide a definitive answer to the question of whether the 50p rate is a net revenue raiser. Officials are currently going through the self-assessment forms and other evidence.

They will present a report to the Treasury in time for the March 21 budget, when the intention is to publish it. It will inform Osborne’s decision on whether to stick with the top rate he inherited from Labour.

I shall come on to the tricky politics of that in a moment. What do we know about the numbers? So far this fiscal year tax revenues have been rising reasonably strongly: from April to December last year central government receipts were 5% higher than in the corresponding period a year earlier.

When it comes to income tax and capital gains tax, however, a breakdown by the Office for Budget Responsibility suggests these were lagging well behind other receipts, up by only a cumulative 1.7%, though December on its own, up 4.6%, was a little better.

How much does the Treasury expect to raise from the 50p rate? Projections done by officials at the time Alistair Darling introduced the new top rate two years ago were for the net addition to revenue to settle at around £3 billion a year. This is not a sum to be sneezed at though it is only 0.5% of this year’s expected government receipts and under 2% of income tax revenues.

Even that sum is called into question by some independent experts. The Institute for Fiscal Studies, in its recent green budget, looked at the effects of the new rate on indirect taxes (such as Vat and excise duties) as well as direct taxes such as income tax and National Insurance.

It concluded that if spending by the high-paid is cut as a result of the tax, then the government may be robbing Peter to pay Paul. The fall in indirect tax revenues almost offsets the rise in direct taxes.

In this case, the IFS found, the net revenue raised by the tax reduces to less than £1 billion a year. Under other assumptions about the way incomes and spending have responded to the new tax, so-called elasticities, the net tax take turns negative. In other words the government’s coffers would be poorer as a result of the 50p rate.

There are things even the IFS cannot model but the Treasury is keenly aware of. If the 50p rate has resulted in enough high earners moving to Switzerland and elsewhere, then all the taxes paid by these people are lost to the economy.

The behavioural changes assumed by the Treasury in estimating the direct revenue gains mainly assumed people would engage in tax avoidance, not that they would choose to become tax exiles.

The fact that many high-earners can do so means that one way of preserving any revenues from the tax - clamping down even harder on tax avoidance schemes - could easily be counter-productive. The effect might be to put people on the next plane to Switzerland.

So what will happen? The chancellor will, as I say, publish the HMRC report in the budget and will respond to it. Given that officials are looking at direct taxes only, it will be surprising if it does not conclude that the 50p rate is bringing in at least some additional revenue, though probably not as much as the Treasury’s original £3 billion long-run estimate.

What will be Osborne’s response? When he was in Davos last month, the chancellor was clear. “I have always said this is a temporary tax,” he said. “The long-term damage of this tax is potentially quite considerable, and that's why it is temporary.” He urged British business leaders attending the speech to furnish him with the evidence on that damage to help him get rid of it.

Since he was in Davos, quite a few things have happened. We have had the affairs of both Stephen Hester’s on-off bonus and the now de-knighted Fred Goodwin.

The Liberal Democrats have increased the pressure for accelerating the move towards a £10,000 personal tax allowance, paid for by increasing taxes on the wealthy. At one time the proposed mansion tax was seen as the price the Tories might have to pay for getting rid of the 50p rate. Now it is being pushed as the way to pay for tax cuts for low earners. Danny Alexander, the Liberal Democrat Treasury chief secretary, wants to scrap higher rate pension tax relief in order to lift the personal allowance to £12,500.

There was a lot of emphasis on unfairness, fat cats and bonuses even before recent events. There is even more now. I may be reading too much into it but I did not see a mention of the 50p rate in Osborne’s speech last week to the Federation of Small Businesses. Some say it could be a deal-breaker for the coalition.

The danger, however, is that the 50p rate takes on an air of permanence. Margaret Thatcher cut the high top rate of income tax she inherited from Labour at the first opportunity in 1979. Nearly two years into the parliament, the “temporary” top 50p rate is intact and, given the politics, unlikely to go any time soon.

So Osborne is a bind. Does he keep a tax that raises little or any revenue and may be doing “considerable” damage to the economy, or does he abolish it and risk upsetting his coalition partners and being seen as the friend of fat cats and bankers.

A compromise might be a firm pledge to abolish it by the end of the parliament. At one time this was the minimum business expected from the government. Now it would be seen as a sign of boldness.

My regular column is available to subscribers on www.thesundaytimes.co.uk This is an excerpt.

The ducks, it seems, are all lined up in a row. Gross domestic product fell in the final quarter of last year, inflation is falling and the money supply is weak.

Sir Mervyn King gave a broad hint in his first big speech of the year that he and colleagues on the Bank of England’s monetary policy committee (MPC) stand ready. It will be s surprise if there is not an announcement on Thursday at noon.

I am talking about the Bank deciding to increase its asset purchases, to add to the £275 billion of quantitative easing (electronically creating or “printing” more money) to boost the economy.

Since October, when the MPC announced an additional £75 billion of quantitative easing (QE), in response to “increased downside risks” for both growth and inflation, the markets have been waiting for this moment.

In 2009, the worst post-war year for the world and British economies, the Bank reached into its filing cabinet marked unconventional monetary policy and unleashed £200 billion of QE, overwhelmingly by buying gilts; government bonds.

Bank rate had been cut as much as was thought desirable - 0.5% represents easily the lowest in the Bank’s 318-year history - and more monetary oomph was needed. Hence the £200 billion of QE in these exceptional 2009 circumstances which, on the Bank’s estimates, added between 1.5% and 2% to the level of gross domestic product and 0.75% to 1.5% to inflation.

For the Bank’s view on how it did so, a paper “The UK’’s quantitative easing policy: design, operation and impact”, is on its website. It has also published some recent working papers which offer supportive evidence on the impact of the policy.

2009 was special because it was so very weak. To announce another £75 billion of QE in October reflected the Bank’s deep concern over the impact of the eurozone crisis, and its fear the economy was going into reverse. It said as much about the economy as any indicator.

The significance of this week’s MPC meeting is that the £75 billion announced in October has been done. In meetings since then committee members have said they would decide on wtether to do more when that point was reached.

The moment has arrived and the fact this is a month in which the Bank publishes a new quarterly inflation report means trhe markets will be surprised if there is not more this week.

A “cautious” MPC will announce a further £50 billion, according to Philip Shaw of Investec and Nick Stamenkovic of Ria Capital. Shaw cites evidence of operational constraints on the Bank - its appetite for gilt purchases may be grater than the markets’ willingness to sell - while Stamenkovic points to the Bank’s January minutes as signalling that some members are uneasy about repeating the October dose.

But both Michael Saunders of Citi and Geoff Dicks of Novus Capital, think it will be another £75 billion. Saunders thinks the Bank can carry on buying until QE reaches £600 billion, nearly 40% of GDP. That would leave £800 billion of gilts still in circulation, enough for institutional investors such as pension funds.

The shadow MPC, under the auspices of the Institute of Economic Affairs, is more restrained. Only three of its members favour an immediate extension of QE.

Could the Bank do anything else as an alternative to QE? Vicky Redwood of Capital Economics floats the idea of the Bank cutting the interest rate paid on commercial bank reserves to zero or even a negative 0.25% rate, as in Sweden. In theory, a penalty rate would encourage banks to boost lending rather than sit on these reserves.

The Bank, however, ran through alternatives last September. They included a cut in Bank rate below 0.5% and setting out guidance on the future path of interest rates, as the Federal Reserve has done. It seems unlikely to revisit those options now.

So it looks like more QE. Having opposed it in the autumn, am I still against it now? On the face of it, the Bank has been vindicated, particularly in its concerns over the weakness of the economy in the final few months of last year.

Some of that weakness, reflected in the 0.2% fourth quarter drop in gross domestic product, was not conducive to a money injection by the Bank. The Old Lady of Threadneedle Street does not have the power to vary the weather and boost energy consumption, or prevent North Sea oil output from falling.

Most surveys suggest, in contrast to the very sharp fall in activity the economy was enduring in 2009, when it did its first £200 billion of QE, a gentle pick-up is under way. Manufacturing appears to have shrugged off some of last year’s weakness. The service sector grew strongly in December and even more strongly in January.

This should be a prelude to stronger growth in the second half of the year, as falling inflation boosts real incomes. Were I at the Bank I would want to make doubly sure of this fall in inflation, particularly after the overshoots of recent years. Worrying about an undershoot of the 2% target in a couple of years’ time, given the forecasting record, seems self-indulgent.

Not only that but the route from QE through to stronger growth in the economy is much less obvious than it was in 2009. Gilt yields are already very low at about 2% and, while this partly reflects the expectation of more QE, it reduces the impact of further purchases.

There is also the question of the eventual unwinding of the policy. That is a long way off but at some stage the Bank will have to sell these gilts back, possibly into a very weak market because interest rates will also be rising. The more the Bank adds to that £275 billion, the more it will have on its books to unload when the time comes. That makes me uncomfortable.

But the Bank, which is not always very good at managing expectations, has given the impression it will do more. To avoid a destabilising policy lurch it probably has to do so. That to me means £50 billion this week and a “final” £25 billion in May. Let us see what happens.

(0)

My regular column is available to subscribers on www.thesundaytimes.co.uk This is an excerpt.

In all likelihood, the 0.2% fall in GDP announced by the Office for National Statistics (ONS) last week will be revised away in time. There were, as there always are, some special factors.

The second mildest autumn in more than 350 years produced a drop of over 4% in gas and electricity output, as well as making it hard for retailers to sell winter woollies and overcoats. A one-day strike by public sector workers on November 30 probably hit GDP, though the official statisticians do not know by how much.

I am not pretending that these were anything but disappointing figures, though there was some relief in the Treasury that they were not even worse. One official recalled what happened a year ago, when everybody was expecting a 0.5% GDP rise for the final quarter of 2010, only for the ONS to report a 0.5% fall. The recovery has been struggling ever since.

The 0.2% fall in fourth-quarter GDP did not change the overall numbers for 2011, which showed 0.9% growth, in line with the late-November projection by the government’s Office for Budget Responsibility. Non-oil GDP, resorting to a distinction that used to be made in the days of booming North Sea output, rose by a slightly stronger 1.4%. The economy has flattened, not dived.

But it was the 0.2% fall that did the damage and, unlike a year ago, there is no automatic reason to expect a bounce in the current quarter. Things are likely to remain flat for a while.

In the headlines and in broadcasts, there is no distinction between a small fall in a flat economy and, say, a 2% drop that would imply a deep recession. People read or hear about the fall, assume the economy is slumping, and their confidence takes another hit.

Another official number last week, showing government debt has topped £1 trillion for the first time, probably has a similar, confidence-sapping effect.

£1 trillion is a big number, equivalent to nearly two-thirds of Britain’s annual GDP, but the milestone did not really mean very much. It was a straightforward consequence of the large budget deficits of recent years.

Underlying it were monthly deficit statistics that are improving at a slightly faster rate than expected.

What about the gloom from the International Monetary Fund, slashing its forecasts for Britain and the world? The IMF has a French managing director, Christine Lagarde, and a French chief economist, Olivier Blanchard.

Though they are right to warn of the dangers of insufficient action by eurozone leaders, there is a danger in seeing everything through a European prism. The IMF looks a little too downbeat on America, predicting growth of just 1.8% this year, and may not have fully picked up on the improved feel recently in other economies.

The global economy did amazingly well in 2010, growing by 5.2%, and not badly in 2011, 3.8%. Even this year, the IMF expects 3.3% growth. It is a slowdown but certainly not a collapse.

It comes to something when you have to look to Sir Mervyn King for reassurance. The Bank of England governor, often criticised for his gloomy tone, reminded us that all crises come to an end.

King’s view on the economy, broadly flat until the middle of the year, before falling inflation eases the squeeze on real incomes and lifts consumer spending off the floor in the second half is one I share.

In the meantime, he said, adjustments are under way in bank, corporate and household balance sheets that will put the economy on “a more sustainable footing than at any point in the past fifteen years”.

Perhaps that is the way we should look at the current situation. Had growth come back quickly and strongly after the worst of the financial crisis, and been sustained, there would have been no need to change.

As it is, the government has belatedly started to introduce supply-side reforms that will bring dividends in the future. They include easing credit constraints on small and medium-sized firms and finding new ways of funding infrastructure.

Though it has been slow off the mark, these reforms, together with the proposed introduction of local or regional pay in the public sector, will have positive effects over the medium or long-term.

But there is much more to be done. The London School of Economics has launched its growth commission, inviting along former US treasury secretary Larry Summers and former monetary policy committee (and current fiscal responsibility committee) member Steve Nickell to do so.

Summers said Britain could not afford to ignore sectors in which it had comparative advantage, notably financial services. Nickell observed that governments had been good at commissioning reports to identify the problems, but less good at acting on them.

Gordon Brown, for example, commissioned McKinsey to report on Britain’s relatively poor productivity performance early in his chancellorship in 1998 but mainly failed to act on the recommendations.

The things identified then, regulatory barriers, low skills, poor management, becoming better at commercialising scientific innovations, remain relevant now. The LSE commission will come up with detailed recommendations

There can never be a magic bullet, or an instant remedy. Looked at with the benefit of hindsight, the despair of the early 1980s turned into a powerful, enterprise-led revival remarkably quickly. At the time it seemed agonisingly slow.

Even so, the questions are being asked now in a way they would not have been. As King suggests, growth disappointment now and the “arduous” recovery may be the process we have to go through to end up healthier in the long run. People and businesses, however, need the confidence to believe in that. At the moment most of them do not.

My regular column is available to subscribers on www.thesundaytimes.co.uk This is an excerpt.

Britain has a budget deficit that compares unfavourably with most of the economies downgraded by the ratings agency Standard & Poor’s a few days ago.

Britain’s overall debt, still rising mainly as a result of that budget deficit, vies only with Japan as the largest among leading economies, according to new figures from McKinsey, the management consultancy.

Yet Britain one of the few countries to retain a AAA sovereign debt rating with Standard & Poor’s - others in the club are Australia, Canada, Denmark, Finland, Germany, Hong Kong, Liechtenstein, Luxembourg, the Netherlands, Norway and Singapore, Sweden and Switzerland - and pays ultra-low interest rates on that debt.

It is quite an achievement, endorsing George Osborne’s claim to have made Britain a safe haven in the storm, though Treasury officials remain alive to the danger that one Friday evening it will be Britain’s AAA rating that gets downgraded.

There is, however, no evidence of that, or warning to that effect. And, given the verdict of the markets is more important than ratings agencies, low gilt yields, currently around 2% for the benchmark 10-year bond, are testimony to market confidence.

Or are they? Jonathan Portes, director of the National Institute of Economic and Social Research (Niesr), begs to differ. Portes, a former cabinet office economist who has taken Niesr back to its Keynesian roots, has a blog Not the Treasury View.

“Our current historically very low level of interest rates is - just as in Japan - a sign of economic failure, not success,” he writes. “The government has got the rhetoric and the economic logic completely wrong on this.”

I find this puzzling. Though this week’s gross domestic product figures for the final quarter of 2011 will underline the struggle Britain is in to get the recovery beyond stall speed, there are other economies with worse growth prospects and much higher bond yields, mainly in the eurozone.

The Japanese comparison also looks odd in other respects. The key to Japan’s lost decades (counting the 20 years since the early 1990s as a failure) was deflation; falling prices. Though inflation in Britain is falling, at 4.2% it remains high. So keen are markets to hold gilts they accept a negative real interest rate for doing so.

The fact the Bank of England is purchasing gilts under its quantitative easing programme is important but does not change the broad picture. It is easy to envisage a situation in which the Bank was buying gilts hand over fist while everybody else was dumping them.

Nobody expects years of deflation in Britain. Niesr is among the inflation optimists but its most recent forecast sees inflation over the next five years tucked just below the 2% target, not negative.

As an aside, and though it has a new forecast out shortly, it does not expect Japanese-style stagnation either. While downbeat for this year, it expects growth to average 2.5% over the 2013-16 period.

So we should knock the Japan comparison on the head. Somehow, though its critics will not have it, the government has fiscal credibility. If anything it is enhanced by the fact public borrowing is dropping even in a slow-growth environment. The fall under Alistair Darling’s plans, remember, was in the context of implausibly upbeat Treasury growth forecasts.

We should celebrate the fact that borrowing costs are so low. Not only will this lay the groundwork for a stronger recovery in future years but it will also mean a smaller proportion of spending will go on paying interest on the debt, with a higher proportion on public services.

Even the critics would surely applaud that. Debt interest used to be described by Gordon Brown as a “cost of failure”. Cutting that cost is to be welcomed.

While I am at it let me deal with another Japanese comparison, as drawn by McKinsey. As noted above, it estimates Britain’s total debt, 507% of gross domestic product, is close to Japan, with 512%.

Ireland is in a class of her own, with 663%, but others are lower. America has debt of 279% of GDP, Germany 278%, Italy 314%, Spain 363% and Portugal 356%.

McKinsey’s contention is that Britain has not begun to come down from these high levels of debt, to “deleverage” and needs to do so. The process of deleveraging, running down debt, is one that could undermine growth in coming years.

There is some truth in McKinsey’s view but not as much as you might think. There is a huge difference between Britain and Japan in government debt. Britain’s is 81% of GDP, Japan’s a huge 226%.

Corporate debt, 99% of GDP in Japan, 109% in Britain, is similar. Corporate debt in Britain is similar to South Korea’s 107% of GDP but lower than France, 111%.

What about Britain’s famously indebted consumers? I am not sure the household sector carries too much debt. Yes, at 98% of GDP it sounds high, and is well above Italy. 45%, France, 48% and Germany, 60%.

But debt is a stock while GDP is a flow and to compare them, while convenient, is apples and pears. Most household debt in Britain is in the form of mortgages. Countries with high levels of owner-occupation tend to have high levels of household debt.

US household debt is 87% of GDP, Canada 91% and Australia 105%. Britain’s household debt should ideally not rise much in coming years - and certainly not as much as it did in the pre-crisis decade. But nobody should expect or want a fall.

Where Britain does have a disproportionate amount of debt, 219% of GDP, is in the financial sector. This is nearly double Japan, more than five times America and roughly three times most other countries.

A significant proportion of that, however, reflects London’s role as a global financial centre and the preponderance of foreign banks in Britain. Take that out, as is appropriate, and total debt comes down to closer to 400% of GDP than 500%.

That is still too high. Not many people are aware that by far the biggest increase in debt in the pre-crisis period was not that acquired by households, companies or government but by the financial sector. The financial sector ballooned too much and, painful though it is in terms of credit availability, it is right it is now deleveraging.

What would be wrong, however, is to add to government debt. Even under the coalition’s deficit-cutting programme, debt will rise inexorably. Adding to that increase would guarantee Britain’s place at the top of the international debt league. It would also be the surest way of turning Britain, in terms of economic stagnation, into Japan. Clearly, it should be avoided.

My regular column is available to subscribers on www.thesundaytimes.co.uk This is an excerpt.

Maybe I spoke too soon. The appropriate response to the eurozone downgrades announced on Friday by Standard & Poor's is to ignore them. But that is not happening, so the eurozone is back in crisis.

This time last week I was celebrating the stronger than expected data we had seen since the start of the year. Then, three days ago, the Office for National Statistics came out with a gloomy set of industrial figures and we appear to be back to square one.

There is a difference. The surveys I was reporting on last Sunday applied to December, while the industrial numbers were for November, when we knew things were weak.

Even so, there is now a mountain to climb if Britain’s gross domestic product is to avoid a fall in the final quarter of 2011 when the statsitics are out on January 25. The arithmetic is straightforward. Industrial production taking October and November together was 1.2% lower than the third quarter.

That is enough, barring a December recovery, to shrink GDP by 0.2% in the fourth quarter. The service sector accounts for the lion’s share of the economy and could compensate but it too had a bad start to the quarter.

The National Institute of Economic and Social Research predicts 0.1% quarterly growth but it is in a minority. The City expects a small fall. Some of that will be down to temporary factors like the mild autumn which has reduced gas supply by 23.6% year-on-year (the weather is never right these days).

Some of it is explained by longer-run changes, including a 14.6% annual drop in “mining and quarrying”, which includes a sharp drop in North Sea oil production, Scottish Nationalists please note.

There is no doubt, however, that there was genuine economic weakness, which one hopes reached its peak in the autumn when fears of a eurozone catastrophe were at their height.

We also had figures for German GDP, “Bruttoinlandsprodukt” as they say in Wiesbaden. There was much to envy in these numbers, which showed 3% growth in 2011 after 3.7% in 2010. German GDP rose above pre-crisis levels during 2011, while Britain is still 4% below where we were. Even the German economy stalled at the end of 2011, however.

If growth in Britain has stalled, or worse - this week’s Ernst & Young Item Club report will talk of “ state of paralysis” for the economy - it will be regrettable, and not just for the obvious reasons.

The two fundamental questions for the economy in the next few years are first, whether growth in productivity - output per worker - can resume its earlier trend and secondly, whether the damage to the economy from the crisis and recession is as bad and as permanent as feared.

It is a big issue. Paul Krugman’s dictum, “productivity isn’t everything but in the long-run is almost everything” neatly captures the fact that without productivity there can be no sustained prosperity.

On the face of it, Britain has been living in a productivity vacuum for the past four years. Employment did not fall as much as feared in the recession but only because productivity did.

In a Policy Exchange pamphlet published at the end of last year, I pointed out that output per worker was some 14% to 15% below where it would be if the pre-recession trend had continued.

I offered some reasons for optimism. There has been no meaningful growth in public sector productivity since the mid-1990s. Rebalancing the eceonomy away from the public sector to the more productive private sector should automatically boost productivity. I also offered some policy advice around the coalition government’s five “drivers” of productivity: investment, innovation, skills, enterprise and competition.

Then, right at the end of last year, we had some modest grounds for optimism of productivity. Official figures showed output per worker rose 1.2% in the third quarter and was up on a year earlier.

The picture for manufacturing was particularly encouraging with productivity at record levels, up by 3.2% over 12 months on an output per job basis and 4.7% measured by output per worker.

Partly spurred by these numbers, Kevin Daly and Adrian Paul, economists at Goldman Sachs, published a rejoinder to the gloom on productivity and the permanent damage to Britain’s economy.

On the latter point, they noted that the economy has shown remarkably steady long-term growth, since about 1920, despite many shocks to the system along the way. As they put it: “Traumatic as the financial crisis has been, it is difficult to argue that it will have a more lasting effect on potential output than either the Great Depression or the Second World War.”

At the very least, it is too early to say that the economy has gone ex-growth, or entered a lost decade.

The Goldman Sachs economists were also optimistic on productivity. One commonly cited reason for productivity pessimism, that some of the highest growth in output per worker was in financial services and that will play a diminishing role in future, is balanced by the fact that so will the low-productivity public sector.

Not only that but Germany and Sweden, they noted, suffered bigger declines in productivity than Britain during the crisis and recession, but both have seen big improvements as their economies have recovered. A similar phenomenon is likely in Britain.

But this brings us back to those disappointing production figures and the prospect of a downbeat number for GDP. Economics can never be a laboratory experiment or merely a run on a computer model.

The test for productivity - and ultimately prosperity - will only come when the recovery is stronger. That will also provide a test of how much GDP was permanently lost and how much spare capacity remains.

A stop-start recovery does not provide the answers to these questions. It leaves us in limbo about where we will be as an economy in three, five or 10 years time.

We need productivity but first we need production. It is hard to have one without the other.

My regular column is available to subscribers on www.thesundaytimes.co.uk This is an excerpt. The table to accompany this piece is available on The Sunday Times website or in the newspaper.

This is not a time when you want to be dragged down further by deepening economic gloom.

Fortunately, despite the best efforts of some new year pundits, it is not happening. Pretty well every bit of economic data we have had so far has surprised on the upside.

As regular readers will know, the earliest readings on the economy are provided by surveys, and in particular purchasing managers’ surveys produced by Markit, a data provider. Official figures come a little later.

Before the publication last week of the December UK surveys, analysts were downbeat. Each one, however, was a pleasant surprise. The manufacturing purchasing managers’ index rose from 47.7 to 49.6, construction from 52.3 to 53.2 and the service sector from 52.1 to 54.

Levels above 50 indicate expansion and the weighted average of all three, up from 51.2 to 53.2, was the strongest since July. Were this just a phenomenon restricted to Britain, one might be suspicious. There are, however, plenty of signs of life elsewhere.

Gavyn Davies, formerly of Goldman Sachs and the BBC, now Fulcrum Asset Management, points out that leading indicators for the global economy bottomed out in July last year and are now showing a decent recovery.

China, which is more locked into the global economy than most countries, may be coming through its softer patch, to judge from the latest readings from its manufacturing sector. South Korean exports showed a significant jump. The global purchasing managers’ index, produced for J.P. Morgan rose to an expansionary 50.8 in December, its strongest since June.

In some cases the stronger numbers are a continuation of what ws happening last year. Back in August, without drifting too far into Irwin Stelzer’s territory, Standard & Poor’s downgrade of America’s sovereign debt rating coincided with deep gloom about the economy. A double-dip, it seemed, was certain.

Instead, America has had an “I’ll have what she’s having” tranformation. With few exceptions, the data has come in stronger than expected. Talk of a dive back into recession has faded.

Even in Europe, German unemployment has continued to fall and Spain’s jobless rate did not increase as much as feared. Survey data from the eurozone still points to mild recession but “mild”, rather than falling off a cliff, is the operative word.

Eight days into the new year is, of course, far too early to be cracking open the champagne, even if there were any left. This may be the economic equivalent of a dead cat bounce. Chris Williamson, Markit’s its chief economist, thinks the UK purchasing managers’ surveys are merely consistent with a flat figure for Britain’s gross domestic product in the fourth quarter.

Though that sounds a little too downbeat, it will take a decent bounce in official data for services and manufacturing to produce any GDP growth in the fourth quarter, fugures for which will be out on January 25. Perhaps for a while we will have to get used to the idea of flat being the new growth.

It can, however, be instructive looking back. As promised I am today publishing my annual league table of economic forecasts for 2011. What turned out to be a fascinating, event-filled year was also a pretty awful one for forecasters.

Let me concentrate on the big picture. Though we will not know for sure for another couple of weeks (and not for certain for many years), current evidence suggests the economy grew by 0.9% in 2011.

Every month, the Treasury publishes a compilation of around 40 independent economic forecasts. In January last year none of these - not one - had a growth forecast as low as 0.9%. The Centre for Economics and Business Research (CEBR) came closest, with 1.1%, and there were a few others starting with a “1” but the consensus was for 2% growth - twice what was achieved - and one optimistic group (Liverpool Macro Research) predicted more than 3%.

While forecasters were much too high on growth, they were far too low on inflation. I estimate that consumer price inflation will have averaged 4.7% in the final quarter of last year. A year ago the consensus was that it would be 3%. The closest was Michael Saunders with 4.1%. Many, however, had forecasts that suggested inflation would come in at barely more than half the outturn.

I have a lot of sympathy with the forecasters. Those who predicted weak growth thought, like the Bank of England, it would bear down more heavily on inflation. Those who thought inflation would be higher believed it would, at least in part, be a product of strong growth. The combination of weak growth and high inflation - and the lack of a response from the Bank of England in higher interest rates - was hard to forecast.

So nobody had a vintage year, which in the past has involved nine or 10 out of 10 in by scoring system. Congratulations, however, to Daiwa Capital Markets and Capital Economics for creditable sixes, with Daiwa just edging it.

Running close behind on five were the Economist Intelligence Unit and the CEBR and following them on four, BNP Paribas and Standard Chartered. I know in at least two cases - Daiwa and BNP Paribas - economists who were instrumental in producing the forecasts have moved on.

Most other forecasters, I suspect, will regard 2011 as a year best forgotten. My own score, a generous four or a more realistic three, was nothing to write home about.

Those who ignore the lessons of history are condemned to repeat them. The headline on the equivalent piece to this a year ago was “Forecasters failed to spot inflation surge”. Then they did it all over again.

What about now? Economists are subdued on 2012 growth prospects (consensus just 0.6%) but do expect inflation to come down to 2.1% by year-end. If they are wrong for a third year on inflation that would be unforgivable.

If they are right, they may be underestimating the positive impact on growth of lower inflation from the return of growth in real incomes and hence stronger consumer spending. This is something I have been talking about for a while. It offers the best hope for a year in which, in 12 months time, we may be able to say the forecasters, instead of being too optimistic, overdid the gloom.

My regular column is available to subscribers on www.thesundaytimes.co.uk This is an excerpt.

Harry S. Truman, or one of his speechwriters, came up with the famous “give me a one-handed economist” line, so exasperated was he with economists saying “on the one hand this, on the other hand the other”.

Hedging your bets rarely convinces anybody. As with those red and green forecasting fan charts produced by the Bank of England and others, which encompass a very wide range of possibilities, nobody applauds a fence-sitter.

So, with all that said, let me get 2012 off to a good start by offering a two-handed view, or at least two distinct scenarios. There are good reasons for doing so, as I shall explain, before saying at the end which I think is most likely.

It will not have escaped anybody’s attention that the eurozone crisis has not been resolved. The Brussels summit at which David Cameron made his stand was as noteworthy for the failure of EU leaders to deliver the deal they were aiming for.

True, the markets showed a spirit of goodwill over the festive period and the European Central Bank bunged nearly ¤500 billion of cheap funding into the coffers of European banks but the underlying uncertainty persists.

Will it be resolved in a disorderly manner, with the eurozone disintegrating, or will EU leaders, the European Central Bank and the International Monetary Fund find some way of muddling through? Or could the euro could survive but with not all its members staying the course? This is something I have long thought likely, if not now then at some stage.

Any of these things are possible but tucked in there somewhere is a very nasty outcome for the eurozone and Britain, what I shall call scenario one, which would see banking crisis and recession return with all the intensity of the autumn of 2008. It should not happen - it should not be allowed to happen - but that is no guarantee it will not.

It is also impossible to ignore. You can split the outlook for this year into one based on fundamentals, which I shall set out below, or you can think about what might happen if we get a re-run of the blind panic of three years ago. As happened then, that would sweep any fundamentals aside.

Before we get too depressed, however, is anybody actually predicting scenario one? They may be doing so in private but publicly available forecasts for the economy say not. According to the Treasury’s compilation of independent forecasts released just before Christmas, the gloomiest, from Standard Chartered, is for the economy to shrink by 1.3% in 2012.

That would be bad news, guaranteeing a substantial rise in unemployment, a worse outlook for the budget deficit and a huge political headache for the coalition.

It would, however, be a far cry from the recession of 2008-9, when gross domestic product (GDP) fell by a cumulative 7.1%. A new recession on the Standard Chartered scale would be more of an aftershock than a dangerous and damaging slide. And remember, they are currently the gloomiest.

Forecasters may be wrong, of course. But most are assuming that the eurozone will be more of a running sore, admittedly a very troublesome one, than a couple of broken legs.

That leaves us with scenario two. We will not know how the economy did in the final quarter of 2011 until January 25 but the assumption is not very much. Either GDP will be flat, or it will have dropped by a little bit, or it will have risen slightly.

And, it seems, we are due for a few more months of this, until roughly the middle of the year. There is nothing to suggest, barring euro armageddon, that the economy is about to fall off a cliff. There is nothing to suggest either that it is about to burst into life.

In scenario two, exports remain adversely affected by the eurozone crisis, even if it does not descend into outright chaos. Businesses are cautious about investing and government spending is being cut.

The economy in these circumstances needs the consumer - how can it not need the two-thirds of GDP contributed by consumer spending? Such spending has been unusually depressed; more so at this stage of the recovery than ever before.

The mechanism for lifting it, and the spirits of consumers, is the restoration of growth in real incomes. That will come, as I have noted before, only when inflation falls far enough. If the Bank of England is right that will come in the second half of the year. Standard Chartered, for all its short-term gloom, expects inflation to be down to 1.7% by the fourth quarter.

Falling inflation, and hence rising real incomes, will be the trigger for stronger growth in domestic demand. With luck, the same starting-gun that gets Usain Bolt away in the 2012 Olympics will fire consumers up too.

Growth is unlikely to be spectacular. The 2012 consensus lurched downwards between November and December, no doubt partly as a result of the Office for Budget Responsibility’s 0.7% forecast. Nobody likes to be above the official forecaster so the new consensus is 0.6%.

I would expect something a little stronger, but closer to 1% (as in 2011) than 2010’s 2.1% expansion. More importantly. however, if this view is right, the tone will be different.

So, while 2011 was a year that started with growth hopes high and then saw them fade, 2012 should be a mirror image. With luck we would be looking forward with optimism to the sunnier climes of 2013 and beyond.

So which scenario will it be? Both are possible but if I had a spare ten shillings I would put it on the second. I would give scenario two a 75% to 80% probability and euro armageddon 20% or 25%. That is too high for comfort, and puts the onus on eurozone leaders to maintain the pressure for a solution to the crisis that lasts beyond the next summit. But it may be as good as we are going to get.

My regular column is available to subscribers on www.thesundaytimes.co.uk This is an excerpt.

The eurozone crisis has provided a scary backdrop to every column I have written here over the past 12 months, as has the ongoing and rather sterile debate about whether the government should stick to its “Plan A” or opt for a “Plan B”.

The answer to that, of course, is that in a ideal world the government would not only have a Plan B, but Plans C, D, E and F as well. But this is not an ideal world. Far from it.

To add some more letters to the alphabet soup, Britain’s AAA rating is hanging by a thread and, as we saw in the autumn statement, George Osborne is struggling to meet his self-imposed fiscal rules. I can predict with confidence and some trepidation that the Plan A/Plan B debate will go on in 2012. The question of whether Britain clings on to that AAA rating will be a live one.

But the big theme of 2011 was one of disappointment. An economic recovery that started very well slowed markedly. As I always say, we should treat the Office for National Statistics’ (ONS) first guesses about gross domestic product with some caution. The figures will be revised.

The picture we have now, however, taking the ONS’s latest numbers, is of an economy that grew by 3% in its first 12 months of recovery - from the third quarter of 2009 to the third quarter of 2010 - but slowed to just 0.5% in the latest 12 months, up to the third quarter of 2011.

A better way of looking at it, perhaps, is by reference to calendar years. In 2010, Britain grew by a respectable 2.1%, the ONS now says. A year ago my expectation, and that of most independent forecasters, was that we would see something similar, that is growth of about 2%, in 2011.

This time last year the Treasury’s monthly compilation of independent forecasts showed an average expectation for 2011 growth of 1.9%, with the newest forecasts slightly more upbeat at 2%. One or two forecasters were positively glowing with optimism, predicting that the year’s growth rate would be 3% or more.

The disappointment is reflected in the latest assessment by independent forecasters, taken from the Treasury’s latest compilation published a few days ago. Now the assessment is that the economy grew by just 0.9% in 2011, less than half the 2010 rate, and half what was predicted by the consensus a year ago.

How worried should we be by this? It is not hard to think of reasons why we should be concerned. The eurozone crisis, of which more next week as I look forward, has hit confidence, particularly among businesses, as well as exports, and is far from resolved.

The issue of weak bank lending - the practical impact of the hangover from the banking crisis - remains with us. Despite the chancellor’s imaginative plan to launch credit easing, lending to small and medium-sized firms has been falling on an annual basis since early 2009 and continues to do so.

Some of the one-offs of 2011, such as the Japanese earthquake and tsunami and its impact on manufacturing supply chains worldwide, will one hopes not be repeated. But there will be other shocks, and there will be other repeat factors like additional bank holidays to celebrate royal milestones.

When an economy is strong enough it tends to shrug off such special factors. The fact that there was a response this time - latest figures show the economy did not grow at all in the second quarter - shows an underlying fragility.

The government’s fiscal tightening - its Plan A - clearly had an impact on growth during 2011. The Treasury would point out that there was also such a tightening during 2010 and so this alone does not account for the growth disappointment.

It is a fair point, though perhaps the nature of 2011’s changes, the Vat hike at the start of the year to a new high of 20% and April’s increases in national insurance contributions, brought home to people the fact that we are all in this together when it comes to cutting the deficit.

The big explanation for 2011’s growth disappointment, however, was the squeeze on real incomes - and to a certain extent business margins - from high inflation. Some of that was due to the Vat hike. Most was not.

A year ago, when we knew about the Vat hike, the consensus among forecasters was that consumer price inflation in the fourth quarter of 2011 would average 2.8%. In the event it has been roughly two percentage points higher.

That makes the difference between a mild squeeze on real household incomes and a savage one. The Office for Budget Responsibility says 2011’s drop in real incomes was the biggest in the post-war era. It made the single biggest difference to economic growth, turning the prospect of a dull but respectable recovery year into a disappointing one.

Without high inflation, growth of 2% would easily have been in reach in 2011. As it is, consumer spending has never been so depressed at this stage of a recovery.

Could anything have been done about it? I started the year thinking the Bank of England would have been wrong to accede to pressure for higher interest rates, given that the die for 2011 was already cast.

But Andrew Sentance, before he left the monetary policy committee (MPC), made a persuasive case that some of the factors that appeared to be beyond the Bank’s control could be influenced. In particular, to the extent we were suffering from high imported inflation, the Bank’s actions - by bearing down on the pound - exacerbated the problem.

So for a time we appeared to be moving towards a rate hike. Three MPC members voted for it and others seemed ready to join them. By the end we had gone full circle, with the Bank opting to resume quantitative easing.

Though I was rather uneasy about that, the proof of the pudding will be whether it is seen to be supportive of growth during the next few months and whether, as the MPC believes, inflation will fall very sharply in the coming months. That, as I shall discuss next week, has to be the hope.

My regular column is available to subscribers on www.thesundaytimes.co.uk This is an excerpt.

Many will be familiar with the Phillips curve, the economic relationship defined in the 1950s by Bill Phillips, a New Zealander who came to the London School of Economics after a dreadful time in a Japanese prisoner of war camp.

His relationship - when unemployment is rising, wage rises (and therefore inflation) will fall- was both logical and simple. It was subject to subsequent revision, most notably by Milton Friedman, but it remains central to policy thinking.

The reason the Bank of England expects inflation to fall is because of spare capacity in the economy. Unemployment, of course, is the human side of spare capacity.

For some time, however, the relationship between unemployment and inflation has seemed to go awry. Inflation has risen for most of this year alongside an increase in unemployment. Much more of that and people would seriously talk of stagflation.

Now, however, normal service is being resumed. Unemployment is rising, the rate for the August-October period was 8.3%. Inflation is falling, and on the consumer prices index measure has dropped from 5.2% to 4.8% in the past couple of months.

That should be the prelude for a much bigger fall in the coming months, notably as January's Vat hike drops out of the annual comparison. Spencer Dale, the Bank's chief economist, said last week that inflation should be in the "low threes" by March. Weaker growth in China, India and other emerging economies is putting downward pressure on commodity prices.

It is important inflation does fall, both to ease the squeeze on real incomes and for the Bank's credibility. It will also be significant in other ways. Inflation affects everybody while unemployment, or the fear of it, affects only a minority.

Even so, it is appropriate to think of the misery index: the unemployment rate plus the inflation rate. The index has risen this year to its highest since the early 1990s - higher than the recession proper - making us all feel thoroughly miserable.

Now, even if unemployment continues to rise, as is likely, it should be more than offset by falling inflation. We will not be happy in the coming months but we should be a little less miserable.

What of unemployment? A month ago we had some genuinely bad unemployment figures. The wider Labour Force Survey measure, having been stuck at 2.5m for two years, rose to 2.622m. Employment fell sharply over the summer.

The latest numbers were not nearly as bad. The new total, 2.638m, was up by a modest 16,000. The monthly claimant count rose by a tiny 3,000. Yet the way they were reported, you might have thought both sets of figures were equally awful.

Some newspapers laid the gloom on with a trowel while the BBC talked of “another leap” in unemployment. No self-respecting salmon would describe it as a leap. Unemployment will rise further but we should not overdo the gloom.

Indeed, something interesting is happening in the data. A month ago, so bad were the figures I thought we would see a sharp fall in both public and private sector employment in the third quarter.

Sure enough public sector employment fell, by 67,000, but private sector employers added 5,000 to payrolls. In the past 12 months public and private have roughly balanced out, a fall of 276,000 in the public sector and a private sector rise of 262,000.

Something else has been happening and on the face of it is rather surprising. In the latest three months the number of self-employed people rose by 166,000 to 4.14m, the highest since records began in 1992.

I wrote last month that we are entitled to be a little suspicious of strongly rising self-employment at a time of weak growth, the suspicion being that it is involuntary rather than a spontaneous outbreak of entrepreneurial spirit.

The statisticians have investigated this and found the new self-employed include the young, the old, some who have left employment but also some who were economically inactive but have set themselves up as self-employed. So it is widely-based.

I wonder, too, whether something else is happening. The public sector is more than meeting expectations for cutting headcount. There is a well-known phenomenon in central and local government, which is that people are made redundant and then re-hired as a self-employed contractors.

It is possible we are seeing some of that in these numbers, so the drop in the public sector headcount exaggerates the squeeze. It would help explain both some of the rise in self-employment and why public sector job cuts have been so much bigger than the Office for Budget Responsibility expected.

Finally, an aside. Given Britain’s financial services sector has been in the news, how important is it? The City UK, which represents the industry, claims financial and professional services together account for 14% of gross domestic product and employ nearly 2m. That, however, includes many in professional services who have nothing to do with finance.

More often it is claimed, including by letter writers to The Times, that financial services are 10% of GDP. That, however, is too high. According to the ONS, the 2008 weight of financial services and insurance in gross value-added was 8.9%. Since then the sector has suffered a bigger decline than the economy as a whole, so its contribution in 2010 was nearer to 8%.

Financial services and insurance employ 1.1m people, according to the ONS. The insurance industry has nearly 300,000 employees, the Association of British Insurers says, leaving roughly 800,000 in financial services alone. If we assume a similar split in terms of contribution to GDP, that suggests financial services are closer to 6% of GDP, perhaps 7% at the outside. That fits the more detailed ONS data.

Financial services are important, and Britain does well exporting them. But they are no more than half the size of manufacturing. Perhaps David Cameron's next veto should be to protect British industry.

My regular column is available to subscribers on www.thesundaytimes.co.uk This is an excerpt.

I am not going to add much to the thousands of words on David Cameron’s tactics in Brussels. But, if John Major could claim “game, set and match for Britain” (not necessarily accurately) 20 years ago at the Maastricht negotations, this was more: “It’s my ball and I’m taking it home.”

It is not obvious the prime minister’s veto will be of benefit to the City of London, whose interests he was keen to protect. A grouping of 10 euro “outs” with Britain as its leader might have been viable. One lonely objector out of 27 is different.

It points towards a looser relationship between Britain and the rest of the EU, a free trade relationship, though achieving it will be easier said than done.

Establishing the regulatory paraphernalia that goes with the single market is easier than dismantling it. Can Britain stay in the EU? Yes, but as the equivalent of a social member at sports clubs, not allowed to participate in most events.

Many in Europe, of course, see Britain as part of an Anglo-Saxon conspiracy seeking to derail their project. So the occasionally harsh judgments of the City on euro rescue efforts are of a piece with last week’s threatened downgrade of most EU economies by Standard & Poor’s, the ratings agency.

The fact some of us have a pretty low opinion of S&P, which seems to think its pronouncements are great publicity coups, is neither here nor there.

What of the deal struck by EU leaders in Brussels on bolstering the euro? It was probably as much as could have been expected. Angela Merkel has acceded to the idea of fiscal union, though she means enhanced discipline over euro members rather than a genuine pooling of debts and deficits.

The deal, limiting “structural” budget deficits of eurozone members to 0.5% of gross domestic product, imposing fines on those whose deficits exceed 3%, accelerating the permanent European Stability Mechanism and making available an extra 200 billion euros in firepower, makes sense as a resting place for the eurozone.

We have to get from here - big budget deficits and tough austerity programmes - to there. Comments by Mario Draghi, the president of the European Central Bank, left open the question of how much the ECB will be smoothing that journey.

We will see what happens in the coming weeks. My sense is that markets are suffering from crisis fatigue and will give the deal the benefit of the doubt for now. But nobody can pretend the crisis ends here.

What is the underlying problem? In introducing the Bank of England’s financial stability report a few days ago Sir Mervyn King rehearsed a familiar line.

The eurozone crisis, he said, was all about imbalances. Some members have big payments surpluses, others have deficits.

As he put it: “Governments will have to confront the underlying causes. A loss of external competitiveness in some euro-area countries has led to current account imbalances and large build-ups of private and public debt, much of it external. The problems in the euro area are part of the wider imbalances in the world economy.”

Hearing that I thought it was a brilliant summation of the problem. Then I thought there must be more to it. Imbalances are like the hunchback of Notre Dame’s “the bells”. They ring so loud they can make you deaf to everything else.

Emphasising global imbalances, whether for China, America or Europe, sounds like a counsel of despair. They have been around for decades. In an ideal world, they would not exist. In the real world they do. No system can deliver perfect balance.

I am not attacking King for being unduly gloomy. It would be alarming if he were suddenly cheerful. It is known in the Bank there are three distinct views: the optimistic, the gloomy and the governor in the corner with a dark cloud over his head.

The point is that the imbalances story does not fit the eurozone that well. True, countries like Germany, the Netherlands and Austria have big surpluses, while Spain, Portugal and Greece have deficits.

True, some countries went into the crisis with a lethal combination of big budget and current account deficits. That applied particularly to Spain, Portugal and Greece. Things, however, have moved on.

Ireland is already back in current account surplus, which did not prevent another tough austerity package last week. Every other eurozone country is correcting its external balance, says the OECD.

Greece, having had a 15% current account deficit in 2008, will be down to just over 5% in 2013. Portugal goes from 13% of GDP to less than 2% and Spain from 10% to 2%. France has a small current account deficit of just over 2% of GDP. Italy’s is 3.6% this year but falling to less than 2% in 2013.

As an aside, my long-time forecast of Britain returning to current account surplus is backed by the OECD, which sees surpluses for 2012 and 2013. Trade figures on Friday showed a sharp improvement.

The issue for the euro is not imbalances but what lies behind them. Nobody would claim Britain’s return to surplus, should it occur, is the sign of a healthy economy. It is happening because of depressed activity.

What is true for Britain is also true for the eurozone. Imbalances are narrowing because of extremely depressed conditions. Weak demand as the eurozone slides into recession is shrinking the imbalances.

The big long-term question, and this takes us back closer to King’s point, is whether eurozone members can claw back the huge loss of competitiveness they have endured since the euro came into being.

Since 2000, German unit labour costs have risen less than 5%. France’s, in contrast, are up 25%, Spain’s more than 30% and Italy almost 40%. Greece and Ireland have clawed back some lost competitiveness (but with a huge gap to close). Most countries will not begin to close the gap in the next two years, according to the OECD.

That, beyond the short-term rescue, is the long-term issue. Is there a mechanism for countries to grow their way out of trouble — and prevent debt from rising inexorably — while remaining in the euro?

I am not sure there is, or that it is in the gift of politicians to bring it about. The agenda in Brussels was about keeping the euro together, with or without Britain’s help. Call me Anglo-Saxon, but there will surely be future summits where talk turns to how to manage the exit of some eurozone members.

My regular column is available to subscribers on www.thesundaytimes.co.uk This is an excerpt.

In the past few days we have had lost decades aplenty, apocalyptic warnings from the Bank of England governor, collective action by central banks to stave off a global liquidity crisis and a general sense of impending gloom.

People want to know, understandably, what it all means. For me it means we are looking at growth which is at best negligible over the next few months, followed by the beginnings of somewhat stronger growth in the second half of 2012.

But that path takes us past a dangerous hazard labelled “eurozone elephant trap”, the one we fall into if Sir Mervyn King’s warnings about inaction come about. And if we fall into it, no amount of contingency planning would save us from a nasty recession, possibly worse than 2008-9.

As if George Osborne did not have enough on his plate, he had to cope with people comparing him with Gordon Brown, because his Autumn Statement contained so many “tinkering” measures. I don’t suppose the former prime minister was too happy either.

I think it was a bit unfair, though some people remain keen to turn Osborne into Denis Healey, the Labour chancellor who tried to spend Britain out of recession in the 1970s, only to be forced to turn to the International Monetary Fund for a rescue.

As it was, had Osborne merely presented gloomy economic and borrowing forecasts without some compensating growth ideas, he would rightly have endured a political pummelling. Credit easing (getting more money flowing to small and medium-sized firms) and additional infrastructure spending are not “game changers” as the Treasury would have us believe but they are useful steps in the right direction.

Where the Osborne-Brown similarity works is that both of them have had to repeatedly admit that they were too optimistic on growth and borrowing. Brown’s optimism left an uncomfortable legacy for Alistair Darling and for the coalition.

Osborne’s retreat from earlier optimism could have more serious consequences for him. He cannot afford a further deterioriation.

This time he only met his fiscal rules by the flimsiest of whiskers, and only as a result of telling the independent Office for Budget Responsibility (OBR) that he would cut public spending in real terms for the first two years of the next parliament.

If the outlook for borrowing were to get worse, the chancellor would either be forced to pile austerity on austerity, by announcing further measures, or lose Britain’s AAA credit rating. This, already under closer scrutiny since the autumn statement, could easily go. If it went, Osborne would be honour-bound to go too.

Let me offer a couple of correctives to the gloom, not forgetting the elephant trap. The Institute for Fiscal Studies is marvellous and you criticise it at your peril. I think, however, it laid it on a bit thick with its “lost decade” (and more) for real household incomes. Paul Johnson, its director, said real median household incomes would be no higher in 2015-16 than in 2002-3, to which one can only say “Ouch!”

That is true on one measure. If we look at real household incomes in aggregate, however, the picture is less gloomy. It takes until 2014 to get back to the 2010 level of real incomes and the biggest fall - this year’s 2.3% drop - is behind us.

On a per head basis (the mean rather than the median), allowing for population growth, it takes longer: until 2016 to get back to 2009 levels, but short of a decade. Retailers who felt suicidal should come in from the ledge.

There were other elements of the OBR forecast that were less downbeat than
the headline-grabbers. The headlines were grabbed by the new forecast of 710,000 public sector job losses by 2017 (compared with a March forecast of 400,000 by 2016).

But the forecast is for these job losses to be more than offset by 1.7m of new private sector jobs. It also eventually expects growth to perk up quite well, hitting 3% before the next election.

The bigger question for the OBR, and the chancellor, is whether the watchdog has got a key technical call right. Back in April I wrote a piece on the importance of the output gap, spare capacity in the economy. It did not set many pulses racing.

It came to the fore, however, last week. Had the OBR come up with a different verdict on the output gap, Osborne’s strategy - eliminating the structural budget deficit by the next election - could have still been on course. There would have been no need for spending cuts beyond the next election.

So a technical judgment by the OBR, that there is just 2.5% spare capacity, has huge implications for politics, and for the hundreds of thousands more public sector workers whose jobs are now under threat.

The OBR, to its credit, runs an alternative scenario in which the economy has not been permanently damaged by the crisis and the output gap is 11% of the economy. Under those circumstances the deficit disappears as the economy grows.

That looks implausible. But 2.5% looks aggressively low. Every 1% reduction in the size of the gap increases the size of the structural deficit - which has to be tackled by spending cuts or tax hikes - by 0.7% of GDP, just over £10 billion.

The OBR points out that many forecasters have smaller estimates of spare capacity (though the OECD, National Institute and European commission are higher). It also notes that its estimates of spare capacity during the recession and its aftermath are historically high (though the latest recession was also much deeper).

This is hugely uncertain territory. The output gap is an economic concept that is almost impossible to measure. I share with Geoff Dicks, formerly of the OBR, the view that spare capacity is rather flexible, particularly in a service-based economy. It is easy to get people in to expand capacity in an estate agency or call centre and, as we know from the unemployment numbers, there are many people to get in.

I apologise for drifting into nerdy territory but this matters. The OBR’s judgment has consequences for people’s livelihoods. A watchdog would not be a watchdog unless its bites were occasionally painful. My worry is that, amid so much uncertainty, the OBR is inflicting additional and unnecessary pain on us.

My regular column is available to subscribers on www.thesundaytimes.co.uk This is an excerpt.

There will be surprises in Tuesday's autumn statement; there always are. The full picture will only become clear on the day.

Nevertheless, some things can usefully be said. Gratifyingly, some of the things I have been banging on about here in recent weeks and months will see the light of day.

So, proposals to launch a “credit easing” plan for small and medium-sized firms, are a direct response to the recovery-destroying fall in lending to this vital sector of the economy, which has been happening for the past three years.

The plan will draw upon the success of Germany’s KfW (Kreditanstalt für Wiederaufbau) and an existing European Investment Bank model, the government using its credit rating to access funds at low rates, which will be channelled through the banks to smaller firms. The scheme will not provide a full solution to the lending famine but is a step in the right direction.

The other is that, having denied it would do so, the Treasury has relented on capital spending. A feature of the spending plans the coalition inherited from Labour, to the extent they were detailed, was the savage cut in publicly-funded capital projects.

My suggestion was that the government should use the savings on debt interest (from low gilt yields) and by trimming some current spending to boost capital spending. That will happen, a £600m building programme for new free schools being one element of it.

The bigger long-term prize, tapping into the vast billions in pension and insurance company funds to privately finance much higher levels of infrastructure spending is also creaking into action and memorandums of understanding are being signed.

As well as these, we had the housing strategy, of which more below. Vince Cable, business secretary, unveiled what his department describes as the most radical employment law reform in decades, including an overhaul of employment tribunals and easing unfair dismissal rules. Nick Clegg, the deputy prime minister, gave us a £1 billion employment and training subsidy for young people.

Why the flurry of pre-announcements and well informed leaks? One possibility is that the chancellor has something so big to announce on tax on Tuesday that the decks had to be cleared. Some accountants have been warning of a tax shake-up, though the Treasury has been guiding against it.

The other is that the government expects this week to be so dominated by the Office for Budget Responsibility’s (OBR) downgrade of growth, and its expected warning that the fiscal rules are at greater risk of being broken, it might as well get some coverage for these other announcements while it can.

In March the OBR predicted 1.7% growth this year, followed by 2.5% in 2012. Both numbers now look too high; the consensus in new independent forecasts is 1% in each of the two years.

Though there are unlikely to be any surprises in the OBR’s forecasts, they will attract plenty of critical headlines. A gloomy forecast tomorrow from the Organisation for Economic Co-operation and Development will set the scene.

Though it has not happened yet, independent economists expect slower growth to impact on the public finances with the average forecast for public borrowing next year, 2012-13, £112 billion, against the OBR’s March prediction of £101 billion.

Carl Emmerson, deputy director of the Institute for Fiscal Studies, expects the OBR to say there is a better-than-even chance of balancing the current budget deficit (adjusted for the cycle) in 2016-17, the new target year, and for debt to be falling as a percentage of GDP by the end of the parliament.

John Hawksworth and his colleagues at Price Waterhouse Coopers sketch out three scenarios. In PWC’s main scenario, with a couple of years of 1% growth, followed by a pick-up, Osborne meets his rules; and does so comfortably in its optimistic scenario.

Only in PWC’s pessimistic scenario, in which the economy goes back into recession next year - a flavour of which we may get from the OECD - are the targets missed badly. Though the deficit goal is cyclically adjusted, a recession would knock it off track. Debt would be rising as a percentage of GDP by the parliament’s end.

The economics of this sound dry but the politics of such an outcome would be explosive. Even viewed in the light of PWC’s main scenario, Britain’s public finances remain in a poor state, though we should not ignore the fact that progress has been made.

It seems longer, but it was only two years ago we were waiting for Alistair Darling’s final pre-budget report. The budget deficit was going from unbelievably awful to completely disastrous. Darling said it would be £178 billion in 2009-10, falling only slightly to £176 billion in 2010-11, before dropping to £140 billion this year, 2011-12.

Though growth has been weaker than the Treasury expected, the deficit has been lower: £156 billion in 2009-10, £137 billion in 2010-11 and it appears to be on course for £122 billion (the OBR forecast) this year.

Over three years borrowing is expected to be nearly £80 billion less than predicted two years ago. Partly that is coalition policies. Mainly it is due to the tendency of economists to underestimate the scope for the public finances to improve in a growing economy.

There, of course, is the rub. For all the flurry of activity, there is not much the government can do about growth in the short-term, and I can predict with confidence two things that will happen on Tuesday.

The Plan B brigade will urge a fiscal stimulus, despite the OBR’s view that there is zero room for manoeuvre. After years when the consensus was that fiscal fine-tuning did not work, it is suddenly regarded by its proponents as the greatest thing since sliced bread. It never was.

The other predictable response will be from Britain’s equivalent of America’s Tea Party, young men of the right, who will criticise Osborne for presiding over a rise in debt. In March, to their horror, the OBR predicted a rise in public sector net debt from £909 billion in 2010-11 to £1,359 billion in 2015-16. This week’s figure will be higher.

This, however, is the way it has to be. You cannot go from a deficit of £156 billion, 11% of GDP, to zero overnight and it is economic illiteracy — of the kind that caused America’s debt deadlock in August — to suggest you can. Borrowing is being reduced; the most you can do on debt is slow its rise.

My regular column is available to subscribers on www.thesundaytimes.co.uk This is an excerpt.

The eurozone is like a patient with a long-term illness. It has good and bad days. The last couple of days have been quite good, with a new prime minister in Greece and the end of Silvio Berlusconi in Italy. But the bad days will return.

One of the questions I get asked most often is why, if the eurozone is in such a terrible state, the euro is still so strong, particularly against the pound?

Sterling has perked up to the giddy heights of 1.17 in the light of Italy’s deep woes. But if I tell you it was briefly above 1.70 not long after the single currency’s birth 12 years ago, and just short of 1.50 when the global financial crisis broke in summer 2007, the fall from grace is clear.

Sterling is at least 10% below what any measure of fair value would suggest. The euro is also stronger than it should be against other currencies.

Why is this? When it comes to the pound, there is a good argument that it has been a victim of deliberate neglect. Every time it has threatened to recover to any degree, the Bank of England usually does something dovish to knock it back down.

That cannot, however, explain it all. It seems the currency markets regard the euro as greater Germany, while the bond markets see it as a Greek-Italian venture.

What do the currency markets know? They appear to be assuming, despite the brinkmanship among eurozone leaders over first Greece and then Italy, that an implosion - to the extent we have not already had one - will be avoided.

What that means is providing a eurozone bazooka big enough to persuade the markets they should lay off betting against the government bonds of Greece, Italy, Portugal, Spain and the others.

Since the proposed bazooka, expanding the 440 billion euro European Financial Stability Facility to an effective 1 trillion, is in considerable difficulty, the European Central Bank would seem to hold the solution in its hands. It, like all central banks, has the ability to expand its balance scheet, creating money, buying every troubled-economy bond under the sun, and also to swamp the system with liquidity.

To be able to use it, however, first requires a lot of swallowing of German pride and principles. Germany does not want the ECB to do this and neither do most people at the central bank. The assumption, however, is that if the alternative is armageddon, it will happen.

Such a solution cannot solve the euro’s fundamental problem. Instead of being a finely-honed grouping of similar and converged economies, it is a ragtag collection of dissimilar and divergent countries.

“It is clear that the eurozone will remain an unstable, crisis-prone arrangement unless critical steps are taken to place it on a more sustainable institutional footing,” write Simon Tilford and Philp Whyte in a hard-hitting essay for the pro-EU Centre for European Reform.

They argue the eurozone has to go part of the way towards fiscal union by means of debt mutualisation, or eurobonds, all members issuing bonds jointly guaranteed by the others. They are also sceptical about whether it will ever happen.

Which brings us to break-up. Reports last week that France and Germany have been quietly exploring the possibility of a smaller, “core” eurozone pricked up the ears of currency traders last week. In the short-term they expect muddling through, in the long-term they expect a stronger, narrower euro to emerge, which is why they have not been dumping the currency.

I have a lot of sympathy with this, having long argued that the euro would survive but with fewer members. Those who can live with Germany will do so, while others will be forced to go elsewhere. Before anybody worried about Greece, I had thought Italy was the weakest link.

The question is how you get there, or at least how you get there without huge fiscal and financial consequences.

UBS, in a research note, said a country exiting the euro would face “corporate default, collapse of the banking system and collapse of international trade”, a hit of 40% to 50% of gross domestic product in the first year. Not only that, “almost no modern fiat currency monetary unions have broken up without some form of authoritarian or military government, or civil war”.

HSBC, in other research, warned: “Keeping the eurozone together will involve huge financial resources and considerable ingenuity. The alternative would be worse. A break-up of the euro would be a disaster and in a worst-case scenario could trigger another Great Depression.”

In the Financial Times Robert Jenkins, external member of the Bank of England’s interim financial policy committee, set out in gory detail the consequences of just a Greek exit, one being that “bank lending across the European Union ceases”.

So it seems to be a catch-22. We can’t live with the euro as it is, it seems, but we can’t live without it either. Or at least we can’t easily get to the point where the euro has fewer members and is sustainable.

People are right to be concerned. The eurozone is experiencing an aftershock of the global crisis so powerful it threatens to exceed that of the crisis itself. It comes when structures are already weakened.

There is no doubt that the short-term consequences for countries leaving are serious. Money would flood out of the country, the banks would take a huge hit, the new drachma, or lira, in people’s pockets would not be worth as much as the euro it replaced. For a while, countries that left would become bond market pariahs and need help from the International Monetary Fund, which would need every penny of the additional resources it can get.

I cannot believe it is impossible, however, particularly if the alternative involves struggling along with a flawed system. There is more to leaving the euro than devaluation in a fixed-currency system of the kind Britain undertook in 1949 and 1967. The challenges, though, are of a similar nature.

The parallels are not exact but some have recalled John Major’s words six days before Britain was forced out of the European exchange rate mechanism (ERM) in September 1992. “The devaluer’s option” would not be allowed to happen, he said; it would be “a betrayal of our future”.

It was not. And nor would it be a betrayal of the future of Greece, or for that matter Italy, to decide it was better to have a relationship with the euro - with their own currency - rather than be in it. These things are difficult. They are rarely impossible.

My regular column is available to subscribers on www.thesundaytimes.co.uk This is an excerpt.

I was in China for much of last week, watching the eurozone crisis unfolding from a safe distance. There have been many contenders but this was the eurozone’s worst week. Greece’s on-off referendum may have all been about domestic politics but it also called the bluff of Angela Merkel and Nicolas Sarkozy.

They, for the first time, accepted that the departure of a member country was possible, indeed could be brought about by a democratic vote. Their tactic may have been intended to stoke up the pressure on the Greek people but it let the cat out of the bag. There is no such thing as a permanent, irrevocable monetary union.

All those learned pieces saying euro break-up was not possible because there was no mechanism for it were as daft as they always seemed. In desperate circumstances, governments do desperate things, whether treaties allow them to or not.

As for the G20 in Cannes, tasked six weeks ago by George Osborne with saving the world, it was the dampest of summit squibs. The one decision, to increase the resources of the international Monetary Fund, has been signalled so often that you believe it when you see it.

The “grand plan” agreed in Brussels 10 days ago is no clearer on the detail of how the rescue fund, the 440 billion euro European Financial Stability Facility, will be boosted to 1 trillion. The Greek shenanigans have taken us further from that.
What the past week has given us is a glimpe of the kind of disorderly break-up the euro could face when democracies are stretched to breaking point by protest and even big debt writedowns solve nothing.

I am all for an orderly reduction in euro membership, having argued a Greek exit, properly handled, is the best outcome. The key is “if properly handled”. That means successfully ringfencing other vulnerable economies and gaining market confidence. It is hard to have any confidence in the ability of eurozone leaders to achieve this.

So the eurozone, which the new president of the European Central Bank (ECB) Mario Draghi conceded is heading into “mild recession” (which could be a highly optimistic forecast), remains the big threat to the world and to Britain. The ECB cut its key interest rate from 1.5% to 1.25%.

The crisis will run and run. As things stand, it is no nearer resolution than it was in May 2010, the first Greek rescue.

I mentioned I was in China. One issue I was exploring was whether the country would be the eurozone’s sugar daddy. Even before the question of Chinese assistance through bond purchases was kicked into the long grass by Greece, it was clear hopes were being unrealistically raised.

Seen from China, any decision to purchase eurozone assets will be done - as everything is done - in the national interest. If there is a case in terms of diversification of reserves or because the return is attractive, China may act. There is no question of a modern version of Marshall Aid. China may be the world’s second largest economy but its 1.3 billion people remain poor, on average, by Western standards.

Not only that, China has her own problems, the other thing I was keen to explore. There is no shortage of pessimism about China, inside and outside the country. Analysts point to a property bubble bursting and an inflation problem disguised by official figures. Some hedge funds have done well betting against China.

China is attracting some colourful analysis. Albert Edwards, Societe Generale’s super bear, says China’s economic situation is “precarious”, “a credit bubble waiting to burst”. A soft landing is, he says, “surely yet another pyramid of piffle”.

Charles Dumas and Diane Choyleva of Lombard Street Research, in a new book The American Phoenix (which is upbeat about America), say China’s “red-hot” economy will slump in the remainder of 2011 and 2012. Its model of export-led growth, they say, has broken down.

How seriously should we take this? When you visit China, the story is familiar. The pace of development is blistering, cities expanding upwards and outwards. The anecdotes about money badly spent on shopping malls, roads, railways and other infrastructure projects are legion.

So is the fact that, while a growing Chinese middle class has never had it so good, life for the majority is tough, sharply rising prices making things uncomfortable.

China is still a fast-growing economy, however. Growth in the third quarter was 9.1% and so far this year 9.4%;. four times the rate, at least, of advanced economies.

Bearishness about China is not new. Analysts have been calling an end to the China growth story for most of the 33 years since it embarked on its reform-based revival, a period that has seen growth close to 10% a year. So far they have been wrong.

China is different. Even before the global crisis, there were worries about non-performing loans in China’s banks, a property bubble and debt hidden in local government and state-owned firms. The fears are back but need to be put in perspective.

China still has an underdeveloped financial system. Mortgages are only about 14% of GDP. There is not the leverage to cause advanced-economy type problems.

China also has the firepower most of the rest of the world can only dream of. It showed it three years ago by unveiling a $586 billlion fiscal stimulus and cutting interest rates and bank reserve requirements, instantly boosting credit.

More recently it has been raising rates and tightening reserve requirements, slowing the economy. But those moves could be reversed. HSBC says China is the least vulnerable of emerging economies.

So, piffle or not, it looks like a soft landing. Growth will slow, but to about 8% next year. The growth target under the current (2011-15) Chinese five-year plan is 7%.

Does Chinese growth matter for Britain? British exports of goods to China are growing, up an annual 15.9% in the latest three months, while imports from China fell 7.5%. But there was still a £5.49 billion goods deficit in the latest three months.

Britain sells other things to China. On my visit I gave a lecture at Nottingham University’s Ningbo campus. Education is an important and growing export to China, as are financial services, business services, civil engineering and so on.

We have an interest in China’s growth. We have a bigger interest in the eurozone avoiding disaster. You can be more confident about the first than the second.

My regular column is available to subscribers on www.thesundaytimes.co.uk This is an excerpt.

It was 1993, and Kenneth Clarke, the justice secretary, was chancellor. In the year after Britain’s humiliating exit from the European exchange rate mechanism (ERM), the system was on the point of collapse.

But Clarke, at a meeting of EU finance ministers, told them to pull themselves together and press ahead with monetary integration. The rest is history, though some would say Europe would be a lot better off if he had kept quiet.

Times have changed. These days EU leaders would never take advice from a British chancellor or prime minister.

That is partly because of their inexperience, partly the Tory attitudes towards Europe revealed in Monday’s Commons vote. But also because any goodwill towards Britain was lost in the years when Gordon Brown lectured them on how to run their economies.

So George Osborne and David Cameron were left wringing their hands and calling for something to be done. They are also left bemoaning the eurozone’s corrosive effect on Britain’s recovery. Are they right to do so, or are they covering for Britain’s home-grown problems? Has Europe done enough?

As it turned out, eurozone leaders came up with a version of the “grand plan” that has been circulating for some weeks and the markets, initially at least, liked it.

Whether intended or not, this was a good example of expectations management. Ahead of the meeting there were fears of no deal at all (though there always is).

The result, a beefing up of the European Financial Stability Facility (EFSF) to ¤1 trillion (£880 billion), a ¤106 billion (£93 billion) recapitalisation of European (but not British) banks and voluntary 50% haircuts on Greek debt, did enough to reassure.

Plenty of doubts remain, particularly over Greece and Italy, and over the details. The markets were perhaps a little too euphoric. The eurozone has been the biggest threat to the recovery, globally and in Britain. If there was an easy way out, the Next chairman Lord Wolfson would quickly be relieved of his £250,000 prize.

Time, however, is a valuable commodity. And the EU has bought it. Has it removed the threat to the rest of us?

Much of the sharp drop in business and financial market sentiment in the past few weeks can be laid at the door of Europe’s difficulties.

The CBI’s very gloomy industrial trends survey, published a few days ago, recorded the sharpest drop in business confidence since 2009, when the economy was in recession, and showed manufacturers expect a drop in output this quarter.

According to Ian McCafferty, the CBI’s chief economic adviser, confidence is “being sapped by uncertainty over developments in the eurozone, leading to broader concerns over global growth.”

If CBI members’ expectations of a drop in output in the current quarter turns into a generalised fall in economic activity, the drop in GDP that the monetary policy committee’s Martin Weale and Paul Fisher fear, the eurozone will be the proximate cause.

Despite the eurozone agreement reached in the early hours of Thursday morning. the downturn in the fourth quarter, certainly in the eurozone, possibly in Britain, is already baked in.

Both of the expected drivers of recovery, exports and business investment, have been affected by the eurozone’s problems. Investment has been undermined by fears of what the crisis might bring, while the sharp slowing in Britain’s biggest export market is taking its toll on trade.

Purchasing managers’ surveys for the euro area are this month below the key 50 level for the second month in succession, pointing to its economy being back in recession in the final quarter, which links directly to the pessimism among Britain’s manufacturers.

It is not all bad news on the trade front. Though export growth is slowing, the trade gap is also narrowing. In August it was £1.9 billion, just over half its level a year earlier. And, while not wanting to jinx it having some time ago predicted a return to current account surplus, the latest figures were also encouraging.

The Office for National Statistics is in one of its dramatic revision phases. As I have said before, this makes much of its data useless for short-term economic management. So we thought we had a current account deficit of £9.4 billion in the first quarter but that has now been revised down to £4.1 billion.

The second quarter deficit, £2 billion, was just 0.5% of gross domestic product. One difference between Britain and the problem hit countries of the eurozone is the absence of a serious current account problem. Greece had a deficit of more than 10% of GDP last year, while Portugal’s was just under 10%. Italy is on course for a deficit of more than 4% of GDP this year.

It would be wrong, however, to blame all Britain’s woes on the eurozone. Though consumer confidence has been pummelled, it would be unusual if British households were responding directly to events even as close as the other side of the Channel by reining back spending.

Thanks to the ONS’s revised numbers, we now have some rather different information on Britain’s households. This year was supposed to be the second in a row real household disposable incomes had fallen. But the new figures show, rather than falling by 0.8% last year, real incomes edged up by 0.1%.

The numbers do not change the broad picture of households not increasing spending in real terms. This, of course, has less to do with eurozone woes than high inflation, rising taxes and fear of unemployment, partly because of spending cuts.

But the ONS’s new numbers do show the previous picture - of consumers not spending but not saving either - was incorrect. The saving ratio in 2009 was revised up from 6% to 7.8%, while the ratio for 2010 is now put at 7.5%, up from 5.3%. In the latest quarter, the saving ratio was 7.4%.

What this tells me is that there is potential for a recovery in consumer spending, which after all is weaker at this stage of the cycle than in any previous episode. Consumers have quietly been putting their finances back into shape. When conditions are right they will spend more. Whether they will do so in time to make up for the shortfall in exports and business investment is the big question.

My regular column is available to subscribers on www.thesundaytimes.co.uk This is an excerpt.

Unemployment is at its highest rate for 15 years and its highest level for 17. Inflation has matched its record high on the consumer prices index and is at its highest for 20 years on the retail prices index.

For followers of the misery index (the unemployment rate plus the inflation rate) this means only one thing; we have not been this miserable for 19 years. Some young people have never been.

So the Nationwide building society reported on Friday its consumer confidence index fell three points to 45 and is lower than when gross domestic product was falling. It is just above its all-time low in February, after the Vat hike to 20%.

The rise in consumer price inflation to 5.2%, and to 5.6% on the retail prices index, came less than a fortnight after the Bank of England had announced a further £75 billion of quantitative easing (QE).

The best way to think about QE is as the Bank does, the equivalent of cutting interest rates when there is no room to do so in the normal way. It calculated in its latest quarterly bulletin that the £200 billion of easing undertaken in 2009 was the equivalent of cutting Bank rate by between 1.5 and 3 percentage points.

The extra £75 billion, on this basis, is equivalent to a further 0.5 to 1 points off Bank rate. That the monetary policy committee did this unanimously ahead of figures showing inflation so far above the 2% target was either brave or very foolhardy.

Applying this relationship mechanically suggests monetary policy is operating with the equivalent of a Bank rate between minus 1.5% and minus 3.5%. It is a long time since monetary policy has been so accommodative or real interest rates (rates adjusted for inflation) so negative.

Sir Mervyn King gives four big speeches on the economy each year, together with the occasional television interview. I’ll come back to another aspect of his latest speech in Liverpool a little later, but on inflation, the content was familiar.

So, inflation is close to a peak and should soon fall significantly and, in any case, it is outside the Bank’s control. As he put it: “Domestically generated inflation remains subdued – and on some measures barely above zero. Increases in energy prices, import prices and Vat account for the current high level of inflation.”

And, while not spelling it out in this speech, his line is that to have kept inflation close to target would be by inflicting further pain on the economy. There was no realistic alternative, in other words. There would have been at least as much misery, though distributed differently between unemployment and inflation.

I would take issue with some of this. You cannot divorce import prices from the performance of the pound. Sterling’s fall, and the fact it has stayed down, has been a key element in Britain’s high inflation. The Bank has blessed a weaker exchange rate and by its actions ensured it is maintained.

High inflation is also a key factor in the disappointing recovery. Retail sales figures showed people spent an astonishing 5.4% more last month than a year earlier. If inflation were 2%, that would be consistent with a strong, consumer-led recovery.

Alas, high inflation meant all but 0.6% of the rise in spending was eaten up by rising prices. Stagnant real consumer spending is a consequence of inflation.

Was there an alternative? Interestingly, as Richard Ramsey, an economist with Ulster Bank points out, you do not have to go too far to find a country with a very different inflation experience in recent years.

Since August 2007, and the start of the global financial crisis, consumer prices in Britain have risen 15.5%. Average earnings have risen by only 8.8%, hence the squeeze.

In Ireland, in sharp contrast, consumer prices have risen less than 1% over those four years; 0.7% to be precise. This is a huge contrast. Even more surprising, as Ramsey points out, is some of the detail.

Some of those ‘impossible to avoid’ price rises in Britain have, in fact, been avoided in Ireland. Food and drink prices have risen by 28% and have been a major factor in sustained above-target UK inflation. In Ireland, however, food and drink prices are 0.7% lower than they were in 2007.

To paraphrase Dickens, this is a tale of two countries. Ireland had a much more serious recession, with a peak to trough fall in GDP of 12.6% versus 7.1% in Britain, as well as ratings downgrades and a rescue. Unemployment, at 14.3%, is much higher than the new 8.1% UK level. Because Ireland is part of the euro, there could be no independent devaluation of the currency.

Ultra low inflation is partly a consequence of Ireland’s economic weakness. Some of the country’s indicators are now moving in the right direction. GDP rose a strong 1.6% in the second quarter, after 1.9% in the first. Industrial production in August was over 11% up on a year earlier.

Ireland’s consumers are not making hay on the back of low inflation. Retail sales volumes are 3.6% lower year-on-year, partly because of high unemployment, zero (at best) earnings growth and higher taxes.

I do think, however, low inflation in Ireland stands the economy in good stead for the future. It is wresting back competitiveness in difficult circumstances and, while that adjustment has further to go, it provides an an example for the eurozone that default and exit are not the only options for troubled peripheral economies.

The Bank chose a different path. The latest MPC minutes spoke of a weaker growth outlook increasing the “margin of slack” in the economy, putting downward pressure on inflation and making it more likely it will undershoot the 2% target in the medium-term. Hence more QE.

I think this is a figleaf. There has been plenty of slack in the economy over the past four years but inflation has been high. There are mathematical reasons why it should fall next year but its path over the medium term will depend more on those factors the governor listed in his speech.

The Bank, with the government’s backing, has tolerated high inflation to prevent greater short-term damage to growth. That is fine, but it should be open and honest about that, rather than dress up all its decisions in terms of spare capacity and medium-term inflation. And whether this strategy is the right one for the economy in the longer-term I very much doubt.

My regular column is available to subscribers on www.thesundaytimes.co.uk This is an excerpt.

The job market has performed remarkably well in recent years. Employment fell far less than expected in the recession, then recovered more strongly than feared when the economy turned up.

Unemployment appeared to be stuck at 2.5m, where it had been for the past two years. True, a drop would have been welcome, but at least it was not rising.

It did, however, rise last week, which was worrying. There was a 114,000 increase in unemployment, the biggest in two years, pushing the rate up from 7.7% in the March-May period to 8.1% in June-August. This was undoubtedly a weak set of figures, suggesting the private sector is not compensating for public sector job cuts.

Worse than the overall rise in unemployment was the increase to nearly 1m in youth unemployment, with the rate up from 19.7% to 21.3% in three months. More than a fifth of young people are out of work, and the talk is of a a lost generation.

I think we would serve young people better if we did not give such a bleak picture of youth unemployment. As everybody knows, the 16-24 unemployment figure of 991,000 includes 269,000 full-time students looking for part-time work.

Taking these out and measuring unemployment as a percentage of the youth population (rather than just the economically active) knocks the youth rate down to a still-high but not so hopeless 9.9%. That is not my figure, by the way, but from the Centre for Economic and Social Inclusion.

There were some striking, possibly odd, features of the numbers. The job market has been notable for the rise in the number of people aged 65 and over in work. From Jun-August 2009 until March-May this year, employment in this age group rose by 138,000. Over the latest three months that went abruptly into reverse, down 73,000.

Was this genuine or employers clearing decks ahead of the abolition of the default retirement age at the start of this month?

If not that, the drop in older workers could be explained by a record, 175,000, fall in part-time employment in the latest three months, accounting for all but 2,000 of the overall fall. It could be that in uncertain times firms or public sector bodies cut part-timers first. But it is a bit odd.

Anyway, strange though some of the detail is, the big picture is one of a weakening job market. Both the broader Labour Force Survey measure of unemployment and the monthly claimant count - up 17,500 to 1.6m - were up strongly. The fall in employment was a shocker.

What should we do? A higher minimum wage - up 15p to £6.08 this month (£4.98 for 18-20 year-olds) - does not help.

I would not reject out of hand all aspects of Labour’s “five-point plan for jobs and growth”. Though cutting Vat ack to 17.5% is a non-starter, a one-year National Insurance break for small firms taking on new workers, a temporary Vat cut to 5% on home improvements and bringing forward capital investment all merit consideration.

Having written on capital investment, and how thre is room to do more, it was disappointing to see little mention of this at the Tory conference. Indeed, having initially got excited about credit easing at that conference, there was not much there to lift the spirits or the economy.

We are also, returning to another theme, paying for our neglect of small and medium-sized enterprises (SMEs). They are the engines of job creation in the economy. SMEs account for 13.5m jobs in Britain and, according to Nottingham University’s Globalisation and Economic Policy Centre, account for 65% of all new jobs created.

They cannot do it without the lifeblood of credit. Lending to SMEs has been falling since early 2009. Firms cannot expand without finance. Without finance - lending from banks - we are starving the engine of fuel. Until we stop doing so firms will struggle to create jobs.

There is one other obvious area. Last week I took part in The Housebuilder’s annual housing market intelligence conference. The housebuilding situation is simply stated. Last year the number of homes built in England, 103,000, was the lowest since 1923, and less than half of the 250,000 (or more) needed to keep up with the growth in the number of households.

Housing has been stymied by two problems. The first is the planning uncertainty that has gripped the industry since the coalition came into power in May last year. Hopes that this uncertainty would be lifted by the government’s new planning regime have been tempered by the fierce and vocal opposition to those plans from the countryside lobby and some parts of the media.

Mainly, however, it is because of a mortgage famine stretching back four years. Wholesale funding markets, that in the first half of 2007 accounted 60% to 70% of new mortgages, have failed to come back enough. Net mortgage lending has been negligible for the past three years.

As with SMEs, housing cannot recover in the absence of finance. The government and the Bank of England could, if they wished kick-start the markets for securitizing (bundling into financial instruments) new mortgages. There are other steps, which the Ernst & Young Item Club takes up in its new report out tomorrow, including permanent stamp-duty exemptiojn for first-time buyers.

Mortgages are, however, the key, and the rewards are potentially great. Each newhouse creates 1.5 jobs directly and three to four indirectly. A much-needed extra 100,000 houses each year would mean at least half a million additional jobs.

It worked in the 1930s, as Steve Morgan, chairman of Redrow (and Wolverhampton Wanderers) pointed out. Though thought of as unremittingly grim, the period from 1932 onwards saw a sustained recovery in Britain, driven in large part by new housing. As I say to people, not for nothing do we talk of the 1930s semi.

Can we have a building boom again? We could, but only if people in authority think creatively about the mortgage market. There is not a lot of evidence of that so far.

Last week I did something rather odd, spending an entire day discussing a 30-year old budget. The witness seminar, hosted by Lombard Street Research in conjunction with Churchill College, Cambridge, examined in detail the 1981 austerity budget, in hindsight the turning point for the Thatcher government and famous for, among other things, provoking a protest letter from 364 economists, including a young Mervyn King.

The point about these witness seminars is that they include many of those intimately involved in the policy decisions.

So I learnt that so upset was Margaret Thatcher about imposing big tax increases on the electorate (mainly in the form of freezing personal tax allowances at a time of high inflation) a resignation letter was drafted for her in Downing Street.

I also discovered that Theresa May, the home secretary, turned her hand to offbeat poetry. One of the Thatcher government’s big problems was controlling the money supply, sterling M3. May, at the time a junior Bank of England official, composed an ode to “this wayward mistress” M3.

The significance of the 1981 budget was that, to bring down public borrowing, it imposed a huge fiscal squeeze on the economy at a time of recession. It was the equivalent of the government unveiling big tax hikes and spending cuts two years ago in 2009, when the economy was still in the grips of its worst post-war downturn.

When Sir Geoffrey (now Lord) Howe presented his budget in March 1981, the consensus was not just that the economy was deep in recession but that it was deepening. It turned the conventional Keynesian remedy, providing a stimulus to lift the economy out of the mire, on its head.

March 1981, through luck or good judgment, turned out to be the low point for the economy. It embarked on a nine-year upswing which gathered strength as it went on, and that 30-year old budget has entered the folklore as the cruel-to-be-kind action that rescued Britain’s reputation from its “sick man of Europe” status, and persuaded business - and eventually consumers - the country was back on track.

Even if he does not say so explicitly, George Osborne will have the spirit of 1981 in mind when he addresses the Tory conference tomorrow. He may also be thinking of the Major government of the 1990s, of which he had direct experience, when chancellors Norman Lamont and Kenneth Clarke, undertook a tough programme of deficit reduction, including unpopular tax increases and prolonged spending cuts, eventually eliminating the budget deficit without killing off the recovery.

Every recovery in the modern era has been accompanied by a significant fiscal tightening. It happened in 1976, when the conditions of Britain’s International Monetary Fund bailout included deep spending cuts, and in the 1980s and 1990s.

Not only did the economy bounce back but it did so strongly, regularly posting growth rates of 3% or more (sometimes significantly more) during these recoveries, even in the face of these fiscal squeezes.

The Office for National Statistics will give us its first big rewriting of history this week when it publishes its Blue Book revisions to the national accounts but it will be surprising if those revisions yet give us anything the kind of growth rates Britain enjoyed in the past.

The fundamental point remains, and it was asked repeatedly at the seminar. How much of the 1981 experience is transferable? If the economy was able to grow with the fiscal brakes firmly on in the past, why should it be different this time?

Participants at the meeting, I should say, were generally cautious about drawing too many analogies. Sir Alan Budd said he was not sure there were any parallels between then and now.

The differences, indeed, are not hard to identify. Thirty years ago there was no banking crisis; indeed the government was in the process of relaxing controls on lending. The banks were moving into the mortgage market and hire purchase controls were about to be removed.

There was no eurozone crisis for the obvious reason that there was no euro. Its forerunner, the European exchange mechanism, had just come into being. Little did we know then where it would lead us.

Debt levels were much lower. Britain’s household debt, in today’s prices, was about £200 billion, a seventh of present levels. The long boom in credit was just beginning, rather than gasping for breath having been badly crunched as now.

In some respects, however, things are a lot better than they were then. The growth figures for the recoveries of the 1980s and 1990s, and after the IMF crisis of 1976, are just that, figures. They do not tell the story of how hard, how fraught, it was.

In the 1980s, for example, it took until 1986, six years after the austerity budget, before unemployment turned down. That is why some signatories of the letter from the 364, notably Steve Nickell, maintain they were right to sign it.

The 1990s, which looks like a model recovery against the headwinds of tax hikes and spending cuts, often did not feel like it. I recall, three or four years into the upturn, Clarke confiding that he doubted whether voters would ever believe in the recovery. The Tory government, meanwhile, was engaged in self-immolation.

Maybe it is early days but it does not feel like that now. The coalition government is holding together remarkably well. People are impatient for stronger growth but they are also resigned to the fact that there are no easy remedies after a financial crisis on the scale we have been through, indeed are still going through.

Voters are equally sceptical about apparently easy solutions like the five-point plan presented by Ed Balls, the shadow chancellor, to the Labour party conference last week, built around a temporary Vat cut.

They know, deep down, the deficit has to be brought down. Businesses know that too, and they know that the slowdown we have seen in recent months reflects a range of factors of which tax hikes and spending cuts are but a minor part. The differences are many but the spirit of 1981 lives on.

My regular column is available to subscribers on www.thesundaytimes.co.uk This is an excerpt.

Scary. The International Monetary Fund, determined not to get caught out as it was when the crisis hit three years ago, has been daily sounding the alarm. The global economy, it says, is in “a dangerous new phase”, while Christine Lagarde, its managing director, warns that the path to continued recovery is narrower than three years ago.

The IMF thinks chances of a new recession are as high as 38% in the US, 18% in France and 17% in Britain. Purchasing managers’ surveys point to a eurozone on the brink of recession. Resolving its crisis in a climate of growth was hard. Doing so in recession is much harder, notwithstanding George Osborne’s warning that its leaders have six weeks to save the euro.

The economic solution, in the form of “shock and awe” from the European Central Bank and an enlarged European Financial Stability Facility, recapitalisation of Europe’s banks and medium-term restructuring of the eurozone (including an eventual Greek exit), is not hard to envisage. The politics of it, however, are horrendously difficult. The eurozone, it goes without saying, is the biggest threat facing the world.

There are caveats. The IMF’s forecast for global growth, 4% this year, and 4% next, is a long way from recession. That figure is not as perky as last year’s 5.1% expansion but is in line with the global economy’s long-run trend. The IMF thinks there is only a 1 in 10 chance of new global recession, which it defines as global growth of less than 2%.

So there is growth. The trouble is that it is not in countries like ours. Western economies will grow by 1.6% this year, 1.9% next, the IMF says, while emerging economies will grow by 6.4% and 6.1% respectively. Rarely has the growth gap been so wide.

Britain’s projected growth rates, 1.1% and 1.6%, are not the worst in the advanced world but are clearly not the best. The question is, what should be done about it?

Three things have happened to spice up the debate. The first is that, as a result of some detective work by the Financial Times and speeches by Robert Chote and Spencer Dale, respectively chairman of the Office for Budget Responsibility and chief economist at the Bank of England, doubts have grown about the amount of spare capacity in Britain’s economy.

The “output gap” is not something they talk about at the Dog and Duck but is meat and drink to policymakers, and worrying if it has got smaller. The FT’s assessment, an attempt to anticipate the OBR’s fiscal verdict on November 29, was that it has and that a £12 billion black hole has opened up.

The second development was that talk emerged at the Liberal Democrat conference of a £5 billion capital spending boost by government. While stamped on by the Treasury, the debate is opening up.

The third thing was that, short of Sir Mervyn King standing atop 1 Threadneedle Street with a loud-hailer, the Bank of England gave the clearest signal it is moving to another round of quantitative easing.

Let me take fiscal policy first. A £12 billion black hole followed by talk of a £5 billion stimulus is confusing, particularly when followed by record August public borrowing and a big downward revision, to £136.7 billion, in the 2010-11 borrowing total. As Geoffrey Dicks oif Novus Capital pointed out, this is £40 billion less than the Treasury was predicting two years ago.

Why is spare capacity, the output gap, important in this context? Because George Osborne’s main fiscal rule is to eliminate the so-called structural current budget deficit. That is a mouthful but, put simply, if you believed there was no spare capacity now, the actual budget deficit would be the same as the structural deficit. The bigger the output gap, the more the deficit reflects the economy’s temporary weakness.

The issue has arisen because productivity, which fell sharply in the recession, has failed to recover. The economy has lost its mojo. It is good firms are hiring workers rather than squeezing more out of existing staff, but it points to an economy that has less spare capacity than thought.

The OBR’s Chote, whose job it is to adjudicate on the fiscal rules, said he had expected the output gap to be 3.9% of gross domestic product now, or more. But the evidence is that spare capacity is less than this. If the OBR becomes pessimistic on the output gap, it could find itself in November telling the chancellor he has to raise taxes or cut spending further to meet his rules.

I don’t think that will happen. Chote, as I think he was hinting, is not going to bet the ranch on very uncertain estimates.

The upshot, however, is that there is also no room for Osborne to offer any stimulus in tax cuts and extra current spending. Is there room to boost capital spending? The argument here is that the government can do this because its fiscal target is set in terms of current spending and revenues, not capital spending. Sadly it is not so easy.

The government’s other rule is that debt is falling as a percentage of GDP by the end of the parliament. This means getting borrowing to around about 2% of GDP from 9% now. You might get away with a bit more capital spending and achieve that, but not much.

I repeat that the way to boost infrastructure spending is to recycle savings on debt interest and anything else that can be extracted from current spending. There is an argument for issuing dedicated infrastructure bonds but problems over the private finance initiative suggest the government will not grab at that.

So, in terms of pressing the growth levers, we come back to the argument in favour of targeted capital spending, not a broad-based fiscal stimulus, unless Osborne abandons his rules.

What about quantitative easing, the case for which has “significantly strengthened”, according to the Bank’s minutes? A research note in its quarterly bulletin suggested the first £200 billion of easing, mainly buying gilts, (government bonds) was equivalent to cutting Bank rate by 1.5 to 3 percentage points and boosted GDP by between 1.5% and 2%.

If £200 billion can do that, how much would £400 billion, £500 billion or £1 trillion do? Osborne is in favour, as is Vince Cable. So is Sir Richard Lambert and other ex-MPC members. With an economic impact like that, it looks like a no-brainer.

But not to me. As well as boosting GDP, the Bank says quantitative easing boosted inflation, by between 0.75 and 1.5 percentage points. That was okay when the fear was deflation, not when it is 4.5% and heading for 5%. The Bank’s chief economist, remember, is worried about spare capacity, which should argue for monetary as well as fiscal caution.

So I shall continue to stand, Canute-like, against the rush to more easing. It is less a magic bullet than a tool to inflate your way out of trouble. It does not boost bank lending. Growth is slow. Sometimes you just have to live with that Of course if the eurozone implodes, all bets are off and every policy option will have to be considered. But we are not quite there yet.

My regular column is available to subscribers on www.thesundaytimes.co.uk This is an excerpt.

We are firmly into “something must be done” territory. While eurozone ministers and officials grappled again with the challenge of saving the euro, central banks announced they were swamping the markets with dollar liquidity, in a re-run of an exercise carried out during the worst of the crisis. The markets liked it.

In Britain Nick Clegg, the deputy prime minister, pledged that “Whitehall will put its foot on the accelerator” on infrastructure spending and announced “that we’re going through the nation’s capital spending plans to hand-pick up to 40 of the biggest infrastructure projects, the ones most important to growth, which will be given new special priority status”.

This was not quite what I suggested last week but it was in very similar territory. Adam Posen of the monetary policy committee (MPC), who has consistently argued for more quantitative easing - creating money through asset purchases - by the Bank of England now clearly thinks the debate is going his way.

“The right thing to do right now is for the Bank of England and the other G7 central banks to engage in further monetary stimulus,” he said in a speech.

As it happens I disagree with him on this. Quantitative easing is an emergency tool and the question of whether to use it again depends on whether you think this is an emergency of merely a period of soft growth. It may yet become an emergency but we will see. We will also see with the publication of the September minutes this week how many other members of the MPC agree with him.

I agree with Posen, however, on an another issue, which is that urgent consideration should be given to “a public bank or authority for lending to small business”. When I have suggested this in the recent past, the reaction of some people has been that this is socialism red in tooth and claw.

But, as he points out, America’s Small Business Administration and Germany’s Kreditanstalt fuer Wiederaufbau (KfW) are living examples of such bodies. His other suggestion was for an organisation to bundle up and securitize small business loans, “a good version of Fannie Mae and Freddie Mac”. Such bundles of loans could be bought and held by the Bank, in my view, in exchange for the near-£200 billion of gilts (government bonds), the central banks has on its books.

Combine these two and you have the makings of a beneficial shake-up of small business funding of the kind that did not feature even in the well-received final report of Sir John Vickers’s Independent Commission on Banking.

There are, then, good ideas around. Some, such as the additional dollar liquidity, will help calm banking fears. Clegg’s accelerated infrastructure spending has been welcomed by business and Posen’s state SME (small and medium-sixed enterprises) bank, if adopted, would support the expansion of this key job-creating sector.

So, this period of weaker growth is producing some creative thinking. Within government there is a desperate search for measures to show that, short of abandoning its fiscal plans, the government is doing its utmost to kickstart growth.

Politically, George Osborne needs something concrete to present to the Tory conference next month and when he presents his autumn statement on November 29.
How much trouble is the recovery in? Growth has weakened, and that is uncomfortable but the economy has not yet given up the ghost. Unemployment rose by 80,000 to 2.51m in the three months to July and that is unwelcome. It has, however, been fluctuating at close to this 2.5m level for the past two years.

Though it would be good to see unemployment falling, it took two years in the recovery of the 1990s before the jobless total began to drop below recession levels. The private sector is creating jobs, 41,000 in the second quarter and 264,000 over the past year, which it would not be in the absence of growth. The bad news on unemployment largely reflected what looks like an unusual bunching of public sector job cuts, 111,000 in the second quarter, which is unlikely to be repeated.

Even the retail sales figures, which might have been expected to bear the full brunt of consumer uncertainty, the squeeze on real incomes and August’s civil disorder, showed that sales volumes, while slightly down last month, were flat compared with a year earlier.

Where will growth come from in the coming quarters? It is good, as I say, that people in authority are starting to think creatively. It would be good if business investment, an expected lever of recovery, overcame the current crisis of confidence.

It would be even better if the rise in exports we are seeing - up 8.1% in value over the past year - was not exactly matched by the increase in imports.

But the recovery also needs the consumer and a key question is whether inflation, 4.5% last month, stays high or, as Posen suggests “is about to peak” and then fall sharply. If he is right, the squeeze on real incomes would be removed and consumers would be able to increase their spending.

Many, of course, are sceptical about the prospect of a big fall in inflation. The Bank’s latest survey of inflation expectations, carried out by GfK/NOP shows that people expect inflation to average 4.2% over the next year and 3.5% for the 12 months after that, in other words staying well above the official 2% target.

If inflation comes down, it would be a pleasant surprise for consumers. It would also enable them to play their part in kickstarting the recovery. As far as the government is concerned all contributions would be gratefully received.

My regular column is available to subscribers on www.thesundaytimes.co.uk This is an excerpt.

Gloom with a capital G. What should we do about it? George Osborne, in a speech, signalled the inevitable: a downward revision of official growth forecasts come November.

The Organisation for Economic Co-operation and Development (OECD), said that the economic recovery has “come close to a halt” in the industrialised countries and appears to be moderating even in strongly-growing emerging economies.

The OECD expects only 0.1% growth in Britain in each of the third and fourth quarters, stagnation in other words. Germany and the eurozone big three (Germany along with France and Italy) will see negative growth in the final quarter, it says.

That loss of momentum was evident in the three purchasing managers’ surveys for August, which suggested manufacturing is shrinking and construction and services slowing, the latter at its sharpest rate for 10 years. Chris Williamson of Markit said the three surveys together pointed to “near-stagnation” last month.

There are caveats. The OECD’s forecasting record is not that great and its numbers carry large margins of error, even for what will happen over the remaining months of the year. The gloom on Germany, indeed on industrial prospects in general, was tempered by the announcement of a 4% rise in output in July alone.

The purchasing managers’ surveys are very useful but not always well-correlated with official data. A month ago we were taken aback by its strength. Its latest weakness had a bit to do with the August riots.

It would be ridiculous to argue, however, there is no slowdown, not just in Britain but across the advanced world. Japan has shrunk for three quarters in a row, not helped by the earthquake and tsunami. Economists are starting to predict a double-dip for America.

The Bank of England decided against relaunching QE at its meeting on Thursday, rightly in my view, deciding to hold fire on more quantitative easing. But it is firmly back on the agenda and, while we do not agree on everything, hats off to Danny Blanchflower, formerly of the monetary policy committee (MPC), for saying it would do so before any interest rate hike.

There is a pressing need for more bank lending to small and medium-sized firms. There may be no surprises in tomorrow’s Indepependent Commission on Banking report but its self-imposed remit, that nothing it does should hamper the supply of credit, is unlikely to be achieved.

So what can be done? The political knockabout between chancellor and shadow chancellor does not get us anywhere. Osborne insists he will stick to his deficit-cutting strategy, while Ed Balls calls for a temporary cut in Vat he knows would leave that strategy in tatters.

Let me offer some assistance. When Osborne set out his spending plans nearly a year ago, in one important respect he stuck to what he inherited from Alistair Darling, his newly-controversial predecessor. He stuck broadly to Labour’s plans for slashing public sector capital spending, on roads, bridges, hospitals, schools and the rest.

Even under tough coalition plans, current spending on public services, including wages and salaries, will rise throughout this parliament, from £600.9 billion in 2009-10 to £713.4 billion by 2015-16.

Capital spending, by contrast, is being butchered. Gross spending will drop from £68.9 billion in 2009-10 to a low of £47.7 billion in 2013-14, before creeping up to £50.4 billion by 2015-16. Spending net of depreciation will fall from £49.5 billion in 2009-10 to £23.8 billion in 2013-14 and will only be £24.5 billion - half its earlier peak - in 2015-16. Remember these are cash sums, so the drop in real terms is even greater.

Cutting capital spending like this is a bad idea. Fiscal multipliers, the amount of economic bang a government gets for its spending buck, are always significantly higher for capital spending.

Spending on projects boosts employment and helps the economy more generally. The Office for Budget Responsibility’s (OBR) fiscal multipliers are three times higher for capital spending than for a Vat cut, further calling into question the Balls’ argument. Official calculations in Washington suggest even larger multipliers for capital spending.

A report from the CBI and KPMG on Friday called for “swift investment across Britain’s road and rail networks, digital, waste and energy” to ensure Britain remained internationally competitive and to kick-start growth. It was accompanied by a survey of 447 firms which showed that 58% rated Britain’s infrastructure as worse than other EU countries.

But how to provide such a boost? After all, as Labour’s chief secretary said on leaving office, there is no money left. The clue is in the numbers. Current spending is rising, capital spending falling sharply. Shift a bit between the two and you have a growth-stimulating infrastructure boost.

Some of this could be done painlessly. Gilt yields have fallen sharply in the past few months, whether reflecting Osborne’s “safe haven” or weaker growth prospects. If maintained then, using the OBR’s ready reckoner, that will cut the government’s debt interest bill significantly, by more than £6 billion in 2014-15 and over £7.5 billion in 2015-16.

I would go rather further. Departments under the spending cosh will no doubt say every penny of current spending is precious. I would be surprised if a few billion, over and above debt interest, could not be squeezed out and diverted to capital projects. At minimum, it should be possible to raise the gross capital spending by government by £10-15 billion, with all the benefits that would bring, but without compromising the coalition’s fiscal strategy.

So there we are. A plan for some good old-fashioned recovery-boosting spending on public works. It does not involve increasing the overall spending totals. It does not involve unrealistic ideas about borrowing more, when the government is already borrowed up to the gills. It is infinitely better than temporary Vat cuts. I commend it to the House.

My regular column is available to subscribers on www.thesundaytimes.co.uk This is an excerpt.

The last few days have brought news of very weak consumer confidence on both sides of the Atlantic. In Britain, the GfK-NOP consumer confidence index fell in August for the third month in a row.

People are a lot gloomier about the economy than they were a year ago and, as Nick Moon of NOP points out, the current confidence reading of minus 31 has only been lower during the worst of the 2008-9 crisis and in the early 1990s. It is close to levels, in other words, that would normally presage a slide back into recession.

In America, if anything, the position is worse. The Conference Board’s index of consumer confidence slumped by 14.7 points last month to 44.5, its lowest since April 2009. US consumers, whose spending is still needed to keep the global economy going, are “fragile, fatigued and fed up”, according to one economist.

I have learned not to ignore these confidence measures. In the autumn of 2007, when no mainstream economist was forecasting outright recession, collapsing consumer confidence proved to be a reliable harbinger of the coming doom.

In Britain, one look at the queues outside Northern Rock branches in September 2007 was enough to convince people something serious was up. In America it took a little longer but the collapse in confidence also told a wider economic story.

So is it time to listen to what the confidence measures are saying and batten down the hatches? The first thing is to look deeper into the weakness in confidence.

August was a trime of alarms and uncertainty. In Britain, unsurprisingly, riots and looting made people uneasy. High inflation, with big utility price rises to come, are squeezing real incomes. The impact of “the cuts” is feared.

In America, the surprise was not that confidence fell but that it did not fall by more. US consumers are heavily affected by the stock market. The August market plunge, coupled with Standard & Poor’s unprecedented downgrade of America’s sovereign debt rating, sent US consumers into a mood into a gloomy mood. When people are being told every day the world is facing Armageddon, they are likely to feel a little downbeat. The same factors that induced panic buying of gold produced a panicky slump in confidence.

So some of the weakness of consumer confidence reflects temporary factors. Markets are not through the crisis but they have recovered ground. Britain’s bout of civil unrest will, one hopes, turn out to have been a moment of madness.

It is not all one way on inflation. Global commodity prices peaked three months ago. There is a chance that the squeeze on consumers will ease.

That will not, of course, suddenly transform the growth outlook in Britain, or for that matter in America. Christine Lagarde, the new managing director of the International Monetary Fund, says countries should examine “all possible measures” for boosting growth in the short-term, while maintainng credible medium-term plans for cutting their budget deficits.

There are not, however, many options for doing this, and Britain and America, with their big deficits, are not obvious candidates. Supply-side reforms will help but take time. More lending into the economy would help too and the banks’ poor record on lending to small firms so far somehow got left out of their lobbying for delay or abandonment of the Independent Commission on Banking’s reform proposals.

The truth is we have had a recovery that flattered to deceive. Last year, according to the IMF, the world economy grew 5.1%, one of only three years in the past 30 when growth has exceeded 5%. That growth was driven by emerging economies but included 3% growth in advanced economies. America grew 3%. Britain’s first 12 months of recovery were stronger than after previous recessions.

That growth could not be sustained, either globally or more particularly in the advanced economies. Gerard Lyons, chief economist at Standard Chartered, predicts that emerging economies will grow faster next year than this, as the effects of measures taken to combat inflation wear off.

Advanced economies, however, face a “long hard slog”. Standard Chartered has not revised its forecasts for America, the eurozone and Britain much, because they were low anyway. My guess is that the weakness of consumer confidence is more a reflection of the tough road ahead than anything more sinister.

What does this mean for the Bank of England’s monetary policy committee (MPC), which meets this week? There was a time when the Institute of Economic Affairs’s shadow MPC was a good predictor of decisions by the actual MPC.

I doubt if that is the case this time. The shadow MPC, which remains concerned about the loss of Bank credibility from persistent above-target inflation, votes 5-4 for a half-point hike in interest rates, though the committee also says the Bank should stand ready for more quantitative easing if the eurozone situation gets out of hand.

A rate rise will not be on the cards when the MPC meets. An expansion of the existing £200 billion of asset purchases (quantitative easing) will be. It looks a bit early to do it and, as I have said before, I do not think it would be a good idea.

Consumers are gloomy, after allowing for temporary factors, because reality is setting in. The twin hangovers - banking and fiscal - are painful but they have to be endured. This is no time for the hair of the dog but for a necessary hairshirt. An artificial monetary stimulus, like an artificial fiscal stimulus, would not solve anything. Deep down, people understand that.

My regular column is available to subscribers on www.thesundaytimes.co.uk This is an excerpt.

The eurozone, to me, is still the biggest single threat to global recovery. There are plenty of hurdles to negotiate before the eurozone can be considered to be even moderately secure. The German constitutional court will rule on September 7 on the legality of the Greek and other eurozone bailouts.

Finland has put the cat amongst the pigeons on the second Greek bailout by demanding collateral in return for participation, helping push the yield on two-year Greek government debt to more than 40%.

When they met a couple of weeks ago Angela Merkel, the German chancellor, and Nicolas Sarkozy, the French president, went seriously off piste in backing an EU-wide financial transactions tax, which would have the effect of damaging London without helping the eurozone one bit.

They also said they favoured more eurozone government, which appears to involve more frequent meetings, Merkel rejecting the idea of issuing eurobonds, as an alternative to the national bonds of individual eurozone members.

In Britain, fortunately, we can only be spectators as this drama, some would say tragedy, plays itself out. It is painful to watch, however, both because it was predictable and because it can be solved.

It is bad manners to mention one’s books but that has never stopped me. In 1999, I wrote a book called Will Europe Work? It predicted, using Robert Mundell’s famous optimal currency area approach, a European monetary union without a fiscal union would soon run into problems.

It did not happen straight away. I remember the then head of the National Institute of Economic and Social Research telling me that the book was based on old economics and that things had changed. I also remember Adair Turner suggesting I had been wrong to say the peripheral economies would be the euro’s Achilles’ heel.

At the time, in the early 2000s, countries like Germany and France were struggling in the euro, while Ireland, Spain, Portugal and eventually Greece, were making hay. Europe had adopted a stability and growth pact, intended to restrict budget deficits to under 3% of gross domestic product. But it was France and Germany which broke the pact rules and effectively killed it off.

In the end, however, the predictable exerted itself. The less-competitive peripheral economies got into trouble, exacerbated by the global financial crisis, their public finances were shot to pieces, and the eurozone sovereign debt crisis was solved.

But it is not too late. And the crisis is, as I say, entirely capable of being solved. This is because the eurozone’s overall fiscal position is quite healthy, and certainly much healthier than Britain or America.

Though France has just unveiled an austerity package, including a 3% tax levy on high earners, and Germany’s Ifo index points to weaker growth ahead, the eurozone does not have a big deficit problem.

OECD figures show that the eurozone’s overall budget deficit last year, 6% of gross domestic product, was significantly smaller than that of Britain, 10.3%, and America, 10.6%. By next year, according to the OECD, the eurozone deficit will be down to 3% of GDP, compared with 7.1% for Britain and 9.1% for America.

The eurozone picture is even better when its underlying fiscal position, adjusted for the cycle and excluding debt interest, is taken into account.

While Britain had a deficit of 5.7% of GDP last year on this basis and America 7%, the eurozone’s was just 1.1%. By next year, according to the OECD, the eurozone will have an underlying budget surplus of 0.9% of GDP, compared with deficits of 3% for Britain and 5.8% for America.

Stephen King, HSBC’s chief economist, points out that Italy’s underlying deficit position is one of the healthiest in the advanced world. It may have a peculiar prime minister but its budgetary position is a lot healthier than markets think.

The task for the eurozone is to harness the overall health of its public finances. If it could do so, the eurozone sovereign debt crisis could be solved. This is why fiscal union has gained some unlikely supporters, including George Osborne.

Ruth Lea, former director of the Eurosceptic Global Vision pressure group, now economist for Arbuthnot, says “fully-fledged fiscal union” is the only long-term alternative to some kind of euro break-up.

The trouble is that the political hurdles to fiscal union are huge. There are plenty of integrationists in Europe who adopt the Rahm Emanuel doctrine that a good crisis should not go to waste but even they draw the line at having far-reaching reforms forced upon them by volatile markets.

Fiscal union is resisted by those who would pay for it, particularly German taxpayers, and by those who would benefit from it, notably the Greeks. Merkel may be the most powerful woman in the world, according to Forbes magazine, but even she could not, at present, persuade the German people to accept fiscal union.

The question, then, is what can be done to hold the euro together while the politics catches up with economic necessity of some kind of fiscal union. The urgent need will be to get away from 11th-hour, piecemeal rescues, which are always subject to being pulled apart, as with the latest Greek rescue, to something more permanent.

This could be a much larger eurozone rescue fund, boosting the size of the existing EFSF (the European Financial Stability Facility), so that bailouts would become less politically charged.

It could involve, as a staging post to the issue of eurobonds, a new Euro Area Borrowing Authority, as suggested by Barclays Capital, to guarantee new bond issues of eurozone members subject to them meeting debt and deficit conditions. It could be the agency for the policy co-ordination favoured by Merkel and Sarkozy.

In the long run, there will have to be fiscal union for the euro to survive. It would not mean individual countries lose control over their tax rates. It would mean they would lose control of their ability to run their public finances irresponsibly. Whether Europe’s leaders can rise to the challenge is the big question

My regular column is available to subscribers on www.thesundaytimes.co.uk This is an excerpt.

The misery index, invented by the late Arthur Okun more than three decades ago, is simply the sum of a country’s inflation and unemployment rates. Given that low inflation and low unemployment are the central aims of economic policy, the higher the index, the worse the authorities are doing.

So why mention it now? Because last week brought news of both rising unemployment and rising inflation. And at 12.5 (a May unemployment rate of 8% coincided with an inflation rate of 4.5%) it is at its highest since February 1994.

It is more than double its recent low point - we are twice as miserable - as September 2004, when it was just 5.8. For most of the 2000s, it was between 6 and 8.

The misery index tells us why consumer confidence is so depressed and people reluctant to spend. Indeed, while there may have been more to worry about when the banks were collapsing and the economy shrinking fast, the misery index is higher now than during the recession proper.

Let me deal with the two components of the index, starting with unemployment. Though the latest figures were gloomier than we have been used to in recent months, and any amount of unemployment is a waste, the story of Britain’s jobless rate is essentially a stable one.

Having risen during the recession, the unemployment rate has been stuck around 8% since mid-2009. This is not unusual. In the early 1990s unemployment remained above 10% until 1994, two years into the recovery. In the 1980s it took even longer, the rate not dropping into single figures until late 1987, more than six years after the start of a recovery that began in 1981.

Some tried to inject a bit too much excitement into the figures. Danny Blanchflower, former member of the Bank of England’s monetary policy committee, urged George Osborne to “get his facts straight” on jobs, arguing that a 6.9m drop in total weekly hours worked in the economy in the year to the second quarter equated to nearly 200,000 lost jobs. He forget the extra bank holiday in April, which by rights should have resulted in an even bigger drop in hours worked during the quarter - an important fact to get straight.

Others sought to generate heat by claiming that every job created in the past year - and more - has gone to foreigners. The Office for National Statistics was asking for trouble when it started producing data for “UK-born” and “non-UK born” employment.

My best reading is that a significant chunk of the 241,000 rise in employment in the past year has gone to recent migrants but certainly not all of it.

Employment among those born in the accession countries (the Czech Republic, Estonia, Hungary, Latvia, Lithuania, Poland, the Slovak Republic and Slovenia) has for example risen 106,000 in the past year. Most of the rest of the rise in non-UK born employment does not appear to refelct recent migration and some if it is among UK nationals. The perception that foreigners are taking all available jobs does not, however, help the government’s cause.

Neither does the struggle to make inroads into youth unemployment, currently 20.2% among 16-24 year-olds, and higher fcr young men than young women. Again, unemployment in this age group is not trending in any direction, and 278,000 out of the 949,000 unemployed are in full-time education. But unemployment in this age group is an undoubted problem.

Overall, the job market is behaving as you would expect. The economy is growing, stripping out distortions, by 1.5% to 2% a year, I would estimate. That is enough to generate growth in employment, 25,000 in the latest three months, but not enough to absorb the increase in the workforce. So unemployment will at best stay where it is in the coming year or so, or at worse rise further, particularly if falling markets continue to undermine confidence. This bit of the misery index is not going to become more cheerful in a hurry.

You expect unemployment to be high in the aftermath of a recession. You do not expect high unemployment to be accompanied by high inflation, which is what we have and why the misery has intensified. After hitting 4.5% in May, Britain’s rate dropped to 4.2% in June before bouncing back to 4.4% last month. According to the Bank, it is on its way to 5% or more.

One easy way of looking at its impact is on retail sales. Consumers spent 4.3% more last month than a year earlier but all this was accounted for higher prices, leaving volumes flat. Had inflation been lower, consumers might have boosted growth, rather than running to stand still.

Sit down with anybody senior at the Bank and they will tell you, as this month’s inflation report said: “Inflation has been pushed up by rises in energy and import prices, and the increase in the standard rate of Vat.” There is, in other words, no domestically-generated inflation.

Look through the latest consumer prices index , however, and you see plenty of price rises that fit the Bank’s description, but also quite a lot that do not. So the cost of insurance has risen by 13.6% over the past year; recreational and cultural services are up 5.5%; car maintenance and repair 4.6%; postal services 10.5%; education 5.3%; hospital services also 5.3%, and so on. Tools and equipment for home and garden have risen by 14.5% in the past year.

Some of these price rises reflect the Bank’s factors but others appear to indicate a shift in pricing behaviour. As an obsessive, watcher of prices it seems to me retailers may now be trying a different tack, by re-stocking for the autumn at significantly higher prices.

I have no proof of this beyond the anecdotal but one explanation may be that if customers are inured to the idea of higher inflation, it becomes much easier to push through increases. If, at the same time firms have given up on the idea of selling at greater volumes, they may be seeking instead to boost margins. The Bank is watching for this very closely through its network of regional agents.

We see this in microcosm in petrol prices, which should have come down long ago under the impact of a significant fall in crude oil prices. Once they might have done. This time they have not.

So all this is rather worrying. There are many reasons why inflation should fall over the next 12 months, most notably January’s Vat hike dropping out of the year-on-year comparison. But firms set prices, not the authorities. If they do not want to play ball, inflation could stay uncomfortably high. And so will the misery index.

My regular column is available to subscribers on www.thesundaytimes.co.uk This is an excerpt.

Though they recovered some ground towards the end of the week, share prices have been reflecting huge uncertainty about America, Europe and the global economy.

Some of that uncertainty was already there but it was ratcheted up hugely by S & P’s downgrade of America's AAA sovereign rating to AA+. Few would quarrel with the decision itself, which reflected America’s lack of credible action on the deficit.

But with the eurozone in crisis and markets already falling sharply, the timing of S & P's decision - shouting fire in a crowded theatre - was hugely irresponsible. It may be shooting the messenger but in this case the messenger deserves to be shot.

Like the other ratings agencies it should be trying to repair its reputation because of its culpability in the crisis, giving AAA ratings to what turned out to be junk securities. Instead, it appears to be doing its best to create another crisis.

At the very least, the timing of these ratings announcements must be clearly signalled in advance, as with official data releases. The US downgrade, before the ink was dry on Washington’s debt ceiling agreement, was an unnecessary man-made shock to the financial system.

But the deed was done, with immediate knock-on effects on the ratings of Fannie Mae, Freddie Mac and Israel and concerns over France.

America, of course, has its Tea party, memorably described by Vince Cable as “a few right-wing nutters in the American Congress”. They have been blamed for making a crisis out of the raising of the debt ceiling and thus the downgrade.

Britain does not have a Tea party. It does, however, have the Labour party. You might have thought after the US downgrade Labour would have rethought. Instead, it gave us some political knockabout on George Osborne’s complacency, before resuming its call for a temporary cut in Vat and attacking the government for spending cuts that go “too far, too fast”.

I do not blame Labour’s junior Treasury spokespeople for this. They are new to it. I do blame Ed Balls, the shadow chancellor. He understands this stuff, or should. He must know the best way to ensure Britain would lose her AAA rating would be to follow Labour’s advice. For the Tea party in America, read the Labour party in Britain.

I write this as one with no axe to grind on behalf of the chancellor, who I criticised a lot for his tactics in opposition. I supported Alistair Darling’s temporary Vat cut from 17.5% to 15%, announced in November 2008, as a necessary measure to stabilise an economy that was falling off a cliff.

I argued, against widespread scepticism, such a measure would help. What mattered was not the 2.1% cut in the price of a flat-screen TV (when people bought rather than stole them), but the cumulative effect of lower Vat across a range of household purchases, boosting disposable incomes.

This is not November 2008. The economy is growing slowly, not collapsing. Consumers have been squeezed by many factors, of which January’s Vat rise was a minor part. They have lost their appetite for taking on debt, many would argue not before time. A temporary Vat cut, if it resulted in more spending, would be marginal at best, too marginal to risk the loss of fiscal reputation and the AAA rating.

The plain fact is that Britain does not have room for a fiscal giveaway, temporary or otherwise. The timing of S & P’s US downgrade was, as I say, appalling. The underlying weakness of America’s fiscal position is unquestionable, highlighted by Stephen King, chief economist at HSBC, using data from the Organisation of Economic Co-operation and Development (OECD).

America’s budget deficit peaked at 11.3% of gross domestic product in 2009 and will still be 9.1% of GDP next year, according to the OECD. Its primary deficit - adjusted for the cycle and excluding debt interest - will still be 5.8% of GDP next year.

If the eurozone was a single economy, its public finances would be quite healthy, a peak deficit of 6.3% of GDP in 2009, falling to 3% next year. The eurozone, according to the OECD, is on course for a primary budget surplus of 0.9% of GDP next year.

Britain is a lot closer, fiscally, to America than Europe, with the red ink peaking at 10.8% of GDP in 2009 and still high at 7.1% next year. Adjusted, Britain’s 3% of GDP primary deficit next year is projected by the OECD to be higher than Ireland (0.4%) and Spain (a 0.5% surplus), and close to Portugal (3.5%), Italy (3.3%) and even Greece (3.5%).

I do not blame Labour for all Britain’s deficit. But it was on its watch that it happened and many will regard it as a bit rich for Labour to now be nagging away at the coalition’s deficit-reduction programme. Labour should be trying to rebuild its economic credibility, which will take time, not indulging in this kind of opportunism.

There is no mileage at all, by the way, in the argument that growth would have been substantially higher and deficit reduction as fast under Labour’s plans. Growth has been hit by a variety of factors, most notably the unintended squeeze on real incomes from high inflation and fears of what Sir Mervyn King, the Bank of England governor, described last week as the “unimaginable”, “unmentionable” fears of a disorderly euro break-up. All that, presumably, would have happened anyway, as well as the downgrade the agencies were warning of at the time of the election.

You might argue a downgrade for Britain would not matter, and that growth and employment are more important than bowing to the whims of the markets and ratings agencies. American Treasury yields have stayed low despite the downgrade.

But it would matter. A loss of the AAA rating would not only be a blow to Osborne’s pride, it would have an immediate and damaging impact on those parts of the banking system that are owned or propped up by the government.

The danger to the AAA rating has not passed. The government has yet to deliver on what Osborne, in his emergency statement to the Commons last week, described as “a new model of growth”, not based on “more debt and government spending”.

Restricted credit availability, as the Bank pointed out in it s inflation report, is constraining the recovery. There is much to be done. Futile and risky gestures like a temporary Vat cut is not one of them.

My regular column is available to subscribers on www.thesundaytimes.co.uk This is an excerpt.

In trying to measure what a large and complex economy did over a quarter that ended just a few weeks ago there is not much difference between flat, slightly down and 0.2% up, which is what we actually got for the second quarter. There is, of course, quite a difference in terms of perception.

So what the Office for National Statistics said about the effect of special factors - the royal wedding and the extra bank holiday, Japan’s tsunami and its impact on manufacturing, Olympic ticket sales and unseasonably warm April weather - was rather important.

These factors, the ONS said, knocked 0.4 points off the service sector’s contribution to growth and 0.1 points off that of the production sector. Without them, growth might have been 0.7% rather than 0.2%.

Many people, reading what were unfairly described as George Osborne’s excuses, might wonder at some of this. But, though this is uncertain territory, it is uncontroversial that an extra bank holiday hits output, partly offset by extra spending associated with the wedding itself. Similarly, the effect of Japan’s supply chain disruption on manufacturing was clear.

Why did exceptionally warm April weather hit GDP? Because normally most of us would still have our central heating on. We switched off and energy production fell. The one I did not see coming was the Olympics effect While we pay for tickets now (if unlike me you were lucky enough to get some) it does not count towards GDP for a year, when the event occurs.

Anyway, there were distortions. I have always said that the period of biggest danger for Britain’s economy was in the first half of this year, with the January Vat and April National Insurance hikes and the onset of the big spending cuts.

The raw figures suggest the economy grew by 0.7% during the first six months of the year, a near-1.5% annualised rate. Adjusting for second quarter special factors, growth was 1.2%, a very acceptable annualised rate of almost 2.5%, which is very good in the circumstances.

If you really wanted to go to town you would do as we used to do, which is to look at non-oil GDP, which rose by an underlying 0.8% in the second quarter alone.

I would not go as far as the Institute of Economic Affairs’ shadow monetary policy committee, which this month votes 5-4 for an immediate hike in Bank rate (though several of its members agree with Vince Cable that the Bank should stand ready to do more quantitative easing). I would not pretend either there are no risks to growth.

The limited information we have for the third quarter suggests a subdued start.
A bigger problem than weak GDP growth, however, is weak productivity. It was Paul Krugman, the Nobel prize-winning economist, who coined the phrase: “Productivity isn't everything, but in the long run it is almost everything.”

Productivity, output per worker, or output per hour, is the key to long-term prosperity. An economy in which productivity stagnates will wither and decline.
Output per worker fell sharply in the recession, by about 4.5%, picked up a little to early 2010 but has been essentially flat since, up by just 0.3% in the year to the first quarter and, though we have yet to see the data, probably no better since.

The problem is not in manufacturing. where output per job has risen by 10% since the recession’s low point. It is in services, where it has not increased at all.

On the face of it, we know why this is. Employment fell by less than feared in the recession and has grown more strongly than expected in the recovery. At 29.28m, employment is only 293,000, or 1%, below its pre-recession peak, while GDP is still 4% down. What we have gained in more jobs, we have lost in productivity.

Bill Martin, formerly of UBS, now with Cambridge University, has taken a deeper look at the producticity question in a newly-published paper: ‘Is the British economy supply-constrained?’

Martin’s sub-title, ‘A critique of productivity pessimism’, provides a broad hint. If you believed that the crisis and recession had deprived Britain of the ability to generate decent productivity growth, this would be a very depressing conclusion for the country’s long-term prosperity.

It would also explain why inflation has been so high in the aftermath of a big recession. The argument there would be that if we have lost the ability to generate productivity growth, we have also hugely damaged the economy’s supply capacity. In the absence of spare capacity - a big output gap - it is not surprising inflation is so high.

Martin goes through the arguments of the productivity pessimists one by one and finds them wanting. His conclusion is thus reassuring on productivity: it was not killed off by the crisis. Spare capacity remains; inflation is due to other factors.

If that is reassuring, is the outlook for jobs much less so? Have firms, particularly in services, been hoarding workers in the expectation of a pre-crisis return to normality that will never happen?

When the penny drops, will we see a mass shakeout, a jobless recovery or, worse, what the Chartered Institute of Personnel and Development once called a “job-loss” recovery. This is a prospect that keeps some in the Bank awake at night.

It could happen. One reason it might not is also identified by Martin. Firms have been prepared to endure weak productivity because wages have been so subdued. The kind of shift we have seen over the past year, 520,000 additional private sector jobs, against the loss of 143,000 generally lower-productivity jobs in the public sector would suggest it may be possible over time to grow employment and productivity together. That has to be the hope.

My regular column is available to subscribers on www.thesundaytimes.co.uk This is an excerpt.

Outside the eurozone, Britain has had the freedom to run her own monetary policy nnd allow sterling to fall substantially.

While European governments struggle to put in place credible fiscal plans and obtain parliamentary and public approval for them, George Osborne has been clear and decisive and has so far pulled the coalition, if not the public, along with him.

The chancellor has become an unlikely poster boy for international bond investors and for the ratings agencies which not so long ago were casting doubt on Britain’s AAA sovereign debt rating.

The question is whether this could be about to change, and not just because European leaders staved off the immediate crisis. On Tuesday the Office for National Statistics (ONS) will unveil the second quarter’s gross domestic product (GDP).

I can remember the days when it was hard to get a quorum of journalists for the GDP briefing, let alone a media scrum, complete with live television coverage from Church House, Westminster, which the official statisticians have booked.

Treasury officials, who will not see the figures until tomorrow, are nervous, particularly about the prospect of a negative number, which would resurrect all the arguments about whether the government’s fiscal strategy is condemning the economy to long-term stagnation.

In any event, however, Labour will have a story to tell about the economy’s performance under the coalition. A flat figure, with no revisions to earlier data, would tell us the economy had grown just 0.6% over the past year, and not at all over the past nine months. Osborne may have reason to be grateful for parliament being in recess.

There are excuses. The royal wedding bank holiday, Japan’s impact on worldwide manufacturing and some exceptional falls in energy production have weighed down temporarily on growth, as poor weather did at the end of last year.

The Treasury points to the impact of high oil prices, the 40% increase in the sterling crude price since last year being potentially responsible for a drop of 0.4 or 0.5 percentage points in growth this year.

Independent forecasters have just revised down their average growth forecast to 1.3% for this year, compared with the 1.7% the Office for Budget Responsibility (OBR) was predicting in March. A year ago, its forecast was 2.3%.

Growth is disappointing. A bit of disappointment, however, is a small price for getting the budget deficit down.

This is why the latest numbers for the public finances were interesting and potentially worrying. In June the public sector’s net borrowing was £14 billion, up from £13.6 billion in June last year.

For the first three months of this fiscal year, 2011-12, borrowing was £39.2 billion, only a whisker below the £39.5 billion total for the corresponding period of 2010-11. This is a year when borrowing should be falling significantly, as throughout the parliament, by about £2 billion a month compared with a year earlier.

It is not happening. Borrowing is at best stuck at the levels of a year earlier. The pain, it seems, is in vain.

The OBR, the government’s independent fiscal watchdog, monitors and comments on the public finances each month. It still has faith in its prediction of £122 billion borrowing for this year, down from £142.1 billion in 2010-11.

Timing differences, it says, will help. This time last year the Treasury had received the £3.5 billion proceeds of the bankers’ bonus tax but the bank levy that replaced it will not flow in until the July figures, which will bear close analysis. Higher oil prices and new North Sea taxes will provide a mini revenue windfall, while in January the government can look forward to the proceeds of the 50% top rate of income tax through the self-assessment figure.

It remains possible, despite a disappointing start, that the government will hit its deficit targets. Logic would suggest, however, that weaker growth must mean higher public borrowing. If growth is so weak as to preclude any reduction in the deficit, Britain will be stuck at first base.

So growth is needed. That is why the past few weeks have been worrying. The economy needs the “animal spirits” of businesses investing for the future. The turmoil unfolding in Europe, and the worries over America’s debt, have meant a rational business response has been to stay under the duvet and hang on to their cash.

This is where it could get worrying. Ross Walker, an economist with Royal Bank of Scotland Financial Markets, points out in a report, UK Investment, that the economy is approaching a pivotal moment.

Corporate Britain exited the recession in good financial shape. Businesses, particularly larger ones, rather than consumers or government, are the main hope for domestic demand over the next couple of years. Put simply, if firms do not invest, the domestic economy will stagnate.

Investment intentions surveys suggest they will, and RBS has factored in a bounce from now on. Overall investment should rise more than 6% next year, it predicts.

But Walker is worried about another possibility. “Our concern is that the deterioration in some of the most timely indicators – either financial market gauges or survey measures of business confidence – hint at an imminent deterioration,” he writes.

Were this to result in projects being axed – or even just postponed – the expected trajectory for growth would need to be scaled back. Confidence in the UK fiscal framework might then be tested, prompting a damaging rise in yields and an inflationary slide in sterling.” It might not happen, but it could. Pivotal indeed.

My regular column is available to subscribers on www.thesundaytimes.co.uk This is an excerpt.

The economy is growing, though much more weakly than in a normal upturn, and that weakness is starting to be reflected in the job market.

Though employment rose by 50,000 in the March-May period, its growth looks to be levelling off. The Ernst & Young Item Club, using the Treasury’s model of the economy, will tomorrow revise down its predicting for growth this year to just 1.4%.

Things get better, with 2.2% growth next year and 2.5% in 2013, according to Item. But this is nothing to write home about. Even if the economy succeeds in cranking up to 2.5% growth in two years’ time, that will still be lacklustre by past standards.

By that stage of the recovery in the 1990s Britain had recorded three years of 3%-plus growth. This time it appears to be different.

There are several reasons. The government’s fiscal tightening will reduce growth, as will the squeeze on real incomes from high inflation (though last week’s drop from 4.5% to 4.2% was welcome).

I want to return, however, to a theme I launched last month, on June 12. The debate was raging over whether a Plan B was needed for fiscal policy, as it will again if second quarter growth figures are poor.

I argued that the problem was monetary, not fiscal. Britain does not have too little public spending, it does have far too little bank lending, particularly to small and medium-sized enterprises (SMEs). Such lending began to fall on an annual basis in early 2009 and it is still falling now, by around 6% annually.

Efforts to persuade the banks to lend more to smaller firms were failing, I argued, as they had failed in the latter days of the Labour government. If this continued the authorities would have to act, either by ordering lending by the part-nationalised banks, Lloyds and Royal Bank of Scotland (who between them have 45% of the SME market), or by means of direct lending by government.

There was a big response to that piece, including from senior members of the government. Downing Street is interested and engaged, as it should be. The Bank of England’s latest credit conditions survey suggests no improvement in credit availability to business during the current quarter.

The situation is most acute with SMEs but credit availability is also a problem in other parts of the economy. The housing market is moribund because mortgage availability is running at barely a third of pre-crisis levels and that is depressing building, construction and the many bits of the economy which rely on a reasonable level of housing turnover.

The problem is with the Treasury. When other government departments have raised the issue, the response they get from the Treasury is identical to the one they get from the banks, that the problem is not one of supply but demand.

The banks insist, in other words, that if only there was sufficent demand from SMEs for funding for viable projects, they would be happy to hand the money over. The Treasury tends to agree.

The problem, as the Bank’s diligent regional agents recently uncovered, is that many firms are reluctant to ask for loans or increased overdraft limits not just because they fear refusal but because they are worried that the response of their bank will be to toughen the terms of their existing borrowings. They may go in for a loan, in other words, but come out with a rate hike on their existing overdraft.

The only way to counter the Treasury view, of course, is evidence. Every minister and MP has examples of SMEs - some deserving, some less so - which have been turned down for loans. The unresolved question within government is whether this is systemic or happening only at the margins. The big figures for falling SME lending suggest the former.

The Treasury, the Business department and Downing Street are not the only players in this. The Independent Banking Commission will report at the end of September. While much of the interest and most of the responses from the banks has concentrated on the commission’s interim proposals for ring-fencing (though not separating) the banks’ investment banking activities, it also has another agenda.

That agenda is banking competition, of which there is plainly too little in Britain. Even after planned divestitures by Lloyds and RBS, the big five (including Barclays, HSBC and Santander) will have nearly 90% of the small business market.

They, together with the Nationwide building society, have 80% of mortgage lending and 87% of personal current accounts. Overall, according to the commission, Britain’s banking system will have become more concentrated as a result of the crisis than it was before.

Measures to encourage new entrants, who by their nature will be seeking to increase market share, will help. The Swedish bank Handelsbanken, together with others, is quietly making an impact on the SME market. The commission is investigating ways of reducing the barriers to entry into British banking but acknowledges this will not be easy.

Over time increased competition will boost credit supply, which is essential if recovery is to be maintained. We may not, however, have the luxury of waiting. Those in government who are concerned about this have to push the Treasury, which appears more concerned about the value of the nationalised bank stakes, into action.

My regular column is available to subscribers on www.thesundaytimes.co.uk This is an excerpt.

Last week the Dilnot Commission on long-term care produced its findings and recommendations. On Wednesday the Office for Budget Responsibility (OBR) will publish its first report on Britain’s long-term fiscal sustainability, in other words the ability of the public finances to withstand the pressures of an ageing population.

Alongside it the Treasury will produce what are known in the jargon as whole of government accounts, essentially the balance sheet of the public sector. This will provide new official estimates of government liabilities on public sector pensions, the private finance initiative, and so on.

Of all the pressures on the public finances in the coming decades, easily the most important relate to demographics. Currently there are 3.6 working-age people for every person of retirement age in Britain. By 2050 that will be just 2.4.

Over the next two decades the percentage of the population aged 65 or over will rise from 16% to 23%, while numbers aged 85 or over will double from 1.5m to 3m.

It is, of course, excellent news that so many of us are liviung longer. It is also a challenge. John Hawksworth of PriceWaterhouseCoopers (PWC), in a detailed preview of tomorrow’s OBR report, projects an increase in age-related spending from 22.6% of gross domestic product in 2009-10 to 27.5% in 2049-50.

Of that 4.9 percentage point increase most, 3.4 percentage points, is health; 1.3 points is state pensions and 1 point is long-term care. It is offset by a reduction in spending on public sector pensions, down from 1.9% to 1.4% of GDP, and education, down from 6% to 5.7%. An ageing population requires less education spending.

You might ask why we should be worried about this. Four decades is a long time. In the short-term, according to the National Institute of Economic and Social Research, growth is the problem.

On the back of the latest industrial production figures it reckons GDP will have risen only 0.1% in the second quarter. Some City economists are even gloomier. Knowing the Office for National Statistics, this at least raises the possibility of a negative second quarter.

Weak growth may not end there. The CEBR (Centre for Economics and Business Research), in a new forecast tomorrow, says without the contribution of a strong consumer and rising government spending, growth will average only 1.8% between now and the end of 2015.

That is about two-thirds of the pre-crisis growth rate and will mean annual government borrowing will be about £20 billion higher at the end of the parliament than forecast at the time of the March budget.

But, as Doug McWilliams of the CEBR points out, this is no reason to relax the fiscal tightening. Indeed, if Britain’s trend growth has permanently dropped, the public spending that can be afforded in the future will be less than was thought.

This is the essential point made by PWC’s Hawksworth, in his preview of tomorrow’s official report on fiscal sustainability. Left unchecked, the path for Britain’s debt in future can be mapped out with reasonably accuracy.

It will rise for the next few years, dip back temporarily as the current fiscal tightening takes effect, but from around 2020 begin to rise again as age-related spending kicks in. The debt will never get below 60% of GDP and by the middle of the century be 90% and rising. Age-related spending and debt interest will be huge burdens on a diminishing proportion of working age people. It is not a bright future.

The Treasury will use such projections to underline the need not to let up on tax hikes and spending cuts now. It may need to go further Hawksworth suggests additional fiscal tightening by 2020 worth 1.3% of GDP, around £20 billion, and a more aggressive increase in the state pension age so it reaches 70 by the 2040s, to put the public finances oln a sustainable path.

That way public sector debt will be 40% of GDP and trending gently lower by the middle of the century, rather than 90% and rising. The dynamics of debt mean a stitch in time really does save rather a lot.

Why, going back to the debate of a week or so ago, does the government need to clamp down further on public sector pensions when the OBR is likely to confirm that, as a result of action already taken, their cost will fall as a percentage of GDP?

It is a good question. The answer, I think, is that it would be politically untenable to make the state pension far less generous - by increasing the age of elibibility (particularly for women) - while not further reforming public sector pensions.

Finally, what about Andrew Dilnot’s proposals for long-term care for the elderly? His proposals, setting a £35,000 cap on individuals’ contributions to their care costs, and raising from £23,250 to £100,000 the means-tested assets’ threshold at which people will have to make a full contribution to these costs, are appealing. An insurance market for these £35,000 of costs could be established.

Their drawback is the cost; £1.7 billion now, rising to £3.6 billion a year by the mid-2020s. George Osborne wants to save money, not spend more.

Geoffrey Dicks of Novus Capital Markets, formerly with the OBR, suggests one way of squaring the circle. Why not, to establish a sustainable system for long-term care, scrap some of the handouts Gordon Brown lavished on pensioners?

These handouts, partly to atone for the infamous 75p state pension rise, include for some or all pensioners free TV licences, bus passes and the winter fuel allowance. Their annual cost is around £3.5 billion, twice what it would take to put long-term care on a sound footing. It should be done.

My regular column is available to subscribers on www.thesundaytimes.co.uk This is an excerpt.

According to the Office for National Statistics, the fall in households’ real disposable incomes last year was the biggest since 1977.

There may be worse to come. That comparison was based on a 0.8% drop in real incomes in 2010. Yet the fall over the 12 months to the first quarter of this year, 2.7%, was not only bigger but is on course to beat the drop of just over 2% in 1977. We could be heading for a post-war record.

There is, as always, a health warning to be attached to early-release data like this. Not only are revisions likely in future but, while most people would accept that their real (after-inflation) incomes have dropped on an individual basis, there has been some compensation at the aggregate level from a strong rise in numbers in work.

Even so, we are in a topsy-turvy period. For most people, recovery is proving far more painful than recession. Real incomes held up surprisingly well in the recession but are falling sharply in the recovery.

Part of the reason for this is fiscal. Labour supported the economy in the recession by cutting Vat, returning it to its previous 17.5% level at the start of last year. So, with George Osborne’s hike to 20% in January, Vat was hiked twice in the space of little more than a year.

Mostly, however, it is monetary. Had the Bank of England kept inflation under control at 2%, real incomes would not now be falling. So when Sir Mervyn King, its governor, says as he did again recently that there was no alternative to the squeeze on living standards, there was, or at least an alternative to its intensity. We should also remember that if the drop in living standards was part of some rebalancing grand plan, it was not in the Bank’s forecasts, at least until recently.

A good way of assessing the relative contribution of tax hikes and other factors to the squeeze is by looking at the Bank’s old target measure, so-called RPIX, the retail prices index excluding mortgage interest payments. It is running at 5.3%. Take out indirect tax changes and it comes down to 3.9%. Three-quarters of the inflation pushing down real incomes is monetary, one quarter fiscal.

A few days ago the Bank had a significant rap over the knuckles about this. The Bank for International Settlements in Basel is the central bankers’ bank. Its record on warning of the crisis before it happened was second to none.

Now it thinks central banks, in keeping interest rates close to record lows, are living on borrowed time and in its annual report last week had particularly harsh words for the Bank.

“Controlling inflation in the long term will require policy tightening,” it said. “And with short-term inflation up, that means a quicker normalisation of policy rates ... In the UK, CPI inflation has exceeded the Bank of England’s 2% target since December 2009, reaching a peak of 4.5% in April 2011. As yet, there has been no move by the MPC but one wonders how long its current policy can be sustained.”

There are, before anybody says it, many reasons not to raise interest rates. Growth is weak, the money supply subdued and there is no sign of anything more alarming than a gentle upward creep in pay settlements. For the minority of households with mortgages, roughly 10m out of 26m, a rate hike would intensify the squeeze.

There are also big dangers on the other side, however. Last week Citi, the bank, reported its latest survey of household inflation expectations, carried out by YouGov, the pollsters. It showed that people expect inflation over the medium-term, the next 5-10 years, to average 4.1%, up from 3.5% in May. Prices, they think, will be rising at twice the rate of the official target.

I do not blame them for this. Everything we have seen from the Bank in recent months suggests it has softened its anti-inflation resolve. Last week some MPC members were at it again, publicly flirting with the idea of more quantitative easing - electronically creating money - even with inflation at more than double the target.

Paul Tucker, the Bank’s deputy governor, was an honourable exception but the damage was done. Sterling weakened a little bit more; the pound’s weakness being the main route from higher international prices to higher inflation in Britain.

It is possible, of course, that people are too gloomy about the inflation outlook, and that they are in for a pleasant surprise when it comes back towards the 2% target. The Bank insists it is looking through the temporary factors that have pushed inflation up.

It is hard, though, to see too many lights at the end of the inflation tunnel. Big increases in domestic utility bills are in the pipeline, which will push inflation higher later in the year. Oil prices have fallen, though the effect on pump prices has been negligible, and oil perked up on the Greek vote in favour of austerity measures.

One reason for the latest drop in consumer confidence, which on the GfK-NOP measure fell sharply last month after a brief rise in May, is the current squeeze on incomes. Another is that people expect that squeeze to continue, because they have lost confidence in the Bank’s ability to keep inflation low. They think a temporary overshoot is becoming permanent.

Falling real incomes provide a grim backdrop for retailers and add to the pressure on the rest of the economy to deliver the export and investment performance needed for growth. Falling real incomes are a failure of policy. And most of the blame for that failure rests firmly with the Bank.

My regular column is available to subscribers on www.thesundaytimes.co.uk This is an excerpt.

The British economy is labouring under a post-crisis hangover and adjusting to a new world of constrained credit and a sustained squeeze on the public sector.

None of the weaknesses identified in successive official reports over the years, whether they be in education and skills, the infrastructure or the country’s capacity for innovation, are getting any better. Inflation is high. In 1997 you could say Britain was a deregulated economy, free of the strangling effect of too much red tape. Nobody would say that now.

These things will take a long time to fix, which is why we should be sceptical of any short-term impact of the government’s plan for growth. Tackling these shortcomings, while essential, will take years.

Are there are any quick fixes? I have written about the urgent need to restore credit growth, particularly to firms. What about an aggressive tax strategy to try to attract activity to Britain? By that I mean cutting the 50% top rate of tax and delivering early on the chancellor’s promise to give Britain the most competitive tax regime in the world.

If such tax cuts could be shown to be at worst revenue-neutral, at best net revenue raisers - admittedly not an easy thing to demonstrate - there would be a powerful case for introducing them even at a time when the public finances are undergoing serious repair.

In the late 1980s and 1990s, Britain’s 40% top rate of income tax shone like a beacon. It spoke of an economy that was “open for business”, an economy that was both flexible and understood the vital contribution made by enterprise. Even when, after 1997, those advantages started to be seriously eroded, the 40% top rate remained.

When it went in April last year, it was a symptom of Britain’s painful loss of competitiveness. This is not just the bleatings of well-off business and City folk.

Today, only a tiny number of countries have a top rate of tax above 50%, notably Denmark, the Netherlands and Sweden. Most are well below it. Britain once had one of the lowest top rates of income tax in Europe. No longer. The eurozone average is 42.4%, the EU average 37.5%.

I wrote in January 2010 about the serious mistake the Labour government was making in raising the top rate, just before the change was introduced (“Tax at 50% is a good way to kill the golden goose”).

As one chief executive told the Times CEO summit: “The biggest challenge we have is the 50% tax rate. There is a massive brain drain taking place that will hit this country for six in the years ahead.”

So, while it was good to hear Lord Mandelson urging an early reduction in the top rate last week, he was part of a government that put it up. And, given there was a Machiavellian political element in the hike from 40% to 50% - an attempt to trap the Tories into opposing it - I doubt very much he was an innocent party.

Under Tony Blair there was a consensus among the two main parties on the 40% rate. That has gone. Any reduction by George Osborne would be opposed by Labour and the Liberal Democrats.

All Ed Miliband could promise last week was no return to the high tax rates of the 1970s (when the top rate was 83% and reached as high as 98% on unearned income). Ed Balls, the shadow chancellor, would bring the threshold at which the 50% top rate kicks in down from £150,000 to £100,000.

In a sense the trap set by Labour worked. Even if the Tories could cope with the flak from Labour and the discomfort of the Lib-Dems, the focus groups and opinion polling that guide government policy would pose a difficulty. When taxes are going up for everybody, how could you justify a cut for internationally mobile business people, even if economically it is the right thing to do?

Perhaps it is indeed politically impossible. All is not, however, entirely lost. In his March budget, the chancellor revealed that he had asked HMRC (Her Majesty’s Revenue & Customs) to review the revenue raised from the 50% rate.

That review will not be ready for a while. HMRC was tasked by Osborne with conducting its review “when the self-assessment forms start coming in”. For many taxpayers, that means after January 31 next year. So even action in next year’s budget will be tight.

The chancellor could of course be brave, and not wait for HMRC’s verdict but that would be a surprise. Even worse, the taxman could conclude that the 50% top rate does bring in net revenue, albeit it not much but enough to make justifying a cut harder. In the meantime, Britain’s international appeal as a location will continue to sink. Can the circle be squared before serious damage is done? I am not sure.

It is not just the top rate of income tax. The reason Ireland has clung to her 12.5% corporation tax rate, despite intense pressure from the rest of the EU, is because it matters.

The government’s planned cut in the main rate of corporation tax to 23% is welcome but hardly revolutionary, merely bringing it down to the current EU average.

The Institute of Directors, in a paper last week, pointed out that corporation tax is but one of many taxes faced by business. For a medium-sized firm, the overall tax rate is 43%. Tax freedom day, the point in the year when such businesses stop working for the government and start working for themselves, is June 6.

High tax stunts growth, for business and individuals. Britain has become a high tax country. As long as that remains the case, growth will continue to be stunted. The golden goose will be well and truly stuffed.

My regular column is available to subscribers on www.thesundaytimes.co.uk This is an excerpt.

Renewed political uncertainty in Greece, together with rioting on the streets of Athens, have put the eurozone crisis back at the top of the agenda. It is, as I said recently, the biggest threat to the world economy over the next 12 months.

It is not the only worry. Sir Mervyn King, freshly knighted for the Mansion House dinner, told assembled bankers “failure to tackle the imbalances during the seven years of plenty before 2007 threatens seven lean years thereafter for at least part of the world economy”.

That leanness is evident in data for America on jobs, retail sales, house prices, consumer confidence and other variables. Stephen Roach of Morgan Stanley says America is a nation of zombie consumers.

The failure of the US economy to maintain strong growth is interesting. Until recently an apparently stronger US recovery, in the absence of tax hikes and spending cuts, was a stick to beat George Osborne over his fiscal tightening. This line of attack has been killed off, for now.

King was careful in his choice of words. When he talked about “part of the world economy” he meant the advanced world: Western Europe, North America, Japan and some other parts of Asia. His seven lean years did not extend to China, India, Brazil, Russia, Indonesia, large parts of Africa, Latin America and so on. In this recovery, the emerging world is the world’s locomotive; where most of the growth is.

That is why we should be worried if fears over the global economy extend to slowdowns in these countries. Ivan Glasenberg, chief executive of Glencore, the controversial commodities giant, warned last week that the firm was experiencing a significant “pullback” in demand in China.

The OECD (Organisation for Economic Co-operation and Development) reports that its leading indicators point to “a possible moderation” of economic activity in China, a slowdown in Brazil and China and the first signs of slower growth in Russia.

All four of the BRICs’ economies, in other words, are showing signs of slowing. The locomotives, it seems, are running out of steam. How worried should we be?

There is often a big difference between fears and economic reality. While fears have persisted since the worst of the crisis, the world has enjoyed a strong recovery.

Last year, according to the International Monetary Fund, the global economy grew 5% and world trade 12.4%. The contrast with 2009, when the world shrank 0.5% and trade slumped 10.9% was striking.

The IMF, in its April forecast, expected good growth to continue, roughly 4.5% this year and next. More uncertainties have crept in but Royal Bank of Scotland, in a just-released forecast, sees global growth of 4.1% this year and 4.4% in 2012.

It also suggests we should put the Chinese and Indian slowdowns into perspective. Both grew more than 10% last year, India shading it at 10.4% versus China’s 10.3%. India’s slowdown this year will be more dramatic, to 7.8% versus China’s 9.7%. But 8% growth is still highly impressive.

There is a health warning on all forecasts, but more particularly when crises are swirling around. The IMF’s July 2008 forecast update, for example, two months before the collapse of Lehman Brothers, predicted 4.1% global growth for 2009.

Why is the global economy slowing at all? That is not hard to explain. The early stages of recovery are steep; once economies reach cruising altitude things steady.

On top of that fiscal policy is being tightened in most advanced economies, while monetary policy is becoming more restrictive - interest rates are being raised - in many emerging economies. That is in response to another growth-reducing factor, soaring commodity prices, though they show signs of easing.

There is a lot of evidence that the Japanese earthquake and tsunami, with its effects on Japan and global supply chains, has resulted in a temporary hit to growth.

All this suggests fears over the global economy are probably overdone. The slowdown is largely due to temporary factors. A blow-up in Greece and the contagion that would spread is the risk.

As Holger Schmieding, chief economist at Berenberg Bank, puts it: “Greece is tiny: 2.5% of Eurozone GDP. What matters is the risk of contagion to much bigger economies such as Spain (11.6%) or Italy (16.8%). A market panic ... could potentially trigger a Lehman-style chain reaction with major damage to the European economy.”

On the other hand, if the European Central Bank and member states allowed their squabbles to result in another major accident it would be unforgiveable. The global recovery is real, even if it has taken a bit of a breather. But the fears, the tail risks, are real too, and have consequences.

This brings it back to Britain. One of the puzzles for Treasury officials relates to the strength of private sector jobs’ growth but the weakness of business investment.

Figures from the Office for National Statistics show private sector employment has risen an impressive 520,000 over the past year and 562,000 since the recession low point in the final quarter of 2009.

Business investment, in contrast, fell by 7.1% in the first quarter and was 3.2% down on a year earlier. The figures are prone to revision but the implications appear clear. Firms are willing to hire but not invest.

Some of that can be explained by the surplus capacity left over from the recession (though investment recoveries are normally very strong in spite of that factor). Some of it may be explained by the availability, or lack of it, of finance.

Most of it, I suspect, is explained by the fear factor. Though the world has recovered, firms are unsure about whether it can last. Those fears over global recovery are not just regularly battering the stock market. By affecting the behaviour of firms they threaten to become self-fulfilling.

My regular column is available to subscribers on www.thesundaytimes.co.uk This is an excerpt.

Thirty years ago 364 economists signed a round robin letter, published in The Times, criticising the Thatcher government’s policies and warning they would deepen the recession.

The signatories, Britain’s economic establishment including a youngish Mervyn King, who had no idea he would later find himself governor of the Bank of England and defending a Conservative-led government’s aggressive fiscal tightening.

By comparison with that missive, last weekend’s “Plan B” letter from 52 academics, the vast majority of whom are not economists, was a pale shadow and read like a plea for more university funding.

There is, however, a thread that links the two. Both were barking up the wrong tree, and in a similar way. Let me explain.

In 1981, the 364 became figures of fun because their letter coincided with the start of a nine-year recovery. This was because, as some have admitted, their focus was on fiscal policy - tax and spending - ignoring monetary policy.

So, while fiscal policy was tightened in the austerity budget of 1981, monetary policy was relaxed, with a two-point cut in interest rates (from 14%) announced in the budget. Monetary policy was the key.

This time the key is also on the monetary side. We have had a big financial crisis and deep recession. The recovery is a little weaker than normal but real enough.

What could stop it in its tracks, and result in prolonged stagnation, is not the fact that taxes have gone up and government spending is being reduced. That will affect the balance of growth and, as I explained recently, take the edge off recovery. Instead of 3% or so in coming years, growth may be closer to 2%.

The real problem, and the one that could do more serious damage, is on the monetary side. The weakness of money and credit is striking. The “broad” money supply measure, M4, was growing at an annual rate of 17.5% just over two years ago. In the past 12 months it has fallen 0.9%.

Adjusting for lending to the financial sector (other financial corporations) ther slowdown is less pronounced but nevertheless significant. Before the crisis this measure of M4 was typically growing by between 10% and 12% a year. The latest annual growth rate is just 1.5%.

Lending to businesses has been negative - falling - since the early part of 2009 and remains so, down over 4% on a year ago. Larger companies can bypass banks and access markets directly, smaller firms cannot. Lending to them is down an annual 6% according to the Bank.

It is not just business lending. Monthly mortgage approvals, including remortgages, are just over 90,000, less than a third of pre-crisis peaks. The credit channel may not be broken but remains badly damaged.

Some would say there was too much credit pouring in before the crisis, and that is true. But there is plainly too little now.

The Bank used to think M4 growth of 9% a year was consistent with economic growth of 2.5%-3% and hitting the inflation target. That may have changed as a result of a shift in the velocity of money but not that much. 1.5% M4 growth is inconsistent with sustained recovery and chronically weak credit growth will hold back growth.

Responding by boosting government spending or cutting taxes is at best oblique, at worst irrelevant, like trying to fix a leak in the roof by replacing the windows. What the economy needs is s sustained private sector-led recovery, and what that needs is an adequate supply of credit.

As it happens, I addressed this problem in a column written in April 2008, before the worst phase of the financial crisis.

I wrote that interest rates had to be slashed aggressively, that the authorities had to pump in liquidity and do whatever else was necessary to stabilise the banking system. But, and this is where I parted company from what subsequently happened, I also said the government and the Bank should consider direct lending into the economy. If the banks were not prepared to lend enough to support recovery, the authorities would need to do so.

Since then, the Bank and Treasury have danced round the problem without getting to the solution. The Treasury concluded its Project Merlin deal with the banks but, in the end, it will founder because there are two sides to a lending decision.

Every banker will say he has money to lend but is not getting enough lendable propositions. Every small business and mortgage borrower turned down will say the terms on which funds were available were unacceptable. Vince Cable can exhort and threaten until he is blue in the face but it is hard to see this changing soon.

As for the Bank, it denies it now but journalists got the impression in March 2009 that the purpose of quantitative easing (QE) was to stimulate bank lending.

According to the Bank now, that was never the idea. While QE would lead to banks holding more reserves and that “might” mean more lending, “if banks are concerned about their financial health, they may prefer to hold the extra reserves without expanding lending”.

So, while the International Monetary Fund suggested last week more QE (and temporary tax cuts) might be needed if growth grinds to a halt, that would be a bad idea. It does not solve the problem of dangerously weak credit growth.

The only person who has said much publicly on this is Adam Posen, the monetary policy committee’s Japan expert. Though I do not agree with him in his regular vote for more QE, which would be a futile gesture, he was early on to “the likely failure of lenders to support recovery”. He, like others, would have preferred it if QE had not been conducted overwhelmingly by the purchase of government bonds. Policy has failed to get credit flowing.

Can it do so? The answer always comes back that civil servants and central bankers are not well qualified to make lending decisions. Fortunately, there are plenty of bankers on the government’s payroll. It should not be beyond the wit of officials to find ways of using this expertise, and the government’s leverage over the banking system, to get credit flowing at a pace that will sustain a decent recovery. That is the real Plan B Britain needs.

My regular column is available to subscribers on www.thesundaytimes.co.uk This is an excerpt.

Anybody venturing overseas, particularly to European destinations, will know the symptoms: the too frequent visits to cash machines, the yearning for the free museums and galleries we enjoy in Britain, the cup of coffee that costs “How Much?”

If you have been around long enough all this is familiar. I have no personal recollection of the £50 limit for British tourists travelling abroad in the 1960s, though I remember when Britain was the poor man of Europe after sterling was forced out of the European exchange rate mechanism (ERM) in September 1992.

Periods of sterling strength, as in the early 1980s (which considerably damaged industry), or the long period from 1996 to 2007, have been all too rare. Mostly the pound gets sand kicked in its face.

Many will see this, like the severe squeeze on household incomes, as the natural consequence of Britain’s necessary economic adjustment. The pound had to fall to rebalance the economy in favour of exports and against imports.

In balance of payments terms, a holiday abroad is as much of an import as a new Audi or BMW. And, while it can be hard to find domestic alternatives for some imported goods, that is not the case for holidays, as the tourist boards will tell you.

Pricing at least some British people out of foreign holidays is economically the same as getting them to spend less on imports and that has to be a good thing.

Not only that but exports are one of the few bright spots of the economy at the moment. They made a significant contribution to the first quarter rise in gross domestic product and, according to the latest purchasing managers’ index for manufacturing provided the spur to growth - admittedly within a decelerating growth rate - against the backdrop of depressed domestic demand.

So, you might say, we should grin and bear it, because the last thing Britain needs at this juncture is a stronger pound. It is, however, a question of degree. Sterling’s average value is around 25% lower than immediately prior to the onset of the global financial crisis in the summer of 2007.

Before he left the Bank of England’s monetary policy committee (MPC) last week, Andrew Sentance pointed out that a depreciation on this scale is much bigger than in previous episodes.

The successful if unintentional post-ERM depreciation of the 1990s, for example, was closer to 15% (and was reversed by the end of the decade), while the the original Harold Wilson “pound in your pocket” devaluation of 1967 was 14%.

The only comparable sterling fall was from 1972 to 1977, a period which included Britain’s IMF (International Monetary Fund) crisis, hardly an example to follow.

Currency markets overshoot. The surprise was not that the pound fell when the global crisis hit in 2007, reflecting Britain’s vulnerability, but that it has stayed down. All sterling depreciations have been followed by significant rebounds.

This one has not, and it is easy to see why. Sterling and monetary policy are intimately connected. Every time the pound threatens a recovery, it is knocked back by the MPC reinforcing its commitment to ultra low interest rates, or by hints it is contemplating more quantitative easing. At a time when other central banks are hiking rates, not just in Europe, sterling is about as attractive as a wet Wednesday in Wigan.

What I think it also does is delay the adjustment to the pound’s lower level. Such adjustments take time. Exporters have to make up their mind whether to enter new markets, which can be risky and expensive. Companies have to decide whether to relocate production and other activity to Britain: the Bank’s regional agents’ survey of why imports had stayed so strong found that UK supply capacity for many components no longer existed.

Such decisions need exchange-rate clarity. And before anybody says such clarity would be provided by euro membership, yes it might, but at a far greater cost to both the euro and to Britain.

The point is that businesses need to know where the pound will settle. Its current level against the dollar, around the mid-$1.60s, is fine; close to the average of the past 30 years. Its level against other currencies, particularly the euro, is wrong.

Against sterling, the euro has ranged from 1.02 to 1.75, and is now in the 1.10-1.15 range. Fair value is considerably higher, probably 1.30-1.35. The pound is struggling against a very troubled euro. Until firms know how that struggle will end - how far the pound will bounce - they will hold off making decisions.

The main reason Britain needs a stronger pound, of course, is that it would help control inflation and limit the extent that interest rates will need to rise to do so.

The weakness of household spending and confidence, attributable to falling real incomes, is very much on the minds of the MPC. Paul Fisher, the Bank’s executive director for markets and an MPC member, cites it as the main factor holding him back from hiking rates. He also said he would contemplate further quantitative easing.

This is where policy risks getting dangerously circular. The low pound will maintain the squeeze on household incomes until fully passed through to inflationt. But as long as the MPC signals it will hold off from hiking rates, sterling will not recover, and could go lower, adding to that squeeze.

Wishing for a stronger exchange rate and achieving it are, of course, two different things. I do not think, however, it is that difficult. Instead of a very soft stance on interest rates, the Bank has to start talking tougher.

It does not have to match the Institute of Economic Affairs’ shadow MPC, which this week votes 6-3 for an immediate rate hike, with five wanting a half-point hike and one a full-point rise to 1.5%.

It does need to recognise the advantages of a higher exchange rate in easing the squeeze on domestic demand (by reducing import prices) and allowing the economy to properly adjust. Neglecting the pound, as the Bank is doing, does nobody any good.

My regular column is available to subscribers on www.thesundaytimes.co.uk This is an excerpt.

Is George Osborne cutting too fast or not fast enough? The Office for National Statistics’ second estimate of GDP in the first quarter, as expected, left the rise in GDP unchanged at 0.5%, following the 0.5% fall in the fourth quarter of last year.

I will not go over old ground on the reliability of these figures, though there are further oddities in the numbers that will no doubt be revised away over time. At face value they tell a story of an economy that has been stagnant over six months. Ed Balls, the shadow chancellor, says the economy has been flatlining since Osborne stood up to deliver his spending review in the autumn, which detailed the cuts.

What the GDP figures also showed, however, was that government spending rose by 1% in the latest quarter, after an increase of 0.4% in the final quarter of 2010. Public spending grew as the economy shrank and contributed two-fifths of GDP growth in the first quarter. Spending in cash terms in April was 5% up on a year earlier.

There is a case that January’s Vat hike contributed to the exceptional first quarter consumer spending weakness, though it is sensible to suspend judgment given that retail sales rose during the quarter. There is no case yet for the argument that spending cuts are killing the economy.

What about an apparent change of heart by the Organisation for Economic Co-operation and Development (OECD)? Its twice-yearly Economic Outlook, endorsed the government’s plans, saying “the current fiscal consolidation strikes the right balance and should continue in line with the medium-term plan to eliminate the deficit”, But its chief economist, Pier Carlo Padoan, appeared to suggest the government should go slow on cuts if growth is weak.

After talking to the OECD, and subsequently listening to Angel Gurria, its secretary-general, what he meant, I think, is that if growth is weaker, so-called automatic stabilisers should be allowed to operate. Weak growth means weaker tax revenues and higher spending on unemployment benefits. If, in spite of these, the chancellor tried to stick to firm deficit targets, he could make things worse. So Osborne should stick to his plans, but not to try to offset any impact on the deficit from weaker than expected growth.

Indeed the OECD appeared to offer some support for the view that Britain’s cuts are not that exceptional. It compared reductions in the projected budget balance (the deficit) in member states between 2009 and 2012. Easily the biggest were the crisis-hit eurozone economies, Greece, Ireland and Portugal, plus Spain, with deficit cuts ranging from 4% of gross domestic product in Ireland to more than 12% for Greece.

Britain’s projected deficit cut is significant, around 3% of GDP. That, however, is not much more than Italy and France, neither of them natural big cutters.

Another OECD comparison, which we reported last week, showed Germany’s public spending to GDP ratio - again to 2012 - falling by 2.5 percentage points, compared with 2.2 for Britain.

This highlights criticism of the cuts by some commentators, that they have been sold as much tougher than they are. Certainly, the coalition has been unsubtle in its warnings about the tough times ahead.

There are two problems with these comparisons, however. One is that the public spending to GDP ratio is not a good measure of the fiscal pain being inflicted. This is because it is influenced by the performance of GDP as well as spending.

So Greece’s public spending to GDP ratio falls only 0.1 points between 2010 and 2012, despite very deep spending cuts, because of GDP weakness. It works the other way too. During Gordon Brown’s tenure at the Treasury the public spending to GDP ratio barely rose until recession hit, even though spending was being increased rapidly.

The other problem is that Britain’s cuts go well beyond 2012, and only really begin this year, 2011-12. The IMF compared planned fiscal tightenings in eight economies over the period 2010-15 - Britain, America, Germany, Japan, France, Italy, Canada and Spain - and found Britain’s tax hikes and spending cuts, nearly 8% of GDP, easily exceeded America, France and Spain (4% to 5%), Canada (3%), Germany (2.5%), and Japan and Italy (less than 2%).

The spending cuts, far from being a scratch, are significant. Revised calculations from the Institute for Fiscal Studies, based on recent (and higher) inflation projections from the Office for Budget Responsibility show over the four years from 2010-11 to 2014-15, real departmental spending will fall 11.7%. Take out the protected areas of health and overseas aid and departmental cuts are even larger.

Overall government spending (total managed expenditure) will fall 4% in real terms over that four-year period. That does not sound much but includes a sharply rising debt interest bill. It is also unusual. In only eight years since 1948 has spending on this measure fallen, and never more than two years in a row. This four-year squeeze will break historical precedent.

Will it kill the recovery? I say not but this is an uncomfortable time for the government. The OECD is the latest to revise down growth forecasts for Britain, forcing the Treasury to trot out the line that recovery was always going to be choppy. Maybe, but not long ago it predicted growth of more than 3% for this year.

Barely more than a month into the start of his four-year programme of spending cuts Osborne cannot change course now. There is a case, as the OECD says, for allowing automatic stabilisers to operate if growth is weaker than hoped, rather than sticking rigidly to deficit targets.

If high inflation persists, as the Bank of England’s Andrew Sentance predicts, there may also be a case for revisiting the cash totals for public spending, to prevent the real squeeze from being even tougher.

There is no case, however, for going back on the thrust of the government’s deficit reduction plans. The chancellor is known for occasionally having spent time on yachts. Any sailor knows that if you drift too much you get into trouble.

My regular column is available to subscribers on www.thesundaytimes.co.uk This is an excerpt.

A few days ago Rightmove, the property website, reported that house prices have risen to their highest level for nearly three years. Nothing wrong with that, you might say, except Halifax, part of Lloyds Banking Group, had just said that prices have dropped to their lowest since July 2009.

Some of these discrepancies are explicable. Rightmove measures asking prices, which sellers may not achieve, while Halifax records prices at mortgage approval stage. There are other differences between house price measures - the Halifax’s index always appears more downbeat than the Nationwide - which I will not go into here.

The big picture is that house prices fell up to a fifth when the financial crisis struck nearly four years ago and cut off the supply of wholesale mortgage funding. Then, perhaps surprisingly, they rebounded by 10% or so, since which time they have been roughly flat.

The LSL-Acadametrics index, based on Land Registry data, tells the story well. House prices peaked at an average of £231,828 in February 2008, then fell 14% to £200,234 by April 2009, before rebounding by nearly 12% to £223,482 by February 2010. Last month the average stood at £223,352.

That is a lot of volatility in a short time but minor compared with the huge swings in housing transactions of the past four years. Last month, 45,000 houses and flats were bought and sold in England and Wales, according to Acadametrics. This was just 52% the long-term April average and barely a third of monthly transaction levels of more than 120,000 four years ago.

The housing market has hit what I would call a low-activity equilibrium, Turnover is depressed but there are few forced sellers: people are staying put. Prices may continue to slip in real terms, as predicted by the National Institute of Economic and Social Research, though I disagree strongly with the view that they will never get back to real (after-inflation) pre-crisis levels.

For that to happen something fundamental would have had to have changed. Housing is damaged at the moment, because of the squeeze on funding and depressed incomes. In the long run, housing will do what it has always done, rise roughly in line with incomes, which means rising in real terms.

The problem is that prices do not rise steadily. Steady is not a word you would associate with the housing market. A few days ago the Joseph Rowntree Foundation’s report, Tackling Housing Market Volatility in the UK was published.

The report, the product of two years of deliberations by a housing market taskforce of experts, including Kate Barker, Peter Williams and Mark Stephens, the report’s author, let fire with both barrels.

“The UK has one of the most persistently volatile housing markets, with four boom and bust cycles since the 1970s,” it said. “These cycles distort housing choices, drive up arrears and repossessions, inhibit housebuilding and heighten wealth inequalities.” Behind the current stasis, it said, there is a fundamental sickness.

“The current model of home ownership has become stretched beyond its limits. Increasing numbers are being priced out of the market and ownership levels are falling, particularly among younger people. There has been a long-run shortage of housing ... and this has also made it harder to access social rented housing. Meanwhile, the private rented sector does not offer a sufficiently secure alternative to meet the needs of many households.”

The taskforce has some good ideas, at the top of which is the need to increase housing supply. Though housing starts rose in the first quarter housebuilding remains close to its lowest levels since the 1920s, having fallen sharply during the crisis from levels that were regarded as woefully inadequate before that.

It suggests a shake-up of housing taxation. Stamp duty, for example, should become a marginal rather than a “slab tax. At present, when you move above a stamp duty threshold you have to pay the higher tax across the entire purchase price, rather than just the wedge above the threshold.

It also suggests using housing taxes to dampen the house-price cycle. Another recommendation, which may be taken up by the Bank of England’s new financial policy committee, is the counter-cyclical use of restrictions on mortgage lending.

At a dinner to launch of the JRF report, it was said we will only really have changed as a nation when, instead of regarding rising house prices as good news, the front pages celebrated falls.

I doubt that will happen. Housing is a substantial component of household wealth and more evenly distributed than other wealth. Two-thirds of households are owner-occupiers. Whatever the social benefits of lower house prices, people cannot be expected to celebrate a fall in their wealth.

Greater price stability is another matter. We could all compromise around that. The question is whether it is achievable.

After two years working on the problem, the verdict at the launch was downbeat. A big increase in housing supply would not solve everything but would help hugely. Unfortunately, there is very little sign of it. The builders are convalescing, the planning regime is more anti development than ever and institutions are reluctant to commit funds to the private rented sector.

As for counter-cyclical tax and credit policy, it might help, but there have to be doubts about whether policymakers can ever successfully dampen the animal spirits of homebuyers when they get a head of steam up.

At this stage it may seem fanciful to talk of the next runaway boom in house prices. But, as things stand, it will happen.

My regular column is available to subscribers on www.thesundaytimes.co.uk This is an excerpt.

Nobody was surprised that the Bank of England revised down its growth forecasts last week; the gross domestic product figures for the last two quarters guaranteed that. Its economists expect the GDP numbers to be revised up but not enough to remove the soft patch for the economy around the turn of the year.

The contrast with the French and German GDP figures, with first quarter rises of 1% and 1.5% respectively, was striking, compared with just 0.5% in the UK. German GDP is up by an adjusted 4.9% on a year earlier.

The surprise, perhaps, was the Bank’s more hawkish tone on inflation, although Mervyn King still seems very reluctant to convert that hawkishness into a hike in interest rates. We will know more with the Bank monetary policy committee’s minutes this week.

There’s a decent chance that the Bank’s prediction of 5% inflation later this year will turn out to be pessimistic, particularly if the recent softness in oil prices persists. For now, however, we appear to be stuck in an uncomfortable growth and inflation mix.

I would not call it stagflation, remembering when that was genuinely the case in the 1970s. But the economy is stuck in the slow lane, buffeted by the rough winds of high inflation.

Why is this? The answer may seem straightforward, particularly if you are Ed Balls, the shadow chancellor. George Osborne, he says, is out of his depth and personally wrecking the recovery with the pace of his fiscal tightening.

I will come back to that but first, let me spend a little time talking about the Bank’s take on why growth has been weaker than hoped, which is interesting.

We have heard a lot about rebalancing - a recovery led by business investment and exports - and an economy being weaned off over-reliance on consumers and government.

It has not been happening much for net trade (exports minus imports), although the picture for the first few months looks a little more encouraging.

On investment, though there is some frustration in official circles that businesses are not spending more, for which part of the answer is continued tight credit availability, capital spending at the end of last year was up 12% compared with 12 months earlier.

Business investment and stockbuilding (the rebuilding of inventories run down in the recession) between them contributed 2.5 percentage points to the rise in GDP during last year. In other words spending by companies accounted for the whole of the rise in GDP, with some left over. Spending by households, in contrast, was down, and subtracted from GDP growth.

Something rather unusual is happening. It may seem obvious but if you want to know why the economy is not growing faster, the answer is mainly that consumers are not spending more. Bits of consumer spending have picked up, and the latest British Retail Consortium survey was upbeat.

But there is more to consumer spending than retailing alone and the big picture is that consumer spending got knocked down by the crisis and has failed, in contrast to the experience of past economic recoveries, to stagger back to its feet.

As the Bank put it: “Around two thirds of domestic demand is accounted for by household consumption. Consumption stagnated throughout 2010, remaining some 4% below its pre-recession peak - the largest such shortfall at this stage of a recovery since quarterly records began in 1955.”

An even more dramatic contrast is provided by the Bank’s comparison between the pre-recession trend for consumer spending and what has actually happened over the past 2-3 years. Had that pre-recession trend continued, spending would today be 12%-13% higher than it is.

So consumers are mainly responsible for condemning Britain to life in the slow lane. There is no doubt that tax hikes are part of that story. The January rise in Vat and last month’s 1% increase in national insurance contributions are taking their toll.

So is the fear, if not necessarily the reality, of the spending cuts. Coalition ministers, including the chancellor, put the frighteners on people a year ago over spending and the fear remains. Whether the reality is as bad as the rhetoric remains to be seen.

These things are hard to calculate but most of the squeeze on households is not, in fact, not as a result of the fiscal tightening. The Bank has an incentive to play up the impact of the Vat hike but found that probably no more than a quarter, perhaps less, of the 4%-plus inflation in the first quarter was due to the hike in Vat to 20%.

It is the unintended squeeze that is proving to be much more damaging; the squeeze on household incomes from other sources of inflation. These include, of course, global energy and other commodity prices and the boost to import prices more generally from sterling’s fall.

Though most of that fall happened more than two years ago the Bank, worryingly, is not sure we have yet seen all of the impact on prices.

This is where the Bank’s gloomier view on inflation matters. Persistent above-target inflation is not just an embarrassment for the Old Lady of Threadneedle Street; it matters.

Until last week it was sensible to write off 2011 as a year for a consumer spending recovery. High inflation and only gradually increasing wages growth meant another year of falling real incomes.

Only in 2012, when gradually rising wage inflation crossed over with falling consumer price inflation would the consumer find relief. That was the light at the end of the tunnel. Now, rather than that occurring at the start of 2012, it may not happen until the end of the year. If this is right it could be another lost year for consumer spending, and an even bigger break with precedent.

This does not mean we will get no growth over the next 12-18 months. It does mean we should not expect much contribution from consumers as long as inflation stays high. If it was up to consumers, we would very definitely stay in the slow lane.

My regular column is available to subscribers on www.thesundaytimes.co.uk This is an excerpt.

Reports of a Greek exit from the euro, or debt restructuring, were dismissed as “stupid” by senior European Union officials, and “flippant” by the Greek government. But we are into one of those ‘no smoke without fire’ periods, symptomatic of what has happened to the eurozone over the past 12 months.

First there was Greece, a year ago. Then six months later there was Ireland. Now, thanks to acting Portuguese prime minister Jose Socrates we have the broad outlines of Portugal’s EU/International Monetary Fund rescue package.

Portugal will get 78 billion euros, about a quarter of it to prop up her ailing banks. The rescue means there have been three eurozone bailouts in the space of a year, at roughly six-monthly intervals.

While things look less worrying for Spain at the moment — and stopping the rot in Portugal is important — at this rate of attrition Madrid might be nervous about whether it can get through November.

And if Spain had to be helped out, not only would that use up most of what is left in the rescue fund, but the next most vulnerable, perhaps Italy and Belgium, would come under the spotlight for 2012.

Last week I argued that the debate over fiscal austerity and economic growth is more nuanced than it often appears. In Portugal, however, it is not nuanced at all.

The terms of the rescue package will require Portugal to cut her budget deficit from 9.1% of gross domestic product last year to 3% in 2013.

That will cause the economy to shrink by 2% both this year and next, according to Fernando Teixeira dos Santos, the country’s finance minister, under the impact of spending cuts equivalent to 3.4% of GDP and tax hikes of roughly half that amount. Britain’s modest growth, by comparison, looks enviable.

Euro membership does not look very appealing for the three rescued economies at the moment. Ireland has just revised down her growth forecast to just 0.8% this year.

The Organisation for Economic Co-operation and Development (OECD) predicts that the Greek economy will shrink by 2.7% this year, followed by growth of 0.5% next.

It is not just budgetary austerity. While the eurozone is fraying round the edges the currency itself is strong. In what some currency analysts call the ugly contest between leading currencies, the euro is less ugly than most. So the pound is back down to 1.13, suffering as a result of Britain’s weak growth figures.

The euro’s appeal is driven, at least in part, by interest rate expectations. While 4% inflation has not prompted the Bank of England to move, and is now unlikely to do so for some time, 2.8% inflation is too high for comfort for the European Central Bank.

The ECB has already raised its key refinancing rate once, to 1.25%. There was some relief on Thursday it did not signal a second increase, in June. But the consensus in the markets is that the stay of execution will be temporary, and that there will be a hike, to 1.5%, in July.

This will not be a problem for Germany and the eurozone’s other stronger members — though evidence is beginning to emerge of a slowdown in growth across the region — but it is a severe problem for the troubled peripheral economies.

Not only are they having to cope with eyewatering fiscal austerity but monetary conditions are tightening too, on top of the sharp rise in their government bond yields. The eurozone, pinnacle of Europe’s integrationist ambitions (so far) is looking battered. Parts are held together only with artificial support.

Where does it go from here? Its crisis is not a new banking and financial crisis but an aftershock of the 2007-09 global financial crisis. But it could become a new and serious banking crisis in its own right if the path to restructuring Greek, Irish and Portuguese debt is mishandled.

At some stage holders of these debts will have to take a loss, a “haircut”, as is usual after sovereign debt crises. But with German and French banks having an exposure of 340 billion euros in Greek, Irish and Portuguese debt, this has to be delayed until banks are healthier. British banks are in for 250 euros, mainly from Ireland.

Avoiding a Spanish rescue is one priority. Another is managing the restructuring of the troubled peripheral countries’ debt in a way that does not collapse the banks, which means doing it slowly.

Beyond that, serious thought has to be given to the future of the euro. While the financial crisis was the trigger for the eurozone’s sovereign debt crisis, an underlying cause was the loss of competitiveness, typically between 25% and 30%, for Greece, Portugal, Ireland and Spain since the single currency was born in 1999. The assumption that economic convergence, and more importantly convergence of costs, would follow euro membership has proved false.

That leaves two choices. Either the rescued countries, alongside fiscal austerity, commit themselves to win back competitiveness within the euro. Their voters might be prepared to make the sacrifice but you would not bet on it. So far, the response to the eurozone’s crisis is a sticking-plaster one, albeit one that, bizarrely, could cost Britain more than £13 billion ( £4 billion for Portugal alone) if guarantees are called in.

The alternative is that, in time, some or all of these economies leave the euro. Economists do not get everything right but most of us knew a euro open to all-comers would not work. To paraphrase Groucho Marx, you would not want to belong to a club of which Greece is a member. That, certainly, is how many Germans feel. In the long term, Europe will need a new currency arrangement.

Whether that involves a northern euro and a southern euro, or a single “hard” euro around which other national currencies float, can be debated. As with debt restructuring, it cannot happen immediately, but it will have to happen eventually.

Nicolas Sarkozy intends to use France’s G20 presidency this year to push for international monetary reform, by which he means the future role of the dollar. He should look closer to home. After the past year, the euro badly needs reforming too.

My regular column is available to subscribers on www.thesundaytimes.co.uk This is an excerpt.

For those looking for guidance on whether the government is doing the right thing by cutting the budget deficit they get, instead, a Punch and Judy show.

Larry Summers, former US treasury secretary, has become the darling of the “don’t cut” school with remarks he made last month at a George Soros-sponsored event at Bretton Woods, New Hampshire.

“I find the idea of expansionary fiscal contraction, in the context of the world in which we live, to be every bit as oxymoronic as it sounds,” he said. “And I think the consequences are likely to be severe for the countries involved.” Only if Britain’s economy booms over the next two years would he change his mind, he said.

At the other extreme are those who argue that while tax hikes will damage growth, spending cuts will not, merely making room for the private sector to grow. You get this from free-market think tanks such as the Adam Smith Institute.

Somewhere in the middle are the OECD and IMF, which back the government’s deficit-cutting programme while at the same time predicting only a modest recovery.

Let me adjudicate. Summers says he would be astonished if Britain boomed over the next two years and so would everybody else. He has set up a straw man.

The government’s deficit programme has removed the threat to Britain’s AAA rating and probably kept interest rates low. You cannot, however, hike taxes and cut spending without some impact on growth, even if there was no realistic alternative.

As for the free marketeers, it is true that over time the private sector will expand into the space left by a smaller state. But in the short-term, in an economy when bank finance is scarce, growth will be slower than without cuts. As I say, Britain had little choice but to get the deficit down.

Surely, however, the GDP figures shift the argument in favour of the “don’t cut”, or at least the “don’t cut so fast” school?

As everybody will know, first quarter growth of 0.5% just offset the 0.5% snow-affected fall in the final three months of 2010. The result, according to the headlines, is an economy that for six months has been “stagnant” or “flatlining”.

Ed Balls, the shadow chancellor, timed this stagnation to October, when George Osborne announced his comprehensive spending review, even though that review’s plans did not kick in until April.

Balls, a former student of Summmers, is not completely barking. It is possible there was an “announcement effect” from Osborne’s spending review. After the election, the coalition’s use of bloodcurdling language on the cuts hit confidence. That lesson has been learned. David Cameron has taken to saying that of every £8 to be cut this year, £7 was in Labour’s plans.

David Blanchflower, former monetary policy committee (MPC) member, said the GDP figures were “Osborne’s fault; the economy slowed sharply because of his incompetence”, adding:. “There is no convincing evidence such policies [a fiscal tightening] have ever succeeded in pulling an economy out of a deep recession."

I find myself a bit torn about the GDP figures. Cameron and Osborne deserve some heat for the way they seized on bad news when Labour was in power. I remember their glee when GDP failed to rise, as expected, in the third quarter of 2009.

On the other hand, it is clear the numbers were strange. Anybody who thinks the economy has been “on a plateau” since 2010’s third quarter, as Joe Grice, chief economist at the Office for National Statistics said, is to my mind some way out.

On any rational reading the economy enjoyed a decent bounce in the first quarter, close to 1% growth. Service sector output rose 0.9%, manufacturing by 1.1%. The lion’s share of the economy grew well.

What dragged it down to 0.5%? Despite much milder weather, construction output slumped by 4.7%, bigger than its 2.3% fall in the snow-affected fourth quarter, lopping 0.3% off GDP growth. That milder first three months of the year led to a 3.5% drop in utilities (gas and electricity) output, taking off another 0.1%, while North Sea shutdowns also hit growth.

The construction figures, based on a series that only began last year, were odd. The ONS has risked its reputation on estimates that look as dodgy as Donald Trump’s hairstyle. So concerned is the Construction Products Association (CPA) it has written to the chancellor saying something is “seriously awry” with the figures and that “the implications for policy making of this kind of inaccuracy are extremely significant”.

The inaccuracies do not all go one way - last summer the construction figures looked too strong - but on this occasion fundamentally changed the debate. We should take them with a huge pinch of salt.

So what does the evidence tell us on the great fiscal debate? Even the GDP figures show the economy grew 1.8% over the past year, 2% if you take non-oil GDP. That, you may say, is pretty paltry when we are just heading into the fiscal tightening.

The point is that we have had a significant fiscal tightening, equivalent to 1.5% of GDP in 2010-11 according to the Treasury. It includes the reversal of emergency crisis measures such as the Vat cut, together with the new 20% Vat rate and other hikes.

Growth of 1.8% in the early stages of a recovery and in the context of a 1.5% of GDP fiscal tightening is not bad. It is also in line with previous experience.

Contrary to Blanchflower’s assertion, the last three recoveries have all been associated with significant fiscal tightenings; after the 1976 IMF crisis, Sir Geoffrey Howe’s austerity budget of 1981 and the long upturn after the 1990-92 recession.

Punch and Judy aside, let us just accept that necessary fiscal medicine has the effect of slowing growth but rarely brings it to a halt or throws it into reverse. That has been true before and likely to be true again

My regular column is available to subscribers on www.thesundaytimes.co.uk This is an excerpt.

You can think of Britain's imbalances in several ways. There are the twin deficits. So the current account of the balance of payments was in deficit by £36.2 billion last year, an imbalance between exports and imports.

The other twin, public borrowing, came in nearly £5 billion below official projections for 2010-11, at £141.1 billion. This is still a very big number - the imbalance between government spending and tax revenues - which has to be corrected.

The twin deficits are symptoms of wider imbalances. The first is sectoral. Britain has too small a manufacturing sector and too big, proportionately, a service sector. The second is the imbalance in expenditure. Too large a proportion of gross domestic product is driven by consumer and government spending, not enough by net exports (exports minus imports) and investment.

Few doubt rebalancing is needed. The government’s Plan for Growth, one of many over the years, was published last month. It said: “Sustainable growth requires a rebalancing of the UK economy away from a reliance on a narrow range of sectors and regions, to one built on investment and exports, with strong growth more fairly shared .... Economic growth was unbalanced, with regions other than London and the South East increasingly reliant on jobs funded by public spending.”

The Organisation for Economic Co-operation and Development (OECD), in its latest survey of Britain, had a whole chapter on supporting and rebalancing the economy or, as it put it, “getting back to balance”.

So this is the way to go. Britain’s economy was successfully rebalanced after the recession of the early 1990s. After sterling was devalued after parting company with the European exchange rate mechanism (ERM), the economy enjoyed a strong recovery led by investment and exports. Within a few years both the twin deficits - current account and budget - were eliminated. It was a textbook rebalancing.

Why should it be harder this time? For a start the fiscal deficit is bigger, though the current account gap smaller, as a percentage of GDP. The big reason, however, is that manufacturing may have been allowed to shrink too much.

To quote the growth plan again: “Manufacturing’s share of nominal GDP fell from over 22% in 1990 to 11% in 2009. In terms of jobs, the position was equally stark with the number of employed in manufacturing falling from 5m in 1990 to 2.5m in 2010.”

Though manufacturing has been enjoying a strong recovery, it is easy to forget it suffered much worse than services in the recession. First quarter GDP figures will be published this week - it is anybody’s guess what they will show - but the previous numbers showed this very clearly.

At the end of last year manufacturing output was still 9% below pre-recession levels while services were less than 3% down. For industry, even getting back to where it was pre-crisis will take time.

The problem was brought out in three publications last week from the Bank of England. The Bank’s monetary policy committee (MPC) voted, as expected, 6-3 to leave Bank rate at 0.5%, a vote likely to be repeated this month.

For the six on hold, the worry was “whether weakness in the contemporary indicators of household spending heralded a more protracted weakness in consumption growth”. They feared a rate rise would hit confidence and spending further.

As it turned out, the Bank’s misgivings were not backed up by official data. These showed a 0.2% rise in sales volume last month for a rise of 1.3% on a year earlier. Sales value was up 4.5% on a year earlier, in contrast to the very weak picture painted by the British Retail Consortium.

The sales figures belie the squeeze on household incomes. Though the rise is slow, an upward trend is clear. It takes a lot to stop Britons’ spending.

The point is that the MPC majority was sufficiently worried about the weakness of household spending to believe it still needs nurturing with ultra low interest rates. It is not confident enough about rebalancing to allow weakness in consumer spending. Unbalanced growth is better than none.

Item two from the Bank was the regular report from its regional agents around the country on business conditions. The agents’ summaries, which help inform the MPC’s decisions, were this month supplemented by a special survey on imports.

The agents, curious to find out why imports had stayed so strong, dulling the impact on recovery of net export growth, came up with some gloomy findings.

Such is the structure of the economy, and manufacturing’s relative decline, that firms which import components and other so-called intermediates have continued to do so, despite the fact that sterling’s depreciation has made them more expensive.

This was because, even with the help of a competitive pound, “domestic substitutes were still considered uncompetitive”, “or there simply were no domestic substitutes to switch to”. Add in factors such as the procurement practices of multinationals and the agents’ reports suggest we will wait in vain for the import bill to fall. Nor, looking forward, was this situation to change, even over the next three years, “lack of availability of domestic substitutes being the overriding influence”.

Finally, the Bank gave us its latest Trends in Lending. What bank lending picture would you expect in an economy that was rebalancing? Stronger lending to firms and weaker lending to consumers.

In fact, according to the Bank, the opposite is happening. Lending to firms, particular small and medium-sized ones, is shrinking, while both mortgage lending and consumer credit are picking up.

If that’s rebalancing, I’m a Chinaman. And if I were a Chinaman I would be happy Britain’s appetite for imports is unabated. Rebalancing is a desirable, indeed a necessary, aim. But it is far easier said than done.

My regular column is available to subscribers on www.thesundaytimes.co.uk This is an excerpt.

We used to think of the chancellor’s task as meeting four objectives: a good rate of growth, stable prices, rough balance between exports and imports and low unemployment.

New growth figures are awaited - they will be published on April 27 - but on the other three the news has been much better than expected. At the same time the Office for National Statistics announced a surprise fall in inflation, it also revealed that Britain’s overall trade gap narrowed sharply.

In December, the trade deficit was £5.7 billion, prompting gloom on my part about whether we would ever see the famed export-led recovery. It narrowed to 3.9 billion in January, still large. But in February, the figures just released, it came down to just £2.4 billion. If it continues to improve at that rate, and it is an if, the numbers could start to look very good indeed.

To cap those, the latest labour market statistics showed a strong rise in employment and falling unemployment. Winter is always difficult in the labour market, despite the fact that the statisticians seasonally adjust the figures. Winter 2010-11 might have been very difficult because of the December snows. I said it would be a minor miracle if we got through without a significant unemployment rise.

Well, we did. Employment grew by 143,000 in the December-February period compared with the previous three months, and unemployment, down 17,000, and the unemployment rate, now 7.8%, fell.

The big picture is that the overall unemployment, 2.48m, has been stuck at around the 2.5m mark for the past two years. But this contrasts with predictions of 3m, 3.5m or even 4m from some well-known pundits. In 2010, there were hefty public sector job losses, a total of 132,000, outnumbered three to one by private sector job gains, 428,000 and this pattern is continuing.

Why, then, is unemployment not falling more? Because the workforce is growing, but also because it is being stretched. The greying of the job market continues apace. In the past two years employment in the 65-plus age group has increased by 183,000.

Of course it is not all plain sailing. The unemployment numbers will be buffeted by both good and bad news. Retailers are feeling gloomy and are big employers.

The British Retail Consortium’s latest survey, showing March sales value down a 16-year record 1.9% on a year earlier, was heavily influenced by the timing of Easter and Mother’s Day. But rebalancing the economy away from consumers will mean weaker numbers for some time.

The Ernst & Young Item Club, in its latest report out tomorrow, is not convinced companies are doing enough to replace weaker spending by consumers.
British firms ran a financial surplus equivalent to 5% of gross domestic product last year but are hanging on to their cash. Peter Spencer, Item’s chief economic adviser, says financing conditions are favourable and the last two budgets have been business friendly.

“However, viewed against this background, the corporate response has so far been very cautious,” he says. “Stocks have been rebuilt, but fixed investment is still 28% below the peak seen in the final quarter of 2007.” That will need to change.
I have left the really game-changing bit of news until last. This was, of course, last month’s drop in consumer price inflation from 4.4% to 4% which, at a stroke, knocked out talk of a May Bank rate hike.

You might argue that, in the light of the inflation fall, raising rates next month would be a smart thing for the Bank to do. It would show the markets it meant business about meeting the inflation target, that it was not a prisoner of the latest numbers and that it was ahead of the game.

With some in the City saying inflation will rise again to 5%, the window of opportunity may not arise again. I suspect, though, the Bank will wait and wsay there are good reasons for doing so..

My old friend Andrew Sentance, for whom May will be his last monetary policy committee (MPC) meeting, would thus leave with his desire for a rate hike unrequited. Having met the immovable object of Mervyn King, who is as opposed to a hike as ever, he is probably reconciled to that.

Sentance’s MPC replacement is Ben Broadbent, who joins from Goldman Sachs. This makes a piece of research from Goldman, done since his departure from the firm, rather interesting. Inflation, it says, is close to a peak, and in a year’s time will be just 1.5%, before settling back at 2%.

Most of that is a mechanical effect - weaker commodity prices and January’s Vat hike dropping out of the 12-month comparison - rather than a consequence of higher interest rates. Though some see the pass-through into higher inflation from higher oil and commodity prices going a lot further, it makes you think.

The inflation figures were the first to surprise on the downside for a very long time and provided tentative evidence that weak domestic demand is bearing down on prices. The MPC will want to wait longer - the markets now think October for the first hike according to ICAP’s Don Smith - to see whether these effects develop further.

That will come as a relief to many. On Thursday I took part in the “great housing debate” organised by the Wriglesworth Consultancy. I will write a larger piece on housing shortly but the general view was that the market needs a rate hike like the proverbial hole in the head.

That is also easily the majority view among businesses about the effect of higher rates on them. The role of a central bank is to balance such opposition, which is not unusual, with other factors. For the time being, however, it looks as if the Bank will hold off until closer to the point next year when falling inflation eases the squeeze on household incomes.

Why should it hike at all if inflation is falling? Because it cannot retain its emergency settings indefinitely and because it is dangerous to leave real rates too low for too long. More on that another day.

My regular column is available to subscribers on www.thesundaytimes.co.uk This is an excerpt.

The amount of slack in the economy, the output gap, matters hugely. It matters for fiscal policy, and the government’s efforts to reduce the budget deficit.

If the economy is operating well below capacity it is fair to assume that the budget deficit we have now, projected by the Office for Budget Responsibility to be £122 billion or 7.9% of gross domestic product for the coming 2011-12 fiscal year, is significantly influenced by the economic cycle.

Take away these cyclical effects and the deficit is still there, at just over 5% of GDP, but looks more manageable. The difference between the two numbers reflects the OBR’s estimate of the output gap.

If the official forecaster thought there was no spare capacity, the spending cuts and tax hikes George Osborne would need to meet its aim of eliminating the deficit would be that much larger. Fiscal policy is couched in terms of the “structural”, or cyclically-adjusted deficit.

This is not always well understood. Thanks to my new status as a tweeter (dsmitheconomics), I am privy to some interesting exchanges. One, last Thursday, was between Peter Hain, the shadow Welsh secretary, and Evan Davis, the BBC Today programme presenter.

After Davis interviewed Ed Miliband, Hain said he was too hard on the Labour leader and “a growth denier”. Davis and the rest of the media refused to accept that more growth would mean less need for spending cuts and tax hikes, Hain said.

You would expect me to come to Davis’s defence. He is, after all, a former member of the economics editors’ club. But I would anyway. Hain’s attack shows a common misunderstanding. If you have a structural budget deficit - one that exists even if you adjust for the economic cycle - a burst of more rapid growth does not make it go away. The only growth that matters is the long-term or trend rate of growth.

That, as discussed in my comments on the budget, takes years to shift. Cutting the deficit more slowly does not raise it. We could do with higher trend growth; the OBR estimates it to be 2.35% up to the end of 2013 and just 2.1% thereafter.

George Osborne has come up with a few ideas about lifting it, though they need fleshing out, while Labour has yet to venture into this territory. Trend growth and the output gap together give us what matters, which is the size of the structural deficit.

This does not just matter for fiscal policy. When it comes to monetary policy, the most powerful argument at the Bank of England for not responding to the surge in inflation to 4.4% is the expectation it will drop because of the amount of slack in the economy. Having a large output gap is crucial to the Bank’s story, as set out in it last inflation report. that “downward pressure from spare capacity” will bear down on price rises.

So fiscal and monetary policy and the reputations of Osborne and Mervyn King rely on the output gap. Unfortunately, it is something of a will of the wisp; hard to spot and difficult to measure.

The OBR, while guessing at spare capacity of about 3% of GDP, has been quick to issue health warnings. Estimating the output gap, it says, “is difficult because we cannot observe the supply potential of the economy directly so as to compare it to the actual level of GDP”.

It notes estimates of the gap vary widely. At one extreme you could argue that spare capacity left over from recession is worse than useless, because it exists to meet a pattern of demand that will never return.

Take the housing market, which for the foreseeable future will be operating at half activity levels that existed before the crisis, so spare capacity in estate agents, mortgage brokers and other parts of the industry is irrelevant.

At the other extreme, some would argue there is at least as much spare capacity as the drop in GDP (6.4%) that occurred in the recession. The OBR goes for something in the middle, not by guessing but by monitoring over 30 different indicators, from business surveys and official statistics.

The Bank also thinks there is significant spare capacity but appears to be becoming less sure of its ground. In its most recent inflation report it was confident that there was plenty of slack in the labour market but warned that “it was difficult to judge the extent of spare capacity in businesses”.

So, quite a lot rests on a hard-to-see, difficult-to-measure concept. It seems to me quite likely that there is spare capacity in the economy, as there always is after recessions. How big it is, and whether it is big enough to bear down on inflation as the Bank hopes, is another matter.

The question, for the Bank and other Western central banks, is whether the spare capacity that exists in their economies is big enough to offset the inflationary effects of strong growth in emerging economies like China and India, which may already be bumping up against capacity limits.

It may be the nature of the global recovery, driven by commodity-hungry emerging economies. But, as Andrew Sentance, the Bank’s arch-hawk has pointed out, the relationship between global inflationary pressures and the world’s output gap - appears weaker than it was even as recently as the first part of the 2000s.

How will we know? Only by watching what happens. If pricing pressures persist and are reflected in higher wage settlements, meaning higher inflation persists. Or, on the fiscal side, if the budget deficit stays high in later years, despite recovery It all depends on the output gap. And we can’t be sure how big it is.

My regular piece is available to subscribers on www.thesundaytimes.co.uk - this is an excerpt.

Wednesday's budget was, in macro-fiscal terms, a non-event, as suggested last week. None of us would mind a net giveaway of £10m individually. Spread across the population, it doesn’t count as small change, given tax revenues for the coming year of £589 billion and public spending of £710 billion.

We are, of course, in between two big tax hikes, January’s Vat rise and April’s national insurance increase. The biggest public spending cuts in decades kick off in earnest next month. The budget provided a peg for a renewed focus on that squeeze.

One of the themes underlining that squeeze is that government has to get more for less. So Osborne set a pretty good example by getting quite a lot for nothing.

Cutting fuel duty by getting North Sea firms to pay was politically astute, even if oil companies are left ruing Britain’s unstable tax regime once again. The chancellor’s version of the fair fuel stabiliser will probably be unworkable. I can’t think of another tax which specifies a price, in this case oil at $75 a barrel, to trigger changes. But there will be time to fix that.

In tone and content, business had much to be happy about. Accelerating the reduction in corporation tax to a new target of 23% when voters are facing a huge fiscal squeeze was politically brave and judging by the limited criticism, well-judged.

Last week I said we needed a signal that the 50% income tax rate would not last and we got it, together with an HMRC (Her Majesty’s Revenue & Customs) review of whether it brings in any net revenue. Such a review is good, though I’m not sure HMRC is the body to do it.

The budget was neutral in fiscal terms. What about growth? Labour had some knockabout fun with a budget that set out a plan for growth while at the same time downgrading the official growth forecast.

It was clear when they were published those poor weather-affected fourth quarter gross domestic product figures were inconvenient. They cast a very long shadow.

Most people, sensibly, do not spend their time deconstructing gross domestic numbers. If they did, they would know that a very weak fourth quarter of 2010 has the effect of undermining the growth number in 2011. So the OBR’s new forecast for this year went down from 2.1% to 1.7%.

What is much more difficult to explain is that the OBR also revised up its prediction of growth through the year - GDP at the end of 2011 compared with the start - because of its prediction of a strong 0.8% bounce this current quarter. Incidentally, the OBR does not believe that the economy ground to a halt at the end of 2010 even leaving aside the snow, though it accepts it slowed to just a 0.2% quarterly expansion.

Growth is the key, now and in future. The OBR predicts 2.5% growth next year and 2.9% in both 2013 and 2014. This is not implausible in relation to past recoveries, but an early forecast downgrade, even for explicable reasons, means the new body has to work building credibility.

There are plenty of threats, most of which the economy can see off. The unexpected one, for the Bank of England and the Treasury, is inflation. Higher than expected inflation was responsible for disappointing new OBR projections for the budget deficit. This year’s net borrowing figure of £145.9 billion, is only £2.6 billion below its previous forecast, against City expectations of a bigger undershoot.

For 2011-12 and beyond, the official forecasts are for persistent overshoots, starting with £4 billion (and a borrowing total of £122 billion) for the coming year and averaging annual £10-11 billion overshoots from 2012, as result of the impact of higher inflation on benefit upratings, public sector pensions and debt interest. Infglation also, as the Institute for Fiscal Studies noted. makes the real cuts in public spending deeper, assuming the government sticks to its cash plans.

This matters. The way Osborne has framed his rather curious fiscal rules should, in theory, be immune to growth coming in slower. He is targeting the cyclically-adjusted budget deficit.

In practice, as the ratings agency Moody pointed out, these things are connected. If slower growth were to force the government to slow the pace of deficit reduction, this “could cause the UK’s debt metrics to deteriorate to a point that would be inconsistent with a AAA rating,” it warned.

The dangers of inflation eating into growth are real. The OBR does not expect average earnings to be rising faster than inflation until 2013. It is assuming Bank rate will start to creep up later this year and average 1.8% in 2012 and 2.8% in 2013.

But it also sets out an alternative “persistent inflation” scenario in which inflation does not fall much next year and averages over 4% in 2012 and 2013 (roughly 6% on the retail prices index). Average earnings respond, and so does Bank rate, pushing up to more than 6% in 2013.

This would be pretty disastrous. The government, when it embarked on its aggressive deficit-cutting programme, expected this to be the squeeze, offset by ultra-low interest rates. High inflation is providing an equally powerful squeeze. For the Treasury - and the Bank - fingers will be resolutely crossed for a sharp drop in inflation next year as Vat and other factors drop out. If not, Osborne’s third budget will be a lot less comfortable than his second.

My regular piece is available to subscribers on www.thesundaytimes.co.uk - this is an excerpt.

George Osborne's second budget, on Wednesday, is likely to be something of a non-event in macroeconomic terms. The emergency budget in June last year set the tax course for 2-3 years, if not the parliament, while October’s comprehensive spending review did that on the public expenditure side.

Though the public finances have improved, and should undershoot the Office for Budget Responsibility’s predictions for 2010-11, there is no room for any significant giveaway beyond fuel duty.

So attention will be on what some officials call the chancellor’s “big bang”, the growth review originally planned for last autumn to be published this week. The fiscal squeeze will impact on the demand side of the economy; the aim of the growth review is to boost the supply side.

You could be forgiven a sense of deja vu. Every government has a growth strategy. John Major’s used to publish a competitiveness white paper each year. Gordon Brown had his productivity agenda.

There are two things about supply-side reforms. One is that their effects take time. The Thatcher labour market reforms of the 1980s did not really bear fruit until the 1990s. They do not offer a quick fix.

The other is that there are few new ideas under the sun, hence Osborne’s decision to give the 30-year old enterprise zone idea another outing. Supply-side reforms mean improving education, skills and training; cutting red tape; easing planning constraints; fostering investment and innovation, and improving infrastructure. Crack those and you have a growth strategy.

There will be a lot of that this week. The chancellor is preparing for a partial u-turn on planning. Housebuilders have been vocal condemning the Tory localist planning agenda as a Nimby (not in my back yard) charter, which will hit already extremely low housebuilding. The industry will welcome this but also say it needs improved mortgage availability.

The Organisation for Economic Co-operation and Development (OECD) was in London last week, celebrating its 50th anniversary. Its survey of Britain urged a shake-up of property taxes - replace stamp duty and council tax with one tax on property value - and only a gradual rise in interest rates from mid-year. It also said, within a fiscal tightening it supports, the government has to ensure the tax system remains competitive.

This is happening for corporation tax, which is on course to be cut to 24%, from the 28% the coalition inherited. It is not happening, as yet, for income tax. And if there is one thing that Osborne could do to persuade business, particularly internationally mobile larger firms, that it is serious about fostering enterprise, it would be to signal his intent to get rid of the 50% top rate of income tax.

The 50% tax on incomes above £150,000, coupled with the withdrawal of the personal tax allowance above £100,000, were the poison pills left by Labour. If you make a lot of money in Britain, you will be hit with a marginal tax rate of 52% (including National Insurance). The government will take more than half of every extra £1 but, thanks to the deterrent effects of the tax on mobile workers, raise little extra revenue.

Removing the personal allowance gives a marginal tax rate from next month of 62% on incomes from £100,000 to nearly £115,000. Not only is this very messy but it destroys incentives. The Institute of Directors last week called for both to be abolished, with a target of 2014-15 for getting rid of the 50% top rate. Sir Richard Lambert, no right-wing firebrand, used his last speech as CBI director-general to urge the government to signal the eventual abolition of the 50% top rate.

The politics of this are, of course, pretty awful. The budget is sandwiched between January’s Vat increase and next months 1% NI rise. Labour’s two Eds, Balls and Miliband, are calling for a re-run of the one-off windfall tax on bankers’ bonuses and Balls would start the 50% rate at £100,000, not abolish it. Any pledge to abolish it would be castigated as helping bankers and the very rich, while everybody else suffers. The Liberal Democrats would hate it.

Sometimes, however, politicians have to be brave. The Tories lost out on tax in the coalition deal, being forced into a hike in capital gains tax and having to abandon their planned cut in inheritance tax.

We have had tax pledges before, notably the one to cut the basic rate of income tax to 25% in the 1980s. This government has such a pledge, aimed at those on lower incomes, of raising the personal tax alllowance to £10,000.

It is too much to ask that Osborne names a date for abolishing the 50% rate. That would offer too many hostages too fortune. It is not too much to ask that he sets a direction of travel, saying that he intends to get rid of Labour’s politically-motivated tax hike during his tenure as chancellor. Business needs a signal, a light at the end of the tunnel. Otherwise the growth strategy will fall on stony ground.

My regular piece is available to subscribers on www.thesundaytimes.co.uk - this is an excerpt.

Though it seems motorway service stations are no longer obliged to post their prices on the carriageway, other service stations do. Petrol is the most visible price in the economy. It is also the classic reluctant purchase. Who spends £80 filling up the car without thinking they would rather spend the money on something else?

For road hauliers and others in the transport sector, it is more than just painful. Britain alrfeady has t he highest duty level on diesel in the EU, and more than double the rate in some countries.

There is no easy answer. Fuel duties are an important part of the government’s fiscal reduction plans, with revenues from them predicted by the Office for Budget Responsibility (OBR) to rise from £26.2 billion in 2009-10 to £35 billion in 2015-16.

Merely cancelling next month’s planned 4-5p (duty plus Vat) increase will cost serious money, more than £1.5 billion according to the Institute for Fiscal Studies. Whether you get much political bang for such an expensive buck - cancelling a planned rise is not the same as a cut - is another matter.

That is why Treasury officials are beavering away on a “fair fuel stabiliser”, varying fuel duty according to the level of global oil prices to produce more stable prices at the pump.

This, as you may recall, was the Conservative policy in opposition - the government could do this in a fiscally neutral way, it was argued, because the public finances benefit from higher oil prices. But it was apparently condemned to death by a damning assessment from its own OBR. The OBR said a £10 rise in oil prices would produce a small net revenue gain, £100m in the first year, but a revenue loss of £700m in the second, as higher prices reduce non-oil profits and the corporate tax take.

The Treasury, however, is pressing on, taking on board the OBR’s analysis. The aim is to present a fair fuel stabiliser that does not pretend to be fiscally neutral in one or two years, but over the course of a parliament as world oil prices rise or fall.

Clearly the chancellor will not want to come up with anything the OBR rejects. But the fiscal watchdog would be failing in its duty if it does not point out the risks. If oil prices were to continue to rise, even when a measure of political calm returns to the oil-producing countries, the government would need to find other sources of revenue to replace the lost duty.

Even if oil prices fall, and they could if China is serious about targeting lower growth (7% rather than 10%) over the next five years, there would be the political challenge of raising duties when world oil prices are falling. But it seems we will get such a stabiliser on March 23.

All this presupposes that Britain is still on track for a recovery, admittedly an unspectacular one, and a falling budget deficit. What if the economy is blown off course by higher oil prices?

As I noted at the start, oil has been associated with difficult times in the past. There are even some out there who believe the recent great recession was caused, not by the financial crisis and the collapse of Lehman Brothers but the run-up in oil prices to $147 a barrel in summer 2008.

Let me try to cut through some of the myths. When oil supplies are cut off, as in the Opec (Organisation of Petroleum Exporting Countries) embargo in autumn 1973, the effects on the world econokmy are indeed recessionary.

Advanced countries depend less on oil than they used to but emerging economies are driving the global economy and they are as oil-dependent (because they have proportionately larger industrial sectors) as we were four decades ago. So the loss of, say, a significant chunk of Saudi production and an oil price of $250 a barrel would kill what has been a strong global recovery.

The effects of lower-level hikes in oil prices are less clear. Though global and British recessions have been associated with higher oil prices, cause and effect are another matter.

Britain’s last but one recession, which started in mid-1990, came before the big Gulf war affected rise in oil prices. High oil prices in the run-up to the recent great recession meant some central banks, including the Bank, were slower to cut interest rates than they should have been, but did not cause the recession.

Going back further, Britain’s recession of the early 1980s, and America’s 1982 recession, were caused by tight monetary policy, 17% interest rates in Britain, 18% in America, not high oil prices. This is the key lesson of past oil episodes.

Oil prices are tricky for monetary policymakers. Their short-term effect is inflationary but their long-term effect is deflationary. Most recessionary effects of high oil prices were when rates were raised too much in response to the initial inflationary shock, with not enough attention paid to subsequent deflationary effects.

Central banks appear determined to avoid doing this on this occasion. The Bank of England left rates unchanged last week, as expected. Rates will go up but in a softly-softly way, more of an easing off the accelerator than a slamming on of the brakes.

That should mean the world and Britain can grow through this mini oil shock. Barring, of course, very much higher prices, serious supply dislocation and panicked central bankers.

My regular piece is available to subscribers on www.thesundaytimes.co.uk. This is an excerpt.

Three members of the Bank of England’s monetary policy committee (MPC) and now six members of the Institute of Economic Affairs’ shadow MPC favour an immediate rate hike. Eventually they will get it, though it would be a surprise if it happens this week. The ECB, for its part, looks ready to hike in April, so a May hike from the Bank would not be out on a limb.

So I don’t want to dwell on this week’s MPC decision. I’ll repeat, because some people have great difficulty understanding this very simple point, the Bank was not powerless to prevent inflation rising above the 2% target. This despite the main upward influences on the price level being international and fiscal (the Vat rise).

The Bank had the choice of offsetting these pressures by imposing downward pressures on other prices by hiking interest rates. It decided not to, sensibly, because the pain would have been too great.

As Charlie Bean, deputy governor, put it last week: “When there are adverse cost shocks: inflation can be stabilised, but only at the cost of volatility in output. Or, as Mervyn King put it more directly recently, “only a much deeper recession” would have stopped inflation overshooting.

The powerlessness argument is economic illiteracy but that does not mean there is no good case against rate hikes.

The strongest of these focuses on the household sector, the “squeezed middle” beloved of the politicians. If I were very poor, or for that matter very rich, I would take umbrage at my squeeze not being acknowledged. But like “hard-working families”, or for that matter the Big Society, politicians cannot resist these labels.

The squeeze is real. Though pay rises are accelerating - Incomes Data Services says median pay awards in the three months to January were 2.8%, up from 2.2% - they remain well below inflation.

People face an array of tax hikes and benefit cuts next month, some of which will come to them out of the blue. They include the 1% rise in employee National Insurance, equivalent to an income tax hike, bequeathed by Alistair Darling; a drop in the 40% higher rate threshold from £43,875 to £42,475; a freeze on child benefit and cuts in child tax credits and childcare support.

Alcohol duties will be increased by 2% more than inflation, while the new 1% fuel duty escalator is also due to kick in (though will surely be scrapped by George Osborne). Benefits and public sector pensions will be raised in line with the consumer prices index rather than retail prices index. Benefits are being squeezed in many other areas and, at the other end of the scale, the inheritance tax threshold is being frozen and stamp duty up to 5% on £1m-plus houses.

The impact of other public spending cuts is harder to quantify but will be real, particularly for households and regions most dependent on the public sector.

So what justification is there for adding to the queeze from rising prices and higher taxes by raising interest rates? Would not that tip many families over the edge, risking a dive back into recession and, by triggering a wave of repossessions and bad debts, create new problems for the banks?

The first thing to say is that most people in Britain do not have a mortgage, or any significant debt at all. There are just over 26m households in the UK, and 10m mortgages, less than 40% of the total.

A rise in interest rates benefits savers while hurting mortgage borrowers - and as every chancellor will attest from their mailbags, there are more savers than borrowers in the economy as a whole.

This is not to say the economic impact of higher rates is neutral. Typically borrowers spend a higher proportion of income than savers. While savers have absorbed their loss of income from a record low Bank rate , without apparently suffering huge distress - in some cases taking Bean’s advice and eating into capital - many borrowers would have found themselves in trouble had the Bank not cut rates so aggressively.

But how much distress would borrowing households face now? The Financial Services Authority, enjoying its swansong period, last week published its Retail Conduct Risk Outlook for 2011.

While there had been some reduction in debt levels, it warned that “many households continue to carry high levels of debt, which may leave them vulnerable to future income shocks - either as a result of unemployment, or rising interest payments”.

The Bank’s aggressive cuts in interest rates created a £20 billion transfer from savers to borrowers, according to FSA calculations, with the lion’s share of that transfer going to those who borrowed heavily - 90% or more of property value - and were lucky enough to take out a Bank rate tracker mortgage before the crisis.

Some of them will be highly vulnerable to higher rates but those who could should have taken action to protect themselves against the inevitable post-crisis rise in rates. There is a moral as well as an economic question about whether savers should permanently suffer to make life comfortable for big borrowers.

The FSA warned that continued very low rates could also be risky. One risk is that even the highly indebted will be tempted to take on more debt. Another is that savers, in the search for return, will be drawn into risky investments.

There are two other points to make. One is that the rise in Bank rate, when it comes, will be a lot gentler than the fall. A quarter-point every three months is what I would expect. I would question how many households cannot cope with that.

Second, I would expect rate hikes to have consequences for bank margins. Households and businesses pay well above 0.5% Bank rate. Credit card rates are close to 20%. There will be scope for these margins to narrow, and they should do so.

For households, and the wider economy, things would be a lot more comfortable if any rate hikes could be delayed until 2012, when, if the Bank is right in its inflation projections, the squeeze on real incomes ease. I doubt, however, if the Bank will have the luxury of waiting that long.

My regular piece is available to subscribers on www.thesundaytimes.co.uk. This is an excerpt.

Britain has the kind of inflation rates that were typical in the 1980s but a very different earnings environment. Then, earnings growth never dropped below 7.5% because wage bargainers never believed low inflation was here to stay. Now, we have earnings growth suited to a world of negligible inflation but not the inflation to match.

There are, however, positive sides to current pay weakness. Wage restraint — including pay freezes and cuts — was important in preventing a bigger fall in employment and a bigger rise in unemployment during the recession.

It remains important now. Whenever the labour-market numbers are published, as last week, it is easy to get lost in the statistical fog. The big picture is this. Unemployment, broadly measured on the Labour Force Survey, is 2.49m, where it has been for the past 18 months.

If this sounds like a stagnant job market, that would be misleading. For unemployment to fall, the number of new jobs has to exceed the growth in the workforce. Over the past year employment has grown by 218,000. It remains below pre-recession levels but is almost 300,000 above its recession lows.

While the latest figures suggested employment dipped towards the end of last year, they also showed a 66,000 rise in the number of full-time employees. Hours worked, an important indicator of labour-market strength, rose in the October to December period, as they had done for the previous three quarters.

A lot of this is down to what has happened to pay. Wage restraint has enabled the labour market to share out jobs among a larger number of people than would be the norm in recession and early recovery in Britain. It is the other side of the pay squeeze coin.

So is the fact that, had pay rises kept up with inflation, we would be looking at a very different monetary policy picture. If earnings growth were 7.5% now, as in the 1980s, or even 5%, the Bank monetary policy committee (MPC) would not be debating whether to raise Bank rate from its historic low of 0.5%. The rate would already be well on the way up.

As an aside, I must comment on what I think is the biggest outbreak of economic misunderstanding in a long time. You see it in letters columns, in commentary and elsewhere. It is that, because the factors pushing up inflation appear to be outside the Bank's control, such as Vat and commodity prices, raising interest rates would have no effect.

In really wince-making versions, people argue that raising rates would hit growth but leave inflation unaffected. Let us be clear. Whether the source of a sustained inflation overshoot is chancellor George Osborne, China or sunspots, the Bank could bring it down by raising rates.

It would do so by squeezing domestic inflation, perhaps even by generating deflation — falling prices — to offset these other factors. How would it do this? The easiest way to think of it is that a rise in interest rates would intensify the squeeze on household incomes, reducing demand and thus forcing firms to cut their prices by accepting lower profit margins. It would hurt, but it would work.

The MPC has decided collectively not to do this, accepting an inflation overshoot because the alternative of keeping inflation at 2% would inflict too much pain on the economy. That is its choice, and many would say it is the right one. But that is very different from interest-rate impotence. The Bank, which is keen on its educational role, still has work to do. The governor did not help last week by describing a token rise in rates as "a futile gesture".

The other route, described by MPC hawk Andrew Sentance in a speech last week, is through sterling. If you are worried about soaring global prices, one way to limit their effect on inflation in Britain is to push the pound higher, and an easy way of doing that is through raising interest rates.

What happens to pay and the income squeeze from now on? Evidence is starting to build of modestly higher pay settlements. XpertHR, the old Industrial Relations Services, reported that while median pay settlements remained at 2% in the three months to January, the median for those in the top 25% rose from 2.3% to 3%, and nearly 70% of settlements were higher than last time.

Sentance, in his speech, pulled out a string of chunky-looking pay settlements, including JCB and Cummins Engine Company at 4.7% and Heinz at 3.9%. My sense, however, is that pay settlements are creeping rather than surging higher.

If it continues that way, there are reasons to be optimistic. Pay will not grow fast enough to hit private-sector employment growth, or scare the Bank too badly. Thus, while we can expect Bank rate to rise this year, beginning in a few months, it can happen in a controlled and gradual way.

Importantly, as far as the income squeeze is concerned, there is light at the end of the tunnel. The National Institute of Economic and Social Research predicts that real disposable incomes will fall by 0.8% this year, after dropping 1% in 2010. But in 2012 it sees a rise of 2%.

How? The Bank expects inflation to fall significantly from early next year, as some of this year's one-off factors such as the Vat hike drop out.

Falling inflation should cross over with gently rising pay settlements, at least in the private sector, to produce the return of rising real pay. In this Micawberite economy, misery will be replaced by happiness. As long as people are patient.

My regular piece is available to subscribers on www.thesundaytimes.co.uk. This is an excerpt.

Every month I look for the promised improvement in Britain’s trade performance on the back of a super-competitive pound, which is 24% below pre-crisis levels. And each time I am disappointed.

Last week was a particular disappointment. It brought the release of official trade statistics for December and the whole of 2010. In December, Britain ran a trade deficit in goods and services of £4.8 billion and a deficit in goods alone of £9.2 billion. The former has rarely been bigger. The latter has never been larger.

There is some evidence that December’s trade, as with other things, was adversely affected by the weather. There was an echo of 1970, and Harold Wilson’s surprise election defeat then, in that the deficit was also swelled by a jump in aircraft imports.

The underlying picture, however, is also pretty awful. For 2010 as a whole the deficit on goods and services was £46.2 billion, up from £29.7 billion in 2009. The deficit on goods alone was £97.2 billion, up from £82.4 billion. Both were annual records.

After improving in 2009, Britain’s trade position took a decided turn for the worse last year. The great rebalancing of the economy, sustained export-led growth on the back of a low pound, is not happening.

Before the Bank of England’s decision to keep interest rates on hold on Thursday, which was widely expected despite growing pressures on the monetary policy committee (MPC) to act, some business groups warned against a rate hike that would push sterling higher.

So far, however, the economy appears to be getting all the pain from a weak pound with higher import prices and chronically above-target inflation, and none of the gain in terms of export-led growth.

You may be a bit puzzled by this. After all, almost every survey suggests that Britain’s exporters are having a bumper time, with order books booming.

That, indeed, is what the official figures confirm. In the past year, despite those disappointing trade balances, Britain’s exports of goods and services have risen more than 10%. Exports of goods alone are up 17%, driving the manufacturing revival.

There are two sides to the trade balance, and I will come on to imports in a moment. Even Britain’s export performance, however, is not quite as special as it looks. After world trade collapsed in 2008-9, its revival has been impressive. A 2009 world trade fall of around 12% was followed by a 12%-13% rise last year.

Many countries exporters’ have done well in this context. Germany’s exports rose by 18.5% during last year; Greece’s increased by nearly 22%.

Nor does Britain’s manufacturing performance, driven by exports, stand out from the pack. Far from it. Its 4.4% growth over the latest 12 months compares with 7% in France and 10% in Germany. Neither had the benefit of Britain’s big devaluation. Sterling is not proving to be the hoped-for elixir for exporters.

On its own, the performance of Britain’s exporters would be enough to generate export-led growth. The trouble is, Britain’s importers have also been working overtime. So the growth rate of all imports over the past year has been 14.5%, and the growth of goods imports alone, 18.5%.

It may be an obvious point but it is impossible to have true export-led growth if that growth is matched, or as it has been exceeded, by the rise in imports. What matters as far as economic growth is concerned are net exports (exports minus imports). Until next exports are rising, there can be no export-led growth.

Why are imports so strong? A traditional piece of economic analysis is the J-curve. The effect of a devaluation is to leave the sterling price of exports unaffected but raise the price of imports. We have to pay more to import a given amount. Only later do trade patterns shift and, because goods made in Britain have become more competitive and goods made elsewhere less so, the net trade position improve.

It is possible, therefore, that - starting on the left-hand side of the “J” - we are still in the deteriorating phase but improvement is on the way. Sterling’s fall mainly occurred, however, during the the latter part of 2007 and all of 2008. Surely by now we should be in the improvement phase?

The other argument is that the sharp rise in global commodity prices, from 2009 onwards, has had the effect of elongating the J-curve and producing a sharper shift into deficit. Mervyn King pointed out recently that since 2007 sterling oil prices have risen by 110% and gas prices by 130%.

These are all important caveats. The bottom line, however, is that sterling’s fall has done little to dull our appetite for German cars or Korean televisions. Imports of manufactures grew faster than exports last year.

We should not give up on the export-led growth strategy. Vince Cable, the business secretary, chose a good day to bury good news last week, the day the trade figures were released the Project Merlin announcement on the banks.

His trade and investment white paper offered more export support to small and medium-sized firms, increased the emphasis of UK Trade & Investment, the official body, on emerging market economies, and called on Europe to de-regulate to improve access to the single market for smaller exporters.

These are the kind of things that will matter over the medium and long-term, as will the quality and desirability of British exports.

None of it will be to any avail unless, however, we can also curb our enthusiasm for imports. Weaker consumer spending will help in the short-term, as happened in 2009. In the long-term, we have to make more of the things here that, for a variety of reasons, we import from abroad.

We probably knew devaluation was no magic bullet and carries important disadvantages in return for only minor advantages. We have discovered it again.

My regular column is available to subscribers on www.the sundaytimes.co.uk. This is an excerpt.

After all the uncertainty generated by those fourth quarter gross domestic products figures, followed by stronger survey data for January, who could vote for an immediate hike in Bank rate?

Well, step forward for a start the “shadow” monetary policy committee (MPC), which meets under the auspices of the Institute of Economic Affairs. Its latest vote, ahead of the actual MPC’s vote this Thursday, is 5-4 in favour of an immediate Bank rate hike to 1%.

The five hikers, Philip Booth, Kent Matthews, Patrick Minford, my near-namesake David B. Smith and Peter Warburton, who have pushed the shadow MPC to its first decision to hike for three and a half years, are worried on several fronts.

They think continued above-target inflation is badly damaging the Bank’s credibility, that rapid growth in the world economy will continue to impact on prices in Britain and that, as pointed out here last week, the pound cannot be regarded as independent of monetary policy.

Sterling’s weakness in the past three years, in other words, at least partly reflects the Bank’s stance. That weakness has been a big factor pushing up inflation.

Interestingly, given Mervyn King has cited it as a reason not to raise rates, the majority on the predominantly monetarist shadow MPC does not believe weak money supply growth is a good enough reason to hold back from hiking rates.

Shadows are just shadows. What matters is what the actual MPC does. We know, barring an economic avalanche, Andrew Sentance will vote to hike, as he has done since June. His colleague Martin Weale voted to raise last month but says he will take stock of the GDP evidence before deciding in a “pragmatic” way whether, as seems likely, to stick to his guns.

What would it take to swing the whole MPC over to a hike? Some people appear to think it should never do it. I was astonished to read a letter in the Financial Times from two economics professors concluding “it is clear that raising interest rates has no role to play in bringing down inflation”.

There may be times when the interest rate weapon is blunted but to argue that changing interest rates has no effect on inflation is extraordinary and against the overwhelming body of evidence.

As for the MPC, for those who need a refresher, there are four “external” members, people appointed from outside, though while on the committee they work three days a week at the Bank.

Sentance and Weale are external members. So is Adam Posen, who looks to be in the opposite camp on rates, favouring more quantitative easing. David Miles, the other “external”, has so far not shown any inclination to join the hikers.

As is clear, no hike in rates can happen without the support of some of the Bank’s five “internal” members, full-time Bank employees, who make up the majority on the MPC. They are the governor, his two deputies Charlie Bean and Paul Tucker, Spencer Dale, chief economist, and Paul Fisher, executive director for markets.

Unless I have misinterpreted King’s speech - in Newcastle, not the film - he will not be in the hiking camp for a long time. Will any “internals” vote against him?

It has happened before, most famously in August 2005, when Bean voted with the four externals, and thus against his Bank colleagues, to cut. Bean has now warned that persistently high commodity prices could force the Bank to act to cut domestically-generated inflation to compensate.

More recently Dale voted for less quantitative easing than the rest of the MPC, including King, wanted. The internal members can vote against the governor without the Old Lady losing their dignity.

Will they this week? There is a point when the Bank runs out of excuses. MPC members said they would worry if higher inflation was reflected in inflation expectations. That has happened. They said they would worry if pay settlements moved higher. That is tentatively happening, with Incomes Data Services reporting provisional median settlements of 2.6% last month, up from 2.2% in December.

There comes a point when, as King noted in that speech, the effect of rising prices is to squeeze incomes and hit growth. You then have to ask whether the effects on growth of a modest rise in interest rates are worse than those of tolerating persistently high inflation.

Markets have started to anticipate higher rates, discounting a rise to 1.25% by the end of the year. Gilts (government bonds), whose performance since the May election has been encouraging, have started to suffer on inflation worries. The kind of rise in gilt yields we have seen recently often presages a hike in Bank rate.

But this week? Anything could happen. In January the Bank’s minutes noted that several of the members who voted to hold saw it as “finely-balanced”. February, with a new inflation forecast, would allow a more thorough analysis of the risks.

It still looks a little early to me for the majority to swing, and it would bring down a torrent of criticism on the Bank’s ahead. But if not this week then May, when the Bank will have the benefit of first quarter GDP figures as well as other data, is beginning to look like a racing certainty.

Before last week, economists thought a small increase in gross domestic product (GDP) for the fourth quarter of last year would be pretty bad news, opening the way to the danger of quarterly falls - the dreaded double-dip - during 2011.

Nobody expected a fall but that, as everybody knows, is what we got. GDP fell 0.5% and, while the fall was due to December’s bad weather, even without it the picture would only have been “flattish”.

Growth, in other words, petered out, even before the January Vat hike, April’s National Insurance increase and the coming big cuts. The statistician in charge of the numbers at Newport, Harry Duff, appears to have duffed up the recovery.

It would be easy to put these GDP figures into the file marked “Office of Nonsensical Statistics”. The reason nobody expected a fall in the fourth quarter was because business surveys, normally quite reliable, did not give any hint of it.

In a report for the monetary policy committee (MPC) earlier this month, the Bank of England’s 12 agents, its eyes and ears in the regions, noted the impact of the December snows on household spending but said non-consumer services and manufacturing were still growing. Treasury data showed tax revenues recovering well even as the nation was snowbound.

The National Institute of Economic and Social Research, which has built a reputation anticipating the official GDP figures using similar information to that available to the statisticians, predicted a 0.5% fourth quarter rise, not a fall. This was one reason why Martin Weale, its former director, now a member of the MPC, voted to hike interest rates earlier this month.

We know, as the ONS pointed out, that last week’s first draft of economic history will be revised over and over again in the coming months and years. The picture will change, for better - and it is usually for better - and sometimes for worse.

Let me, however, come to the defence of the statisticians this time. The official picture we have of recovery so far is plausible.

The economy took a while to get going after the worst recession in the post-war era and when it did, in the final quarter of 2009, it was with a modest, 0.5% rise. This dipped back to 0.3% in the first quarter of 2010, when bad weather and the return of Vat to 17.5% took the edge off the recovery.

The reversal of those weather effects and the delayed impact of Labour’s recession-fighting public sector capital spending produced a 1.1% rise in GDP in the second quarter. Some of this carried through to the third quarter, when there was a 0.7% increase in GDP. Then came the fourth quarter, of which more in a moment.

It is interesting to note that the Office for Budget Responsibility, the government’s independent forecaster, expected 1.2% growth for 2010 as a whole in its post-budget forecast in June, though revised that higher in November. The latest information suggests the economy grew by 1.4%, stronger than expected in the middle of the year, though we arrived at it via a more circuitous route.

So did the recovery peter out at the end of last year? Definitely not, in my view. Calculating weather effects is notoriously difficult, as the ONS admits, though it has gone to some effort to try to gauge them.

My rule of thumb method would be a simpler. A quarter consists of just over 90 days. If, in that period, you lost half a day’s economic activity as a result of the worst December weather for 100 years, GDP would be down by roughly 0.5%. If you lost a day’s activity, it would be down some 1%.

During December Heathrow, itself a small economy, closed for four days. Brent Cross closed on the Saturday before Christmas. Across the country, construction sites shut down early for the winter break, train services came to a halt and people stayed at home. Other ONS figures show sales of petrol fell by 4.6% between November and December.

So I do not find it implausible that the weather knocked the economy by 0.5%. I would not be surprised if the effect was larger, 1%. That would be in keeping with survey evidence, and point to underlying growth of 0.5% in the quarter, knocked down to minus 0.5% by the weather.

So the recovery is on track. Some economists are looking forward to a decent bounce-back in the current quarter, which was once expected to be weak, with growth of up to 1%.

That said, last week’s figures were still important. For one thing, they have added to nervousness about the economy, among business people and politicians.

For business, the risk is that a distorted figure becomes self-fulfilling, persuading firms to delay expansion and investment plans until things are clearer. Most business people seem prepared to look through the numbers and do what they were planning anyway but the danger is there.

For politicians, the figures sharpened the debate. The arrival of Ed Balls as shadow chancellor means the key political battleground in 2011 will be between him and George Osborne. Balls has had a dream introduction to his new job. Osborne has to demonstrate that he can win the debate against a stronger opponent and carry the coalition and the country with him through the tax hikes and spending cuts.

The GDP figures were also a useful reminder that, after the kind of recession we had, it will be a long climb back to normality. As things stand, the economy is 4.4% smaller than it was at the start of the recession nearly three years ago.

If the economy grows by 2% or so, it will take a couple of years, until the end of 2012 or early 2013, to get back to pre-recession levels. In between, there will have been a lost five years for the economy.

That climb gets a lot harder if you lose your footing, as appeared to have happened in the final three months of 2010. Even without that, it will be hard work.

My regular column is available to subscribers on www.thesundaytimes.co.uk. This is an excerpt.

The Bank of England's ’s reputation has rested on its monetary credibility. Its record on inflation, both in the period of quasi independence from 1992 to 1997, and in the decade following the granting of independence in 1997, was superb.

Its critics could attack it for failing to pay enough attention to asset prices, such as housing, though it was only tasked with targeting inflation. Even people who saw no good whatsoever in Gordon Brown had to concede his achievement in giving the Bank independence (and keeping Britain out of the euro).

That is now changing. Ministers expected all the grief this year to be about tax increases and spending cuts. Instead, their mailbags are full of concern about rising prices. Inflation was not meant to be a problem, other than that reflecting higher taxes such as Vat.

Now the worry is that on top of the fiscal tightening there will be a monetary tightening, higher interest rates, as well. The implicit contract between the government and the Bank - while one aggressive cuts the deficit the other keeps rates down - is under threat.

Last week’s inflation figures, showing consumer price inflation up from 3.3% to 3.7% in December even before the Vat hike, were bad. Though the measure of inflation I referred to last week, CPIY, consumer prices excluding indirect tax changes, is bang on the Bank’s target at 2%, that is of small comfort. CPI inflation, which the Bank is required to target, is about to go above 4% and could stay there most of the year.

Most people in Britain set their inflation watches by the retail prices index. Retail price inflation rose from 4.7% to 4.8%.

The Bank’s credibility now hangs by a thread. Even its earlier reputation is being questioned; the argument being that it benefited from favourable international developments, including the “China effect” on prices of goods in the shops.

Only the fact that the labour market is weak (though it could have been a lot weaker) prevents these inflation rates being reflected in pay deals. The longer inflation remains high, the greater the risk of that occurring.

The Bank made two big errors. I would not have cut Bank rate to 0.5% in March 2009, arguing at the time that 2%, which would have equalled the lowest in the Bank’s 300-year plus history, was as low as was needed. Below 2% it was hard to see any benefit to borrowers.

But the Bank went further, arguing it needed to go as far as it possibly could. These very low rates, to be fair, helped the banks recover.

The mistake was allowing a 0.5% Bank rate, which it should have made clear was a temporary emergency rate - to be withdrawn as the economy recovered its footing - to become a new norm.

Perhaps the Bank did regard it as something like the new norm; at the time it predicted average inflation of 1% through to 2012. But it is very dangerous when the exceptional becomes commonplace.

As I wrote in March 2009: “The Bank has to be ready to raise rates as quickly as it cut to avert any medium-term inflation problem. It would also give a powerful signal that the worst was over.”

The second big mistake was the Bank’s failure to look beyond the crisis. Britain’s inflation problem is a product of two factors: the sharp fall in the exchange rate that began shortly after the crisis broke in the autumn of 2007 and the post-crisis rebound in commodity prices.

Even if the Bank did not foresee the extent of these factors, and in the case of sterling there is little excuse, it should have been alert to the possibilities. A few well-placed warnings of extreme inflation volatility would have countered the impression that the Bank has been completely caught out.

As it was, two years ago in its February 2009 inflation report, the Bank saw no chance at all that inflation would be above 3% now, though it did see a small possibility that economic growth would be 5.5% or more.

Sharp-eyed readers will notice I have not blamed the Bank for its £200 billion of quantitative easing. Though it would be easy to blame “printing money” for current high inflation, there is no evidence to support that.

For that, quantitative easing would have had to either boost the money supply significantly or contributed to a sharp weakening of the pound. Neither has occurred. Sterling’s big fall happened before the Bank embarked on its easing policy.

What should the Bank do now to try to restore its reputation? The easy thing, it would seem, would be to start raising interest rates. The problem with that is that it is too late now to have much impact on inflation over the next 12 months, even if it were the case that the drivers of inflation were domestic - and in the Bank’s sphere of control - rather than international, or tax-induced.

A rate hike last June, when Andrew Sentance first voted for it on the MPC, would have been ahead of the curve. Anything the Bank does now would be regarded as a belated response to an inflation problem it failed to predict.
Hiking interest rates could push up the pound in the short-term but, to the extent it damaged recovery prospects, the effect would be short-lived.

So the Bank probably has no choice but to see its experiment with ultra-low interest rates through, to hope that some of the current pressures will abate and that inflation will find its way back to 2%. Whether it ever gets its reputation back is another issue.

My regular column is available to subscribers on www.thesundaytimes.co.uk. This is an excerpt.

You see Asia's growth in the statistics. While it will take another year or two for most advanced economies, including Britain's, to get back to pre-recession levels of gross domestic product, Asian economic activity and Asian trade are comfortably above pre-crisis levels and rising fast.

You also see it in booming construction, with new skyscrapers dwarfing and in many cases replacing the old ones. Rising Asian prosperity is tangible, as the world's top retailers, which populate its shopping malls, are aware. Nowhere in the world is the middle class growing more rapidly than in Asia.

Asia is not the whole story of this new growth phenomenon. Many economies in Africa are booming, and not just on the back of soaring commodity prices, as is much of Latin America. Asia, however, is the driving force, the world's locomotive.

In 2009, the worst year for the global economy in the post-war era, Asian economies grew by 4% while advanced economies shrank by a similar amount. Last year Asia grew by more than 8%. This year, according to Goldman Sachs, Asia will grow by more than 7%, three times advanced country growth and nearly four times the rate of growth in the eurozone.

China, by offering to help the eurozone with its difficulties, is demonstrating the country's increased economic clout.

That looks set to increase further. HSBC, in its exercise The World in 2050, has China as the world's biggest economy by then (encouragingly, with Britain in fifth place, ahead of Germany). In fact, China is likely to get there well before that.

Standard Chartered identifies a new supercycle for the world economy, led by emerging economies in general and Asia in particular, in which China overhauls America by the early 2020s.

It is not just a China story. HSBC emphasises prospects in India, which it sees moving to a faster growth rate than China, as well as economies such as Indonesia, Malaysia and Thailand. Perhaps nothing illustrates the Asia story better than the strong performance of Vietnam and Cambodia, in contrast to the former communist economies of eastern Europe.

It is easy to forget that it has not always been this way. A decade or so ago, growth rates in emerging economies taken as a whole were barely higher than in the advanced world. Asia was coping with the aftermath of its 1997-98 financial crisis, which apparently snuffed out prospects of a miracle in the region.

Asia learnt from that crisis and now the boot is on the other foot. My view is that the hangover from the more recent global financial crisis for advanced economies will have the effect of accelerating the global shift to economies such as China and India by five to ten years.

What does Britain get out of this global shift? Potentially quite a lot. Last week on a visit to Britain Li Keqiang, China's vice premier, played Lady Bountiful, with £2.6 billion of export contracts and commercial agreements and a loan of pandas to Edinburgh zoo.

Though export trade is biased towards the slower-growing European Union for good reason (inward investors came to Britain to sell into Europe, not ship back to the Far East), things are changing.

The latest Ernst & Young Item Club forecast, published tomorrow, notes that more than 80% of Britain's exports go to advanced economies rather than the emerging ones. Change is afoot, however. With east Asia's share of the global economy on course to double from 16% in 1990 to 31% by 2015, Britain's exporters are starting to respond. Exports to China are up 45% over the past year. Exports to the rest of the European Union are up 12% but non-EU exports are up 21%.

Peter Spencer, Item's chief economic adviser, is optimistic. "UK exporters have been able to refocus successfully in the past, and the strong growth in exports to the emerging Asian and other markets suggests that this is happening again."

Item predicts that Britain's overall exports will rise by more than 7% this year, 9% next year and 8% in 2013.

Part of the reason for my trip to Asia was to give a lecture at a conference organised by Nottingham University's Globalisation and Economic Policy Centre. Nottingham has a 4,000-student campus near Kuala Lumpur, Malaysia, which is impressive. Education is one of the many services Britain can export successfully to Asia.

What could go wrong? The view on the ground is that high Asian inflation, evident in commodity prices and in some cases wages, is manageable without much of a slowdown in growth.

Those looking at these big long-term shifts have to be humble. I remember visiting Japan in the late 1980s when construction was also booming and the prosperity tangible. It was followed by the bursting of Japan's bubble economy and two decades of economic stagnation.

Today Japan is benefiting from the boom in Asia and grew by more than 4% last year. But talk of it overhauling America, once popular, has been forgotten.

I don't think the rest of Asia will go the same way, or that a similar fate will befall its economic giants like China, though you can buy books warning of its imminent economic collapse. Such books have been published regularly for most of the three decades in which Chinese growth has averaged 10% a year.

Asian growth is more broadly based and less dependent on booming asset prices than Japan's was in the 1980s. The world is changing and that change has been brought into sharper focus by the crisis.

My regular column is available to subscribers on www.thesundaytimes.co.uk. This is an excerpt.

It is early days but so far inflation is the economic story of the year. Some of this is specific to Britain. Tuesday’s Vat increase to 20%, though the extent to which it has been passed on is patchy, has got everybody thinking about higher prices. Rail fare increases averaging more than 6% and an average petrol price of almost 128p a litre (132p for diesel) represent the reality of those higher prices.

Some of it is global. Britain's high fuel prices reflect the chancellor’s desire for revenue, with both an excise duty and Vat effect. But they are also a consequence of a crude oil price which is threatening to rise above $100 a barrel again. Food prices are at an all-time high, according to the UN’s Food and Agriculture Organisation.

Central banks were put on earth to worry about inflation. Across the world, many have raised rates because of the inflationary threat. This is mainly in the emerging world, including India and China. Beijing hiked on Christmas Day.

Some advanced economies such as Sweden and Norway raised rates in 2010, as did Australia. The question is when we see a move from the big four, our own Bank of England, the Federal Reserve, the European Central Bank and the Bank of Japan.

The Bank of England’s monetary policy committee (MPC) has its first meeting of the year this week. There have been suggestions that a good way to show its anti-inflationary resolve would be to surprise markets by nudging Bank rate higher.

Andrew Sentance, so far the only MPC member to vote for a rate hike in the post-Lehman Brothers era, has fought a brave and increasingly public campaign to seek to convince people. Not only does the Bank need to show it means business on inflation but the beginning of the return of rates to normal levels would show the MPC was more confident about the economy.

I have quite a lot of sympathy with Sentance’s view. The longer Bank rate is held at 0.5%, and we are approaching the second anniversary, the harder it will be to shift from this extremely low emergency level.

Other central banks have raised rates without the skies falling in. Properly handled, there is no reason why a nudge up to 0.75% would be interpreted by the markets as a non-stop journey up to a “normal” 5% level. The effect of a gradual rise in Bank rate on interest rates in the economy as a whole may be limited. The banks have the scope, after all, to reduce their margins.

Why has most of the MPC been so reluctant to join Sentance in gradually raising Bank rate? It may reflect a reluctance to be the first of the big four to break ranks.

Most of it reflects what the MPC majority would see as hard economic arguments. Thus, the spare capacity left over by the recession will bear down on inflation over time. Inflation will move higher over the next few months; the markets are expecting 4%, with retail price inflation exceeding 5%. But the more that can be blamed on higher Vat, the more helpful it is to those against early rate hikes.

Not only will this month’s Vat hike drop out of the inflation calculation in a year but its ultimate effect, like any tax hike, is deflationary. The same is true of commodity prices. They are outside the Bank’s control and their effect will be to slow global growth, partly because some central banks have responded to them by hiking rates.

Inflation expectations are rising. The latest Citi-YouGov survey shows people expect inflation to average 3.5% over the next 12 months and 3.8% over the 10 years. But the MPC majority appears relaxed about this, at least until these higher inflation expectations are converted into faster pay rises, which is not yet happening.

There is another reason. The “shadow” MPC, which meets under the auspices of the Institute of Economic Affairs, is instinctively more hawkish than the actual MPC. But, after a couple of knife-edge 5-4 votes to hold rates at the end of last year, its latest vote to hold rates is a more comfortable 6-3.

Its majority is concerned about the continued weakness of money and credit growth, which brings us back to Friedman. As Gordon Pepper, the veteran monetarist economist, puts it: “Do not judge the stance of monetary policy by the behaviour of interest rates. It should be judged instead by in depth analysis of the behaviour of the monetary aggregates.” With the adjusted M4 money supply measure growing just 1.4% annually, a monetarist would see little inflationary danger.

Dovish shadow MPC members are also worried about the government’s fiscal measures (a January rate hike hard on the heels of the Vat increase would be a double whammy), weak growth in Britain’s European trading partners and de-leveraging - running down debt - in the banking system. The practical effect of this deleveraging is very weak bank lending growth, so far unresponsive to ultra low rates.

This is perhaps the nub of it. It is easy to forget that the Bank has two core purposes. One is monetary stability; meeting the inflation target. The other is financial stability, “protecting and enhancing the financial systems of the United Kingdom”.

In theory, the MPC should concentrate solely on monetary stability. It is hard to avoid the conclusion that since the onset of the banking crisis, much of its attention has been diverted to the second, financial stability objective. A normal monetary stability approach would see rates on their way up by now. The Bank clearly thinks things are a long way from normal.

At some stage the MPC will surprise us with a rate hike. Surprises, by their nature, cannot be anticipated, so it could happen at any time, including this week.
The Bank, however, has given us no indication it is contemplating such a move, now or in the near future. It needs to be confident about financial stability, in Britain and the wider world. The implication is that it does not yet have that confidence.

My regular column is available to subscribers on www.thesundaytimes.co.uk - this is an excerpt.

There are two big questions about Britain’s economy this year. One is whether inflation will come down after yet another “temporary” blip. The other is whether the recovery can survive both tax increases and spending cuts.

On Tuesday Vat will rise to its highest level in Britain’s history, 20%. Back in the 1970s, when the tax replaced the old purchase tax, there was a standard rate of 8% and a 12.5% rate for luxury goods.

These were combined into a single, higher rate of 15% in Sir Geoffrey Howe’s first budget under Margaret Thatcher in 1979, followed by the increase to 17.5% by Norman Lamont in 1991. You will notice that every Vat increase has been by Conservative chancellors.

In theory, Tuesday’s VAT hike to 20% should be neutral for inflation. This time last year, Labour reversed its temporary cut in Vat to 15%, restoring the rate to 17.5%. So, while the Vat hike raises the level of prices - by 2.13% if you do the arithmetic - it should not add to inflation.

In the real world, however, things are a bit more complicated. Evidence from the Office for National Statistics and the Bank of England’s agents suggests that while the effect of the temporary cut and subsequent hike in Vat in 2008-10 was partial - many companies did not pass it through in their prices - the permanent Vat hike to 20% will have a bigger impact, close to full pass-through.

It could even be beyond full pass-through if, as is possible, firms use the Vat hike as cover for other price hikes. If you wanted to be optimistic, on the other hand, you might conclude that firms have already begun to anticipate the Vat hike in their prices. You may remember those record November price hikes in furniture and clothing.

Vat is not the only headache for the Bank. Ross Walker of Royal Bank of Scotland has a grim list which includes utility price rises of 7%-9%, 6% rail fare increases and continued high food price inflation. Though he does not expect inflation to hit 4%, as many do, he thinks it will be above 3.5% for most of the year.

This is exactly what the Bank’s monetary policy committee (MPC) does not want. When fiscal policy is being tightened, the understanding is that monetary policy stays loose. That is what the government is assuming. If that assumption is wrong, this will be a tricky year for the economy.

I am assuming that the MPC will move heaven and earth to “look through” the inflation overshoot, as before. So we either get no change in Bank rate or at most a gentle move up to 1%. We need inflation to be back below 3% by the end of the year and falling, which is what I expect, but this is a risk.

If the Bank were forced to raise rates more sharply, it would add to the impact of the government’s fiscal tightening. John Philpott, chief economist at the Chartered Institute of Personnel and Development (CIPD) predicts 120,000 public sector job losses this year, and an additional 80,000 in the private sector, pushing unemployment on the wider measure up from its current 2.5m to 2.7m, 9% of the workforce.

This is a big uncertainty. In 2010 private sector job creation was strong, as in the 1990s when public sector jobs were cut. But the momentum appears to have weakened towards the end of the year.

Households look set for a double whammy of below-inflation pay increases and the threat of unemployment. I would expect some rise in unemployment in the short-term, pushing the narrower claimant count up to 1.55m by the end of the year.

As for overall growth in the economy, Britain needs a substantial contribution from investment and net trade; exports minus imports. Recent news on business investment has been encouraging, net trade less so.

I would expect that to come through during 2011, with the current account deficit falling from more than £30 billion to £15 billion on its way to balance. Investment should continue to pick up, giving overall economic growth of about 2%. That’s unexciting but not bad in the circumstances. Growth could surprise on the upside again.

Looking back on what I expected for 2010, I was a little pessimistic on growth (1% versus a likely 1.7% outturn) and unemployment (1.75m), too optimistic on inflation (2%) and the current account (a deficit of £10 billion versus a likely £30 billion-plus) and wrong to expect a small rise in Bank rate to 1%.

Whether the mistakes this year are on the optimistic or pessimistic side remains to be seen, but 2011 will certainly be fascinating.

PS Matters arising from last week. The responses to the forecasting competition have been flooding in but some people are unsure of what they need to forecast.

So, two competitions for the price of one and two sets of prizes. We may by then have Alistair Darling’s account of life at the heart of the crisis and perhaps even Vince Cable looking back on his time in government. I have a title: Eye of the Storm.

My regular column is available to subscribers on www.thesundaytimes.co.uk - this is an excerpt.

In economics, as in life, “it’s all relative” is a useful motto. Compared with most years, 2010 was pretty difficult, with unremarkable economic growth, record government borrowing and plenty of economic and financial turbulence.

Compared with 2009, however, and with the final few months of 2008, the past 12 months have been a breeze. The economy recovered, despite predictions from plenty of non-economists that it would not.

Though you would not think it now from the indiscretions of Liberal Democrat MPs and ministers, the coalition made a huge difference. Against market worries that a hung parliament would tip Britain over the precipice, guaranteeing the loss of the country’s AAA sovereign debt rating, the emergency budget in June and the comprehensive spending review in October succeeded remarkably in first stabilising then improving sentiment.

The Treasury under George Osborne is not an exciting organisation bristling with ideas. It has made errors, some of them easily avoidable. But it has taken a workmanlike attitude on its main priority - getting the budget deficit down - and investors have decided that this is non negotiable.

This chancellor will stand or fall, not on imaginative tax reforms, or on his ability to charm his political opponents and allies, but whether, at the end of this parliament, the budget deficit is no longer an issue. That is the goal, and that is how he will be judged.

The benefit of the doubt from the markets comes in spite of the fact that recent numbers on the public finances have been disappointing, culminating in record net borrowing of £23.3 billion in November. Borrowing so far this fiscal year is down on the equivalent period in 2009-10 but only marginally so; £104.4 billion versus £105.1 billion.

What would have happened if Labour had won the election? Alistair Darling will give us his account soon (I have yet to see a copy of Gordon Brown’s book) but I would not be surprised if part of the narrative is about how he was as determined as anybody to get the deficit down but was continually frustrated by the then prime minister and his allies.

Certainly, senior officials at the Treasury had come to the conclusion that successful deficit-reduction would be impossible with Brown in charge. Mervyn King got into hot water for making a similar view a little too public.

The economy’s ability to grow through the cuts and the tax hikes is the big issue for 2011 and there will be a lot more on that next week. We started 2010, however, with plenty of people wondering whether there would be a recovery at all.

You may remember the kerfuffle over the Office for National Statistics’ initial stab at growth in the fourth quarter of 2009 - a mere 0.1% - immediately followed by the weather-affected first three months of this year, which some said would then be followed by election uncertainty.

Talk of a double-dip was rife, or the alternative of no recovery at all. In fact, that initial stab at the fourth quarter of 2009 was revised up again last week to 0.5%. And, despite some small downward revisions in the growth numbers for this year, the overall picture is of an economy that recovered well, particularly over the spring and summer. Over the past 12 months growth has been 2.7%. Calendar year growth for 2010 - this year’s gross domestic product compared with last year’s - looks like being 1.7%, though that depends on the current quarter.

Growth in the economy generated growth in jobs, up 219,000 over the latest 12 months, despite a small fall in the latest three months. There were those who thought we would pay for the smaller than expected jobless rise in 2009 with a big increase in 2010 but that, so far at least, has not been the case.

I will come of to my forecasting league table in a moment but this was a year when forecasters recovered their composure and a little bit of their pride.

Economists were a little too downbeat on growth at the start of the year, though not excessively so. Though some were not averse to a bit of double-dip headline-grabbing, the consensus forecast of 1.4% growth at the start of the year was close enough to the outturn to be respectable and certainly a vast improvement on the failure to hit the barn door of the recession in 2009.

Where forecasters did go wrong was on inflation. The consensus in January was that inflation would end the year just below the official 2% target, rather than stuck above it at 3.3%. Forecasters expected, as did the Bank of England, that the spare capacity left over by the recession would exert larger downward pressure on inflation than it did.

The persistent inflation overshoot is an embarrassment for the Bank and its forecasters. Most independent forecasters also failed to spot the danger, however. The two exceptions were Michael Saunders of Citigroup, a regular strong performer in my annual league table. He was a little too pessimistic, predicting 3.8% inflation by now.

The other, Brian Hilliard of Societe Generale, was spot on with 3.3%. He also did well with his other predictions, just edging this year’s forecaster of the year title from Saunders. You may think it strange that a French institution carried off the forecasting prize for Britain’s economy, though Hilliard is British and based in London.

You have to go a few steps down my league table for the first British name. After Societe Generale and Citigroup comes Bank of America/Merrill Lynch, BNP Paribas, the Daiwa Institute and J.P. Morgan. Only then do you get Peter Warburton of Economic Perspectives - last year’s top forecaster - and Lombard Stree Research.

I have taken recently to opening up the forecasting competition beyond the professional forecasters, with gratifying results. For the past few days I have felt rather like an exam marker. There were plenty of individual entries as well as some mass ones.

I am pleased to say that the amateur forecaster of the year was from one of the mass entries, from the King’s School, Canterbury. David Chan, a pupil, predicted 2% growth, 3% inflation, 1.35m unemployment and a £30 billion current account deficit. He blotted his copybook slightly with a prediction that Bank rate would be above 2% by now, but otherwise his effort scored a commendable eight out of 10.

Prizes will be on their way to him in the new year as they will be to the three runners up who each scored seven out of 10; Thomas Kyriakoudis, Chris Taylor and J.B. Blackamore. If I had some copies of that Gordon Brown book, I’d include them.

Overall, the standard was very good, with many others only just missing out on a high score. So I am happy to repeat the exercise for 2011. Will it be a year of reckoning, continuing unspectacular recovery, or a boom? Send in your entries.

My regular piece is available to subscribers on www.thesundaytimes.co.uk - this is an excerpt.

There are three worries about the 2011 outlook. One is that external events will derail recovery, of which the most obvious candidate remains the eurozone.

The European Central Bank last week virtually doubled its capital base, taking out crisis insurance. The second worry relates to “the cuts” and the tax increase. More on that and global risks, over the next 2-3 weeks.

The third worry is the banking system’s ability to support the economy. Last week the Council of Mortgage Lenders confirmed what its members have privately told me; anybody looking for a big upturn in mortgage lending will be disappointed.

Gross mortgage lending will be similar to this year’s £135 billion and net lending will drop from £9 billion to a three-decade low of £6 billion. Housing activity will trundle along at half of pre-crisis levels.

What about the more important business lending, currently showing an annual fall of over 5%? The Bank of England’s latest quarterly bulletin found “a substantial and persistent tightening in credit supply conditions” alongside the drop in credit demand that is normal in recessions.

The banks, for their part, insist their business customers have unused credit facilities that will come through as the upturn gathers pace. Peter Ibbetsen, RBS’s head of small business lending, says there will be two spikes in credit demand from smaller firms over the next 12-18 months.

One will be when their cashflow needs increase as activity returns towards normal levels, employees are taken off short-time working and stocks are replenished. The other will be when firms need to borrow to invest in new capacity.

Ibbetsen is confident that, just as RBS will meet its £50 billion commitment to lend to small and medium-sized businesses by the end of March, so will the banks as a whole. Lending to businesses, currently down on an annual basis, will return to growth over the next 12-18 months. We should hold the banks to that.

In the meantime, the government is giving a fair wind to new ways of funding small and start-up businesses. Earlier this month Paul Forrest of Forrest Research gave a presentation to the Accumulation Society, a City-based club for economists. He described the workings of the Black Country Reinvestment Society, a mutual organisation which provides finance to small firms which have no track record or fail conventional credit scoring tests.

Forrest argued that the banks have never really lent properly to this type of business. As long ago as the 1930s the Macmillan committee identified this as a gap in Britain’s financial system.

Last week Mark Prisk, business minister, endorsed this “micro finance” lending to firms, offering improved access under the enterprise guarantee scheme. It will never replace bank lending but is a step towards the kind of diversity in business funding available in Germany.

Could longer-term banking issues impact on shorter-term lending? One worry about the banks, rehearsed in the Bank’s Financial Stability Report on Friday, is the £400-500 billion of maturing bank debt, including support under the special liquidity and credit guarantee schemes, that has to be rolled over by the end of 2012.

The Bank thinks the banks have made good progress in improving resilience and managing their funding, but it is a hurdle.

Another is the threat of government-imposed changes to the banking system. Will banks lend to support the recovery if they fear they are about the be broken up? Could that threat of act as a blight over banking?

I have mixed feelings about this. If you wait until a crisis is forgotten before taking action, the steam will have gone out of it. If you act too soon, you threaten damaging recovery. History tells us America acted quickly with the 1933 Banking Act (the Glass-Steagall Act), which shook up the banks, separating commercial and investment banking. But the depression lasted.

Britain’s independent commission on banking, chaired by Sir John Vickers, has pledged it will pay “careful attention” to the cost and availability of credit and the implications for growth.

The commission’s brief is wide, ranging from whether the banks should be broken up on competition grounds, to whether commercial and investment banking should be divided, Glass-Steagall style. Some commissioners favour very narrow banking, others argue that if governments pick up the tab when banks fail, you might as well have fully nationalised banks all the time. The case will be put for an increase in bank capital beyond anything proposed under the Basel III framework from the Bank for International Settlements.

The commission will not report for another nine months. It will be a fascinating intellectual exercise. Even so, apart from the limits on Britain’s freedom on banking reform - the European commission has greater powers in this area - reform of any sector by government diktat creates a sense of unease.

If governments are unhappy about how part of the economy is working, they can make it easier for other firms to enter the market, or act on monopoly or collusive behaviour. What they do not normally do, these days at least, is force break-ups.

You could argue that the banks behaved so badly that they surrendered their entitlement to normal treatment. You could argue, equally, that the banks would not have behaved so badly had they been properly regulated, and not just in Britain.

Either way, the worst thing would be if the banks did not lend to firms in a way that supports recovery. Even worse would be if the threat of break-up provided the excuse for inaction.

My regular Sunday Times piece is available on www.thesundaytimes.co.uk, and now on the new Ipad app. This is an excerpt.

Britain is caught between two powerful forces when it comes to inflation. In most advanced economies there is a bigger worry about deflation than inflation. Inflation rates are typically 1% or so, and lower on a core basis excluding volatile items. America’s core inflation of 0.6% in October was the lowest for 50 years.

In America, the eurozone and Japan, inflation is the least of the worries. Last week’s sharp rise in government bond yields had nothing to do with inflation concerns and everything to do with fiscal fears, particularly the worry that the Obama administration will never get to grips with America’s budget deficit.

Poor Ireland’s debt troubles are made worse by the fact that it is in the grip of deflation. On the same basis that Britain has inflation of 3.2%, Ireland has deflation - prices are lower than a year ago - of 0.8%.

In many emerging economies, in contrast, the problem is inflation rather than deflation. Chinese inflation, 5.1%, is at its highest for more than two years. India’s wholesale price inflation is running at nearly 9%, as is the country’s food inflation. Argentina, though its figures are dodgy, is seeing inflation running up towards 30%.

Here in Britain, the inflation problem will get worse before it gets better. Petrol prices have been going up in the past few days, even before the January excise duty and Vat hikes. That Vat hike will affect a range of prices, even if retailers try to cushion the blow. The fact Vat also went up last January, when the rate was restored to 17.5%, means the impact next month on inflation will not be as bad as it might have been.

Even so, the Bank will have to make sure King’s inkwell is filled. After peaking at a little over 3.5% in the first quarter, it expects inflation to stay above 3% through 2011, before then falling.

The interesting question is how long the Bank will be able to keep interest rates at 0.5%, which it did again on Thursday, if the inflation overshoot turns out to be more enduring than it currently expects. It has already stretched the timetable for the return to the 2% target on several occasions.

It is not hard to explain why emerging economies have an inflation problem while most advanced economies do not. Commodity prices have risen 30% since the summer. The lower a country’s per capita gross domestic product (GDP), the bigger the share of incomes spent on food and other staples. Food prices are important in Britain, particularly for those on lower incomes, but their weight in the consumer prices index is less than 11%.

Should we be more worried about inflation or deflation? An interesting research note from economists at HSBC, led by Stephen King, nicely links deflation worries in the advanced economies to inflation in the emerging world.

The first part of the link is familiar. As HSBC’s King puts it: “In their desperation to kick-start growth and avoid the perils of Japan-style deflation, central banks in the Western world have opened up their monetary laboratories to find a cure.”

Though we cannot know for sure, that cure appears to have been partially successful. It has helped avoid a second Great Depression and, while some countries have fallen into the deflationary trap most, just, have so far avoided it.

Unfortunately, a bigger effect of all this monetary largesse appears to have been on the emerging world, and on commodity prices. “As the effects of QE have leaked out into the emerging world, the effect has become more and more visible.”

Before the crisis, people used to worry about the so-called yen carry trade; borrowing at near-zero interest rates in Japan and reinvesting in Britain, America or other countries where returns were higher.

Now there is, in effect, a global carry trade from all the advanced economies to the rest of the world. Investors can borrow at near-zero rates in America, Britain, the eurozone and Japan and re-invest elsewhere. In case of doubt, central banks are pumping money in to allow them to do so.

That is why emerging economies, led by China but including Brazil, South Korea and Hong Kong, have protested about the Federal Reserve’s latest round of quantitative easing (QE II). America, they say, is trying to solve its problems by creating inflationary bubbles in their countries.

It is also why, according to the HSBC analysis, the entire exercise may turn out to be counterproductive. Not only is much of this easing leaking out, but it is also creating a dangerous feedback for advanced economies themselves. Even though their sensitivity to higher food and commodity prices is less, the effect will nevertheless be to squeeze real incomes in the West, holding back the recovery in spending needed to get out of the economic morass.

What is the answer? One would be if, contrary to the conventional Washington wisdom of the past three decades, emerging economies were encouraged to reimpose capital controls. That would ensure that policy aimed at the West stayed in the West. Some countries such as Brazil and Thailand have already done this.

The other is that advanced economy central banks adopt what you might call the Doris Day approach, in other words Que Sera Sera, whatever will be, will be.

Western economies have to adjust after the crisis. Part of that adjustment involves slower growth than before. Trying to avoid it through super-expansionary monetary policy will not work. It is why I am against further expanding quantitative easing in Britain, and why the launch of QE II in America made me very uneasy. Sometimes you have to accept things have changed.

My regular column is available on www.thesundaytimes.co.uk - this is an excerpt.

Should we take any notice of the new forecast from the Office for Budget Responsibility (OBR), which George Osborne was so pleased with last week? After all, the economic models that forecasters use failed dismally in predicting the crisis and would again if there was another one.

Though a lot of work is being done to try and improve the financial and monetary sectors of economic models, there is a long way to go. The models being used now are pretty much the same as those of 3-4 years ago. And, even when they embody better understanding of the financial sector, forecasters may warn of crises but they are unlikely to have them in their central projections.

The OBR, headed by Robert Chote, with Steve Nickell and Graham Parker as fellow members of its budget responsibility committee, is aware of this. “Prospects for growth in the medium term are inherently uncertain,” it says. Its job is to try to steer through that uncertainty.

Much of the criticism of its new forecast, out last week, is that it is too optimistic. Some of that criticism, it is worth noting, came from economists who have been far too pessimistic about the recovery so far. The OBR, indeed, had to revise up its forecast for this year from 1.2% to 1.8%.

Economic forecasts are as much about the past as about the future. That is not just a question of economists needing aan accurate picture of the past in order to peer into the future but the fact that precedent plays as important a role in economics as it does in the law.

So the OBR, in looking at what might happen over the next few years, has examined the record of previous recoveries. So far, against expectations, this recovery has been stronger than after past recessions. But the next few years will be weaker, it says, than the recoveries of the 1970s, 1980s and 1990s. Unusually, there will not be a single year in which growth hits 3%.

It may be that this is too pessimistic a view and that history does repeat itself and we get a 3% year, or two, as in past recoveries. It may that the OBR has underestimated the impact of the fiscal tightening and weak credit conditions and we get a more subdued recovery.

That is where the debate should be. It is not remotely implausible to predict years of economic recovery, even after a big crisis and deep recession. Those who said there would be no recovery, who have gone quiet recently, had little knowledge of economic history.

There is a lot in the OBR report, enough for several columns. Let me concentrate today on just three interesting aspects of its assessment.

The first is the rebalancing of the economy I wrote about last week, and for which encouraging evidence was provided last week by the purchasing managers’ survey for manufacturing; it showed the strongest overall picture since 1994 and the best for jobs since 1992.

We had such a rebalancing in the first half of the 1990s on the back of sterling’s post-ERM (European exchange rate mechanism) devaluation. The current account went from big deficit to balance in an export-led recovery. It came to an end and went into reverse in the second half of the decade, partly because the pound rose sharply, more than reversing its earlier fall.

The new forecast assumes sterling’s fall since autumn 2007 will be locked in. The move from a significant overvaluation vis-a-vis the euro to the current undervaluation of perhaps 10% (sterling’s fair value is around 1.30 to 1.35 euros) is an essential ingredient in what you could call a devaluation-led recovery.

The trouble is that this can only ever be an assumption. At some point in every previous recovery there has been a tendency for the pound to rise. It happened immediately after the IMF rescue in 1976 and, eventually, in the 1980s and 1990s.

The euro’s problems this time add an additional dimension. What happens to the eurozone matters because of the impact on Britain’s banks, export markets and the financial markets. But Europe’s woes, if they resulted in a sharp weakening of the currency, would remove one of the planks of recovery.

The OBR is assuming sterling stays close to current levels for the next five years, so that between a quarter and a third of growth comes from net exports. If the pound rises then either growth is slower or, as in one of its alternative scenarios, it comes in an unbalanced economy.

Another interesting thing was the new, headline-grabbing prediction for public sector jobs. Instead of 490,000 job losses by 2014-15, we now have 330,000, with an additional 80,000 expected in 2015-16.

The logic behind the new forecast is hard to fault - the October comprehensive spending review had smaller reductions in departmental budgets and bigger cuts in welfare than in the June emergency budget - though the changes went further than expected. The new plans are for real cuts of 19% in non-ringfenced departments, not 25%, so you might have expected job losses to be reduced by a fifth, not a third.

The other surprise, at face value, is that the OBR is predicting fewer state job losses over the next few years than in the 1990s. As it notes, public sector employment fell by 550,000 between 1992 and 1998, when there was considerably less fuss about such job losses.

Part of the answer is that it has discovered that 150,000 of the job losses in the 1990s were due to classification changes, bringing the 1992-98 figure down to 400,000. Even so, limiting job losses to that period’s numbers will require public sector managers to be clever.

Finally, the new forecast suggests the coalition will have a good story to tell at the next election in May 2015, if tuition fees and other tensions allow it to hold together that long.

The budget deficit will have been all but eliminated. The chancellor’s March 2015 budget will look forward to public borrowing of just 1% of GDP over the following 12 months and the cyclically adjusted deficit will have returned to surplus. Public sector net debt will have peaked at under 70% of GDP and be heading lower.

Does that mean all the hard work will be done? Even if these forecasts are exactly right - and we can guarantee they will not be - the long-term challenges wlll remain. Public sector net debt by the middle of the century could be zero, or it could be 100% of GDP. The difference is determined by whether this government and its successors can address the costs, in health spending, long-term care and pensions, of Britain’s ageing population.

On Thursday December 2, the University of Bath's Economics Society invited me to deliver the annual Taysom lecture, as part of its international economics week. It was a very enjoyable occasion in the splendid location of Bath's historic Assembly Rooms. My congratulations to the Economics Society for organising the event so well. This is the lecture.

I’m very grateful to John Taysom for sponsoring this lecture. It is a great thing when successful people put something back into their places of learning.

It is also a great pleasure to be here in these historic Assembly Rooms. Most people know them because of Jane Austen, who featured them in at least two of her novels. Or Charles Dickens, who lectured here more than 150 years ago. I think of them for a slightly different reason – an economic reason. In early September 1992, the British government hosted a meeting of European finance ministers and central bankers. It was intended to be a routine meeting, hence the location – the idea being to show the Europeans this magnificent city.

Unfortunately, by the time they assembled in these Assembly Rooms, the European economy was deep in crisis. We did not have a euro back then but we did have the exchange rate mechanism of the European Monetary System, which linked the currencies of Europe in a formal way. As you will recall, Margaret Thatcher had resisted joining the ERM as it was called, until the eve of her departure from office. So in September 1992 Britain had been part of it for less than two years. But Britain, along with Italy, was hanging on for dear life.

There was a threat to the entire system. So in these rooms we saw a titanic struggle. The easiest way to ease pressure on the system was for Germany to cut interest rates. Four times Norman Lamont, Britain’s chancellor, called on Helmut Schlesinger, president of the Bundesbank, to cut interest rates. Four times he refused, protesting that the decision was not for him but for his full Bundesbank council, finally threatening to walk out.

The meeting broke up without agreement and less than two weeks later we had Black Wednesday – or Golden Wednesday if you think it was a necessary liberation – when sterling was forced out of the ERM by pressure from speculators like George Soros.

It changed the course of British politics, paving the way for Tony Blair and new Labour, and it changed the course of Europe. In the following few months the ERM almost collapsed entirely. European leaders resolved to redouble their efforts to defeat the speculators and decided that the best way to do this was to speed the timetable for establishing the single currency. These very rooms played a part in giving us the euro just over six years later, at the start of 1999. As we’ve seen, the euro itself is in trouble, which I’ll return to, though I don’t think a meeting here in these Assembly Rooms is planned.

Anyway, in this your International Economics Week, I want to talk about where the global economy is after the biggest financial crisis in the post-war era. And I also want to talk about what kind of world economy we can look forward to in the coming decades.

The first thing to say is that this is a great time to be studying economics, and for those in the audience who are not, to be interested enough to attend an evening lecture on it. When I look back on the period when I was at university, I think back to a time when it was surprisingly easy to avoid the news events of the day, even the very big ones. My sense is that you are different. Apart from the fact that the repercussions of the crisis will live in the memory as the time a coalition government – itself very rare in Britain – introduced a huge hike in tuition fees, I think everybody got a sense of the drama we went through, perhaps are still going through, in the crisis.

The global financial crisis started more than three years ago, in the summer of 2007. That was when we moved from the easy credit-driven growth of the 1990s and 2000s into something very different. Funding markets froze, making it difficult for banks to fund their lending. Initially it was thought that this was just a liquidity crisis and that if the authorities, the central banks, could pump in enough liquidity into the markets for a couple of years everything would be fine.

Now we know it was much worse than that. The crisis faced by the banks was one of solvency – many did not have enough capital to survive. So two years ago, in the autumn of 2008, the Western banking system came very close to collapse – this was the time when at a practical level the cash machines almost didn’t get refilled, the supermarket shelves not restocked, the wages not paid. It was very close to a full state of economic emergency. You can see that by the exceptional actions that were taken, the partial nationalisation of Royal Bank of Scotland and the Lloyds Banking Group and Bank rate reduced to just 0.5%, comfortably its lowest level in the 316 years of the Bank’s existence. Exceptional circumstances required exceptional measures.

How did it happen? When I embarked on my book The Age of Instability I tended to think that the crisis was the product of relatively recent developments. There were those Ninja mortgages in America – people with no job, no income and no assets – all that subprime lending which was sliced, diced and packager into securities that were really junk but were rated Triple AAA. By the way, I thought that Ninja was a term of abuse when it came to the mortgage market. Far from it. Ninja mortgages were patented by one US lender, and they are still available. Had it been just this very recent phenomenon, I don’t think the crisis would have been as bad.

So I believe it was the product of a much longer development – a very long-running credit boom that went back perhaps decades. The so-called shadow banking system in America, which as its name suggests operates outside the public eye and away from the gaze of regulators, dates back to about 1980. By the time of the crisis, the shadow banking system was as big as the actual banking system in America. Some people say we shouldn’t be too hard on the banks. After all, they were simply providing the credit for businesses to invest and for consumers to spend and buy houses. There’s some truth in that and there’s no doubt that the majority benefited from the easy availability of credit. But the biggest increase in credit was in the financial sector itself. Two-thirds of the rise in debt in Britain between the early 1990s and 2008 was financial sector debt. Finance is supposed to finance industry, to finance economic growth. Mostly, finance financed itself, and generated large returns for the people who worked in it in the process. That can’t be allowed to happen again, though whether regulators get cleverer in preventing it than they were in the past is open to debate. People sometimes forget that we had crises even when bank lending was tightly controlled, though not on the scale of recent events.

Before getting on to where we go from here, every economist, and I suspect every economics student, has had to live with the accusation that economics fell down on the job when it came to predicting the crisis. What looks so obvious with hindsight was somehow missed by the mass of economists.

I think some of the criticism is justified. Certainly most economists did not think enough about the banking system. We assumed that the banks and their boards knew what they were doing. We assumed that the regulators would not allow them to do anything as risky and irresponsible as they did. We regarded them as the equivalent of financial utilities – a tap of credit to be turned on when it was needed. Having said that, economists are not particularly well qualified to assess the risks of individual banks, let alone the system as a whole. Those who were qualified, such as the banks’ auditors and specialist banking analysts, mainly failed to spot the problems too.

Second, we came to believe too much in the infallibility of policy. From 1997 to 2007, you could have believed that we had entered a period in which the economy could be controlled by tiny little touches on the tiller. Every month the nine members of the Bank of England’s monetary policy committee met and we all got very excited if it happened to nudge interest rates up or down by a quarter of a percentage point. Now we know that economies are more difficult to control than that. Maybe it was a bit of illusion. Maybe we just have these periods of stability, followed by instability, followed by stability again and it doesn’t matter as much as we thought what central banks do.

Third, people believed less in the infallibility of economic models, but it was the case that models were simply incapable of picking up on the developments that led to the crisis. Things are being remedied now but the majority of economic models had underdeveloped or non-existent monetary and financial sectors, and that’s where the crisis came from. Models are only as good as the assumptions that go into them. Nobody assumed a banking crisis and even if they had the models would have found it hard to accommodate them.

Having said all that let me speak up for economics and economists. We get all the jokes – lay every economist in the world end to end and you never reach a conclusion; economists are people who found accountancy too exciting – and so on, but the truth is that when it comes to predicting crises and catastrophes, a more valid criticism of economists is that they predict too many, not too few.

So, economists have been banging on about global imbalances since the mid-1980s. Global imbalances were an important factor in the crisis. But could anybody predict that it would take 25 years for the chickens to come home to roost?

Similarly, the idea that economists were sidetracked because they assumed that every economic actor was rational and every market efficient seem to me pretty wide of the mark. The efficient markets hypothesis, which to me simply says that markets reflect the information known at the time, has been given a prominence in the criticism that it did not deserve. I think the problem with economics is that in the public mind it is associated too much with forecasting. Economic forecasting has its uses. Economists are pretty good at predicting longer-term trends. What they are not are soothsayers or magicians. When we think about the crisis, it is easy to think that it was always going to pan out in the way it did. But on the contrary, it is better to view it as a whole series of crossroads, at each of which we could have gone in a different direction. There was no guarantee it would go in the way it did. The biggest crossroads of all was in September 2008, and the failure to rescue Lehman Brothers. It is quite possible that the global banking system would still have come close to collapse and the world economy fall off a cliff in the absence of the failure of Lehman Brothers. But it is also quite possible that things would have turned out very differently, and that the outcome would have been much less damaging than it was. In some senses, then, the crisis was literally unpredictable.

But it happened, where did it leave us? One of the interesting things is how quickly the global economy has bounced back. 2009 saw the first year in the post-war period when world GDP actually fell – previous world recessions had seen growth slow very sharply but not fall. World trade fell by 12% last year, compared with just 1% or 2% in previous post-war global recessions. Pretty well all of that happened in what I call the falling off a cliff moment, from October 2000 until May-June 2009, since which time we have had a good recovery. So this year we should see growth of between 4.5% and 5% for the global economy, similar to the rates of growth we were seeing before the crisis. World trade has almost made up the ground it lost last year, and should show a rise of about 10% this year. As far as the world is concerned, at least on the basis of the big numbers, things appear to be back to normal.

They are, however, very different. The central thought I want to leave you with this evening is that the effect of the financial crisis has been to significantly accelerate a trend that was there before it. That trend is the shifting axis of the global economy. Emerging economies, led by China, but also including India, Brazil, perhaps Russia, Indonesia, Vietnam, Nigeria and many other countries in Africa, are much less affected by the aftermath of the crisis. Their banking systems are much less damaged, their public finances much less in trouble and therefore not requiring substantial surgery. Asian economies, having had their rehearsal with the Asian financial crisis of 1997-98, made themselves more resilient, less vulnerable to the whims of the markets. Western economies, in contrast, are hobbled, in some cases very badly, by these twin hangovers, of broken banking systems and damaged public finances.

Two things arise from this. The first is the balance of global growth has shifted substantially. Not so long ago, the picture was fairly clear – two-thirds of world economic growth came from advanced economies and one-third came from emerging and developing economies. Now and for the foreseeable future it will be the other way around. Two-thirds of global growth will be from the emerging world; they are the engines of the world economy; its locomotives.

The other development relates to size and economic outlook. On the eve of the crisis, the trend seemed pretty clear. China would overtake Japan as the world’s second largest economy by about 2015 and become bigger than America in the 2030s. Many people, particularly Americans, had trouble believing such predictions. But now, as we know, China has already overtaken Japan, doing so this year, and is on course to overtake America by 2020. The crisis has had the effect of accelerating the global shift by 5-10 years, if not more. By the mid-2030s, the world’s big three will be China, India and America, in that order. That does not mean the people of China and India will be as rich or own as many cars as the Americans, even then. It does mean that their economies will be bigger, and with that goes increasing economic and political clout.

It is possible to see many of today’s developments via that way of looking at things. So the crisis of 2007-9 perhaps marked the end of the American century, the passing of the torch to Asia. You write off America at your peril, and I would not want to do this, but you can see in America a country that has lost its way economically and politically. Suddenly all the dynamism of America appears to have been diverted into the curious corruption of Wild West financial capitalism. America is the world’s only superpower, though not for very long, but the crisis has knocked the stuffing out of it. The hangover from the crisis in America seems that much worse. Unemployment is high and looks set to stay so. There’s an end of empire sense about America now. It will still be a formidable economic player, but the torch is clearly passing.

You can see it too in what has been happening to the euro-zone. This was Europe’s most confident statement of its own future. A zone of economic and financial stability even in an unstable world. Every new member of the EU is required to join the euro when it has met the rather loose financial conditions for entry. The euro was a monument to European integration. What the euro could not cope with, however, was the financial crisis. It has brought out all the contradictions inherent in the single currency. The eurozone is not an optimal currency area, in other words it does not have wage flexibility, geographical mobility of labour or a central Treasury. The idea that countries need not be too economically converged when they entered, because they would achieve such convergence once in, has proved to be false. The trouble-hit peripheral economies of the eurozone – Greece, Ireland, Portugal and Spain - have lost between 20% and 30% competitiveness since the euro came into being in 1999, or since they joined. This is not a tenable situation. Either they have to regain that competitiveness, which looks like a huge challenge, or they have to leave the euro. I have long believed that while the euro will survive, it will not do so with all its members. Some new member states in Eastern Europe, who are committed to entry, are thinking again about whether there interests are best served by joining.

The problems in America and eurozone are reflections of the fundamental shift that’s occurring. They don’t mean that there will be no growth in America and Europe, simply that most of the interesting action will be in Asia, and in South America and in Africa.

What do we have to do in the light of this shift? We saw in the case of the crisis in Ireland a lot of criticism of British industry for the fact that we export more to the Irish Republic than to China, India, Brazil and Russia put together. I think this is a misleading statistic. A lot of trade between Britain and Ireland is border trade between Northern Ireland and Ireland. Just as Lancashire trades a lot with Yorkshire, so there is a lot of local trade across the Irish border. There’s also a lot of criticism of British business for selling too much into Europe. Certainly it does not look that smart for more than half of Britain’s exports to be going to other EU countries. There is, however, a reason for that. If you think about much of the inward investment Britain has attracted over the past 20-30 years, for example the Japanese car assembly plants such as Nissan, Toyota and Honda. They did not come to Britain to supply the Asian market but to sell into the EU. They came to the UK because of our flexible labour market but even that does not mean they’ll sell much to China from the UK, particularly since they have their plants there. That would be like selling coals to Newcastle, as people used to say when the north-east still produced coal.

In general, Britain is pretty good at tapping into parts of the world that are growing well. The UK is an open economy that does well when the world economy is growing. Sectors like financial services, business services such as advertising, accountancy, law and architecture, all are internationally competitive. So is much of what is left of manufacturing. Of course we have to get better, for if there is one clear message it is that every country has more or less the same strategy. But we can get better. And there is no reason why we should not. It does not mean, very definitely, that we have to look forward to a grim future, or that everybody should uproot and get themselves off to Shanghai or Mumbai. I am very much of the view that the re-emergence of China, India and the rest will be a benefit – it is a sustained positive economic shock for the world. I say re-emergence because you only have to go back a couple of hundred years to a time when China and India, between them, accounted for between 50% and 60% of the world economy.

What if the world does not turn out quite like I think? Some of these big predictions come right but some go badly wrong. In the 1980s, when there were also serious doubts about the US economy and Japan appeared to have the answer to everything, it was common to come across predictions in which the all-mighty Japanese economy would overtake America and become the world’s number one. It did not happen, as we now know. In fact, Japan went into its long period of stagnation, America rediscovered the elixir of growth, and such predictions came to look very silly.

Could the same thing happen to China, India, and the rest of the fast-growing emerging economies? Let me focus on just one, China, and ask the question.

There are economic risks in China – partly from the outside world and, say, protectionism by America and other advanced economies. If China’s markets were cut off, China would grow much more slowly. There’s another economic risk, and it’s what happens when China tries to move towards more balanced growth. I wouldn’t pretend that it is easy for any economy to grow but economic growth based on heavy investment in infrastructure and exports is fine as far as it goes. Will China be able to adjust to something more like Western-style growth? And then there is the big political question. Can you have economic freedom without political freedom? How long will China be able to suppress democracy? There are already 100,000 officially admitted protests a year. China has embraced the world economically but is very different politically.

What’s the answer? We shouldn’t pretend any of this will be easy. I usually come back to a single statistic, which is that China has grown by an average of 9.5% a year for more than three decades, beginning in 1978. All through that period people have been predicting imminent disaster for the Chinese economy, that its growth will run into the sand. So far it has not happened. At some stage it might. But the West would be unwise to rely on China crashing and burning.

Its leaders are intelligent and its economic resilience impressive. It could go wrong but it seems to me that this is one of those shifts that happen from time to time in the global economy. And what goes for China goes for most of the other emerging economies too.

My regular column in available to subscribers on www.thesundaytimes.co.uk - this is an excerpt.

There will be many moments of truth for the government in the coming years but one will come tomorrow, when the independent Office for Budget Responsibility (OBR) gives its verdict on last month’s comprehensive spending review.

The OBR will publish forecasts for growth, public borrowing, debt and a range of other variables. Robert Chote, its new chairman, was often a thorn in the government’s side when director of the Institute for Fiscal Studies. If he were to declare tomorrow that the government’s cuts will drive the economy back into recession, it would be a huge problem for the coalition.

I do not expect that to happen, though no economist says never on such matters. Chote and his team have to answer the question most people in business ask me: where will the growth come from? When we have the “squeezed middle”, in fact the squeezed everybody, where will the demand be? I shall come back to how the OBR may answer that in a moment.

One thing we need to know is the intensity of the squeeze and I am indebted to Lord Young of Graffham, until recently the government’s red tape adviser, for encouraging me to delve into corners of the Office for National Statistics’ (ONS) website that often go unexplored.

He, as you will remember, got into trouble for declaring that most people had never had it so good, despite the “so-called” recession, mainly because of ultra low tracker mortgage rates.

He and I go back a long way. In the 1980s, when he was employment secretary - before he became “enterprise” secretary - I remember him turning up to a briefing by statisticians on the unemployment figures to berate journalists for being too gloomy about the labour market.

Though it is not a good idea for politicians to go around saying “you’ve never had it so good” - Harold Macmillan used a variant of it in the 1950s when his government was under pressure - most of the time they can get away with it.

Lord Young could have got away with it, statistically if not politically, not so long ago. In the second quarter of 2009, near the end of the recession, real household disposable income hit a record high of £221.4 billion (in 2006 prices), an increase of 4.7% since the recession’s start in 2008.

Real incomes rose even as the economy endured its worst recession in the post-war era, because employment held up well, inflation for a while was low and Vat was cut. It was an odd combination.

Even odder is that real incomes have been falling as the economy been recovered. A year on from that 2009 high point, household incomes fell by 2.6%. High inflation has eaten into incomes as earnings growth has stayed low. The January restoration of Vat to 17.5% did not help.

So where do we go from here? ONS figures for real incomes go back to 1948, since when there have been only five years when they have fallen on an annual basis. The years were 1951, 1974, 1976, 1977 and 1981. The recession of the early 1990s came and went without an annual fall in real incomes. Though they fell away sharply after the second quarter peak, real incomes in 2009 showed a 1% rise over 2008.

So this year looks like being unusual. Independent economists surveyed by the Treasury expect real incomes for 2010 to be 0.5% down on 2009, followed by a smaller 0.2% fall in 2011. Some will ask whether next year’s fall may be bigger, given the January Vat hike, the April increase in employee National Insurance contributions and the impact of spending cuts.

The upshot, however, is that we are in the middle of a rare two-year fall in real incomes, not seen since Britain’s IMF crisis in 1976-77. Taking account of the modest rise in 2009, by the end of 2011 Britain will have had three years in which, overall, real incomes will have been stagnant. The effect of this can be seen in the numbers.

Though the CBI’s November survey was upbeat, official figures show that retail sales volumes in October were marginally down, by 0.1%, on a year earlier. Monthly mortgage approvals from the major banks are showing a 12-month fall of 27%. With the scrappage scheme no longer helping, private new car registrations last month were almost 36% down on a year earlier.

Though these falls may exaggerate it, the squeeze on incomes means the recovery will not be led by consumers, or realistically can be.

So where will the growth be? The Ernst & Young Item Club, which uses the Treasury’s model of the economy, has produced a useful preview of the OBR forecast, to be published tomorrow. One positive development it expects is a reduction in the number of public sector job cuts, from the 490,000 estimated after the June budget to around 400,000. This is because the spending trimmed average real spending cuts in non-ringfenced departments from 25% to 19%.

As for the rest, the numbers should be reasonably upbeat. This year the economy has grown faster than expected, so the OBR’s June forecast for 2010 growth of 1.2% will be revised up, perhaps to 1.7%. Item’s forecasts for 2011 and 2012, 2.2% and 2.9%, are similar to the OBR’s June forecasts of 2.3% and 2.8%. This is despite consumer spending growth of a feeble 0.8% next year.

How? This is where the great rebalancing kicks in - a recovery led by net exports (the difference between exports and imports) and investment. And, while I can sense scepticism, it is not necessary to look into the crystal ball to see this rebalancing beginning.

Figures last week confirmed that the economy grew by 0.8% in the third quarter. Half of that growth came from net exports, with export growth easily outstripping imports. Investment is growing at a good pace and should pick up further.

Exports and investment are starting to replace consumer spending and government as the drivers of growth. That is why the economy has grown by a strong 2.8% over the past year in spite of falling household incomes. It is also why the recovery can continue through the squeeze on incomes. As with a diet and exercise regime, it may not feel very comfortable. We should, however, emerge healthier and better balanced from it.

My regular column is available to subscribers on www.thesundaytimes.co.uk - this is an excerpt.

Ireland’s woes in recent weeks, indeed the panic over the euro’s ability to survive, can be put down to the clumsiness of Angela Merkel, the German chancellor and her insistence that investors in European sovereign debt should bear some of the cost of future eurozone crises. For future the markets read current, and panic ensued.

That was how we got here, though at some stage we would have reached this point, if not for Ireland, then for Greece (again), Portugal, or Spain.

There will be those in Europe who see the eurozone’s woes as an Anglo-Saxon plot - driven by uncontrolled financial markets - to wreck their grand project. European leaders may regret having insisted the eurozone would be a haven of stability as the global crisis raged.

You might think, as one who long argued that Britain should not touch the euro with a very big bargepole - I still get people suggesting entry now would be a good thing - I would be crowing at the eurozone’s woes.

You might think, as the author of a book more than a decade ago (Will Europe Work?) arguing the euro project would hit problems because Europe is not an optimal currency area, I would be dancing on its grave. (An optimal currency area is one is which there is wage flexibility, geographical mobility of labour and a strong element of centralised fiscal policy).

Far from it. A break-up of the euro now, if allowed to happen, would seriously set back an impressive global recovery. When all the talk has been of currency wars, the distintegration of the euro would be like somebody exploding a nuclear device.

The euro, for its current problems, has not been a disaster. The European Central Bank, under Jean-Claude Trichet, has earned credibility in the markets.

Some will say Britain, despite being prepared to help out Ireland, is in no position to lecture. We had our boom and bust, and our spectacular shift into budget deficit. Being out of the eurozone, however, has allowed sterling a substantial fall from what was a seriously overvalued position before the the autumn of 2007. There is a flexibility in UK monetary policy eurozone members can only dream of.

Moreover, the nature of the boom in Britain was different. Ireland and Spain are picking up the pieces after construction booms fed by banks falling over themselves to lend. Here, there was plenty of action on house prices but activity struggled, the building of new homes never getting to levels needed to meet long-term demand.

In Ireland, in contrast, there are some 300,000 unsold and unoccupied homes left over from the crisis. In Spain, there are 1.5m, a backlog that on optimistic assumptions will not be cleared until 2017. Everybody’s problems are different. One problem Britain does not have is being in the euro.

So what does the euro have to do to get through this. Can it do so? I still think that while the euro will survive, it will not do so with all its members. Greece had no business joining, and the authorities no business allowing it to do so. The others had a stronger case, but did not follow through with the correct economic discipline.

The pact euro members signed up to was that they would keep costs down, ensuring they maintained competitiveness against the stronger members, in return for which they would be rewarded with German-style short and long-run borrowing costs. Instead, most of the problem-hit “peripheral” economies - I won’t call them the Pigs - allowed their labour costs to rise, over time, by 20% to 30% vis-a-vis Germany.

Greece, as I say, should not be there, though will not be leaving for some time. For now it needs to be kept in to protect others from contagion fears. The question for Ireland, Portugal and Spain is whether their people can make the sacrifices, which will include wage cuts, to survive in the euro. Ireland has started on this path but there is a long way to go. Countries in the euro waiting room in central and eastern Europe are considering their positions.

It is not just the weaker members where the problems lie, however. The eurozone’s problems are a scaled-down version of those facing the global economy. It has big surplus economies, most notably Germany, whose formidable exporting machine has produced what looks like a permanent current account surplus. Then it has those with chronic current account deficits, such as Greece and Portugal.

On the world stage, these imbalances have led to talk of exchange rate manipulation and currency wars. In Europe, as long as the eurozone holds together, there cannot be a way out of it through currency adjustment. These very considerable tensions have to be resolved by other means.

One of those means will be greater economic discipline among weaker “deficit” countries. But this is a two-way street. If Germany wants the euro to develop in the image of the D-mark, an ultra low inflation currency with permanently weak domestic demand growth, it will only succeed in splitting the euro up.

It will not just be the peripheral economies who will struggle to keep up with this, but those at Europe’s heart, including of course Italy, but also France. Both have lost significant competitiveness versus Germany in the euro’s 11-year existence.

So Germany has to change to make the euro work. She has to loosen her stays, get her current account surplus down and meet the other euro members somewhere in the middle. Otherwise the euro’s break-up will not be the fault of Greece, Ireland, Portugal, or Spain, but Germany.

An excerpt from my Sunday Times piece, available to subscribers on www.thesundaytimes.co.uk

The Bank of England is tasked with achieving 2% inflation. It is a year since inflation was below target, which it was for six months, preceded by 20 months above it. If the Bank is right, it will be at least 12 months before it is below target again.

Maybe maintaining recovery after the biggest post-war financial crisis matters more than whether inflation is 3% rather than 2% for a while. It is why, while talk of further quantitative easing - electronically creating money - beyond the £200 billion so far has died down, though not gone away, interest rates remain a whisker from zero.

The Bank, for good reason, does not provide forecasts for interest rates. It does publish the path of Bank rate implied by money markets. A year ago, markets thought Bank rate would be on its way up now. Three months ago, rates were seen rising in spring 2011. Now markets see the first move not coming until late 2011.

While the recovery is stronger than after the recessions of the 1980s and 1990s - gross domestic product is up 2.8% over 12 months - the Bank fears it will not maintain that pace. Though its forecasts suggest growth in the coming years will average about 3%, the worry is about the risks.

You can never have enough warnings that if political leaders do silly things like engage in protectionism or currency wars the world economy could be back in trouble. So King was right to fire a salvo in the direction of the G20 gathering in Seoul.

The global upturn has been much stronger than expected. In the spring of 2009, the London G20 meeting in Docklands, the International Monetary Fund predicted global growth of less than 2% for 2010. Its latest projection, with not much of the year to go, is 4.8%, then 4.2% for 2011.

To go from there to the governor’s warning that the next 12 months could be more difficult than the period we have been through would be pretty dramatic but, as I say, reminders are always useful.

Then there is the renewed outbreak of eurozone tensions, particularly swirling around Ireland. Could these hit Britain? Of course. Any new turbulence is unwelcome. Britain’s banks have a direct and indirect interest in Ireland and other eurozone economies. 7% of Britain’s exports go to Ireland.

A report this weekend from Oxford Economics warns that a chain of defaults would push first the eurozone then Britain and America back into recession. The authorities are determined to prevent any such thing happening, but the risk is there.

Then there are domestic risks. I have written a lot about whether the private sector will fill the gap left by spending cuts. The governor has rarely shown his irritation more than when responding to report s about unease in the Bank about his support for the coalition’s cuts.

King said it would be astonishing if a central banker did not support deficit cuts. Equally, it would be astonishing if there were not voices in the Bank urging a slower pace of deficit reduction.

You do not have to read much between the lines of speeches by the MPC’s Adam Posen, a student of the Japanese economy, to find it. The Royal Economic Society’s latest newsletter laments the lack of a response by members to its previous issue, in which it set out the case against the cuts. I happen to believe King is on the right track but there is no disguising deep divisions among economists on the issue.

It is another domestic risk I want to focus on for the rest of this piece. “One uncertainty surrounding the macroeconomic outlook is the extent to which deleveraging in the banking sector will continue to restrict the supply of credit,” the inflation report said.

Kate Barker, until recently an MPC member, told a Credit Suisse seminar that worries over the banks’ ability to support recovery was the main reason why the Bank may do more quantitative easing.

I will do a bigger piece on banking, armed with statistics like the fact that Britain’s biggest 10 banks have grown from 40% to 459% of gross domestic product in 50 years. There is room for debate over such figures and whether changes to the system - which the Independent Banking Commission is investigating - are needed.

For the next year or so, however, the key question is whether the existing banking structure will provide enough credit. While money and credit growth are weak, close to zero, it is not yet clear lending to business is weaker than after previous recessions. That does not mean some businesses, notably smaller ones, are not being starved of credit. But the overall picture is fairly typical of post-recession periods.

Will lending pick up from now on? If it does not, it may be for a couple of reasons. One is the unwillingness of the banks to lend, in which case the government should do what it always criticised Labour for not doing enough, press the banks harder.

The other is that the banks cannot lend because, as the Bank noted, “they will need to refinance substantial amounts of maturing funding over the coming years, including that presently supported by the official sector”.

That support, £165 billion in the Special Liquidity Scheme and £120 billion under the Credit Guarantee Scheme, will come to an end. In all, the banks have £480 billion of maturing debt to roll over in the next 2-3 years. This, handled badly, could starve the economy of credit for years to come.

It seems to me, however, that if that were the cause of an ongoing credit crunch, it would make very little sense for the Bank to try to offset it by engaging in more quantitative easing. The authorities would be taking away with one hand, by withdrawing official support for the banking system, while giving with another, through further easing.

Anybody looking at this from outside would conclude this was a silly way to proceed. The Bank, with Treasury approval, would do better to extend the period over which official support is withdrawn. Problem solved, or at least one of them.

An extract from my regular column, available to subscribers on www.the sundaytimes.co.uk.

Recent economic numbers have been good, including that highly encouraging 0.8% third quarter gross domestic product (GDP) figure and last week’s better-than-expected purchasing managers’ surveys for manufacturing and services. This was the time, remember, when some warned that we would already have dropped into the dreaded double-dip.

Numbers are numbers, jobs are real. Most people do not spend time poring over the national accounts data or the surveys. Economic misery, or joy, is mainly defined by the state of the labour market.

What counts, therefore, is whether growth is converted into employment. Friday’s American job numbers have not altered a picture in which unemployment hangs like a cloud over America, a symptom of a deeper malaise reflected in the mid-term elections.

The performance of the job market helps explain why America appears more obviously and visibly damaged and depressed by the crisis than many other countries, including Britain.

Last year I mentioned the Zarnowitz rule, after the American business cycle export, the late Victor Zarnowitz, which was that deep recessions are almost always followed by steep recoveries. Some countries are obeying the rule, including you could argue Britain in the second and third quarters. America is not.

In fact, while the crisis was triggered by events in America the US economy had a milder recession than most advanced economies, GDP falling by 4.1% from peak to trough. Employment, however, dropped by significantly more, 6.1%.

Britain’s recession was deeper, with a 6.4% drop in GDP but the employment consequences were far less. At its worst, the level of employment dropped by 2.8% from pre-recession levels, since which time there has been a 1% rise. Employment is less than 2% lower than before the crisis.

The story in Germany has been even better. Germany’s unadjusted unemployment total, which five years ago rose above 5m, has just dropped below 3m. Uniquely among big economies, Germany’s unemployment rate has dropped during the crisis and recession, despite a big fall in GDP. Compared with July 2007, there are 2% more people in jobs in Germany.

That experience is not matched across the European Union, or you would have to conclude that Europe’s less flexible job markets produce better outcomes than the sometimes brutal American approach.

Helped by Germany, however, the rise in EU unemployment, a third since the start of the crisis (7.2% to 9.6%), compares favourably with the more than doubling of unemployment in America.

Returning to Britain, when the data revisions come through the recession should look less severe than it currently does. The 6.4% GDP drop in the recent recession compares with 2.5% in the early 1990s and 4.6% in the first Thatcher recession of the early 1980s (her only one if you regard the early 1990s’ recession as John Major’s).

Whatever happens to the GDP data, employment has held up better. In the early 1980s and early 1990s, the shakeout in jobs followed the recent American pattern, with drops of 6.3% and 6.1% respectively. This time, so far, has been different.

It has been different, as an analysis by the Office for National Statistics points out, because part-time employment rose through most of the recession and has risen even more strongly in the recovery. Full-time employment, in contrast, has followed the economy more closely, dropping by 5% from pre-crisis levels.

Some of that reflects employees accepting a switch to part-time hours to preserve jobs, though most of it is due to new part-timers being hired in a different part of the labour market to that where full-time workers were made redundant. So the composition of employment has deteriorated. Even so, it could have been a lot worse.

Will the job market stay different from previous recessions? Has the unemployment problem been merely delayed, rather than avoided? Every day several e-mails land in my inbox from the GMB union, detailing jobs under threat or being cut in the public sector, mainly local government.

John Philpott, chief economist at the Chartered Institute of Personnel and Development, set the cat amongst the pigeons and provoked a row with the Institute of Directors by predicting 1.6m job losses by 2015-16.

The combined effects of public spending cuts and higher taxes, notably the January rise in Vat, will lead to 725,000 public sector jobs losses and an eye-catching 900,000 in the private sector.

He would concede that he has been too gloomy about unemployment so far, expecting something closer to normal recessionary labour market behaviour and a rise in unemployment to over 3m. As it is, while the prediction of 1.6m job losses grabbed the headlines, he also expects that the rest of the private sector will generate enough jobs over the course of the parliament to offset these reductions - which I agree with - though it may not do so in 2011 and 2012.

That is the question. Ian Harwood, chief economist at Evolution Securities, thinks the economic growth pattern of this year, when the strength of the upturn has beaten expectations, will be repeated in 2011. Most other economists remain more downbeat, however, and the very latest labour market statistics have had a slightly softer tone.

History tells us that the early phase of a recovery is when employment growth is most fragile. That is because there is slack to use up within organisations following the recession, and because employers are typically cautious about hiring.

So in the early 1980s the trough in employment was a full two years after the economy’s low point. In the early 1990s the lag was shorter, exactly a year. From 1991 to 1998 700,000 public sector jobs were lost but overall employment grew relatively strongly.

We are now four quarters into the economic recovery, so on the early 1990s’ model should be on a sustained upward path for employment. Certainly the summer saw a big rise in private sector jobs, the biggest since records began in 1971. If it is the 1980s all over again, however, 2011 could yet be difficult, the recent employment rise being a false dawn.

We will know quite soon. The job market performed a minor miracle during the recession. It would be another one if we get through the winter without some rise in unemployment. If it is a relatively modest rise, which I would expect, the damage would be limited. Anything much bigger and the government would find itself in a sticky patch.

This is an excerpt from my regular column, available to subscribers on www.thesundaytimes.co.uk

Though George Osborne exaggerated it by smattering his Commons speech with so many projects and commitments you had to listen hard for the cuts, the spending review was better than feared.

The headline figure of £81 billion cuts by 2014-15 is still eye-catching, the difference between the planned total and what was needed to keep up with inflation. £10 billion of that £81 billion will hurt nobody, however, being the reduction in debt interest.

There will be losers but for years experts have called on governments to do something about inexorably rising welfare spending, so £18 billion (£7 billion of which was announced last week) was a good start.

Limiting the cuts in spending in non-ringfenced departments to 19% over four years not only allowed the coalition to make a political point at Labour’s expense (though stretching the data to do so) but it increased the chances of achieving them. The difference between 25% real cuts and 19% may not sound huge but it could be very significant as governments get down to the hard job of delivering them.

Finding an extra £2 billion for capital spending, admittedly because existing contracts could not be broken, ensured a supportive nod from business. None of this disguises the fact that it is tough, as the IFS reminds us. It is the toughest for overall spending since the war, for spending on public services since 1975-80s, and even for the ringfenced NHS the toughest since 1951-56, just after it came into being.

But some of the commentary on the spending review was, frankly, silly. To admonish Osborne for using the analogy of a household living beyond its means confuses the use of an explanatory political device with the underlying analysis.

The Treasury has many faults but it knows the difference between household finances and the public finances. Similarly, to attack deficit-cutting as “pre-Keynesian” policy ignores most post-Keynesian economics, much of which has demonstrated the limitations of fiscal policy.

One surprise to have emerged from the crisis is how many unreconstructed Keynesians still exist. This may be an age thing - people who studied economics at a particular time - but it is nonetheless surprising.

I had thought this had disappeared at roughly the time of former Labour prime minister James Callaghan’s “you can’t spend your way out of recession” speech in 1976. I do not recall much of it when the Conservative government embarked on a similar fiscal tightening in the 1990s.

Keynesians looking for support in the great man’s General Theory for running big budget deficits indefinitely will not find it. As Sir Samuel Brittan, a critic of the cuts, noted ruefully in a recent speech: “Unfortunately Keynes did not take the final logical step of endorsing budget deficits and indicating their safe and desirable limits.”

Now the overall spending allocations have been made, two things will happen. Government departments will publish business plans, not providing line by line detail of cuts but timetables for departmental priorities, and indicators by which the achievement of these should be judged.

The more tiresome development will be that every economic morsel will be seen through the prism of “the cuts”. Rare too will be the company statement that does not include a reference to public spending or tax increases, or both.

One key test of the fiscal plans is the recovery’s durability. Economists have no real excuse for using the spending review as justification for lowering their forecasts. The £81 billion of cuts announced last week were marginally less than the £83 billion signalled in the June budget.

Those cuts, according to the Treasury’s latest compilation of independent forecasts, were consistent, on average, with 1.9% growth next year, not rip-roaring but a recovery. If they are revised down, logic suggests it will not be because of the cuts. The debate will run and run.

The other requirement for the next few years is that the economy rebalances. “The case for rebalancing is even stronger in the wake of the financial crisis and recession that followed the nice decade,” Mervyn King said last week.

“To achieve rebalancing we need to sell more to and buy less from economies overseas. To close the gap between exports and imports, more than half a million jobs will probably need to be created in businesses producing to sell overseas – compensating for fewer employment opportunities serving consumers or the public sector.”

The Bank of England’s acronyms department has come up with a new one for the governor, Britain’s “sober” decade of savings, orderly budgets and equitable rebalancing. It does not trip off the tongue.

Balancing the government’s books and balancing the economy should be part of the same story. When household incomes are squeezed by benefit cuts, other spending reductions and tax hikes, consumer spending should grow more slowly.

In the tightening of the 1990s, when a budget deficit of 8% of gross domestic product was turned into a surplus in five years, Britain’s trade position improved in tandem. The current account went from a deficit of 5% of GDP to balance by 1997.

People are gloomier this time about exports, because of a perceived reluctance of firms to take advantage of sterling’s lower level, currently 23% below pre-crisis levels on an average basis. Companies, it is said, are increasing their margins rather than their export volumes.

Export volumes have, however, risen by a strong 14.5% over the past year. The challenge of eliminating the current account deficit, currently 2% of GDP, is less.

The conditions are in place for the recovery to be a balanced one, led by exports and investment, as happened for several years in the 1990s. As with cutting the deficit, there is really no alternative.

My regular piece is available to subscribers on www.thesundaytimes.co.uk - this is an extract.

Criticisms of the government's comprehensive spending review on Wednesday will come from those who think the deficit doesn’t matter and the government should borrow for as long as it wants. Others agree it matters but not as long as the economy is fragile.

Some will say the government has got the balance wrong between tax hikes, 23% of the planned adjustment, and spending cuts, 77%, arguing taxes should bear more of the burden. Against them will be the spending hardliners, who want bigger spending cuts but at the same time lower taxes to boost the private sector.

My list is not exhaustive but there will also be those who back big spending cuts but think infastructure and other capital spending should be protected. That is the view of most business lobby groups.

Let me start with some numbers. On one side there is Lord Skidelsky, Keynes’s biographer, the great man’s vicar on earth. The government, he wrote last week, plans “the most audacious axe-cutting exercise in almost a century”, cutting spending 10% over four years and taking 5% “out of a shrunken economy”.

On the other there is the Centre for Policy Studies’ paper on Friday, talking about the “modest” cuts the chancellor will unveil and repeating the point made here, that in cash terms spending will continue to rise every year in this parliament.

What’s the truth? The generally accepted number for cuts, £83 billion over this parliament, compares what would have happened if spending were to keep pace with overall inflation in the economy with what will happen. So, though the spending “envelope” will rise from £640 billion in 2011-12 to £659 billion in 2014-15, that implies a significant real cut.

The size of that real cut is acutely sensitive to inflation. The government assumes just to stand still public spending needs to rise nearly 3% a year. That seems generous. It seems to me overall spending will be about 4% lower than if it were to keep pace with inflation, following a 10-year period in which it rose 50% in real terms.

Is the planned fiscal tightening unprecedented? It is unusual, though the Treasury notes it is similar to that in Britain between 1993-4 and 1999-2000, and over a similar period in Sweden and Canada.

Will it snuff out growth? People who make this claim appear to have read too much about the public sector accounting for half of the economy, which it does not.

Roughly speaking, taking numbers from both the Office for Budget Responsibility (OBR) and the Ernst & Young Item Club, public spending boosted the economy by an average of 0.6% a year during the splurge years from 2000, sometimes more. Over the next few years, the straight arithmetic of the cuts means spending will subtract 0.6% a year from growth.

Does that mean stagnation? Not if you believe the economy is only capable of growing by a tiny amount each year. If the private sector’s long run growth rate is 2.5% or so, which is reasonable if not conservative, it can grow by 2% even through the cuts. If, as is normal, the economy grows faster in the recovery period from recession, it can manage more than 2%. The OBR, under its new chairman Robert Chote, will give its pronouncements on this, though not until November 29.

The arithmetic may overstate the impact of cuts. Though hard to quantify, the private sector will expand into the gap left by a smaller state and low long-term interest rates will help all sectors.

Does not the aftermath of the crisis, and the damage to the financial system, mean government spending should be maintained for longer? Many people, on both sides of the debate, cite This Time Its Different, the study of past financial crises by Carmen Reinhart and Kenneth Rogoff.

To be clear, I sought out Rogoff, former chief economist at the International Monetary Fund. The lesson from his study, he said, is that governments have to be careful about their debt in the aftermath of crises.

Rising debt can seemingly have little impact, as is the case in Britain now with very low government bond yields. But the relationship is “typically quite non-linear”, Rogoff says “so interest rates can rise quite suddenly as a country hits its debt ceiling”. A plan for getting the deficit down is vital.

Even under the coalition’s plans, public sector net debt will rise from less than £700 billion 18 months ago to £1,316 billion by the end of the parliament. The old “ceiling” of 40% of gross domestic product set by Gordon Brown for government debt will not be seen again until the 2030s.

Many of those who argue blithely that the goverment should carry on spending appear content to ignore the debt issue, even though the burden for future generations will grow and Britain’s debt dynamics could yet turn nasty. The more subtle ones argue that debt will rise even faster if the chancellor cuts too soon and drives the economy into the buffers.

There is, as I have written before, a legitimate debate about the speed of cuts, with the plans the coalition inherited from Alistair Darling (halving the deficit in four years) the minimum, and the plans to be confirmed by Osborne on Wednesday probably the maximum. If the squeeze proves too intense, things can move more slowly, as some ministers have hinted.

It would be a mistake, however, to hint at a change now. A failure to follow through this week with a review that fills in the details on the numbers set out in June would be seen as a loss of nerve.

History is littered with examples of governments that have set out plans for spending cuts and failed to achieve them. We will not know for 3-4 years whether this government can do it. This is, however, its only realistic opportunity. It has to give it its best shot.

In its honeymoon, the government has boasted of getting to grips with the public finances and staving off the dreaded loss of Britain’s AAA rating. Most of the hard work to live up to that boast starts now.

My regular piece is available to subscribers on www.thesundaytimes.co.uk. This is an excerpt.

It was brave for the Tories to attack last week one of the welfare state’s sacred cows, risking the wrath of its own supporters in middle England and demonstrating that the pain of the cuts will reach up the income scale.

What there was no excuse for, however, was announcing the change in such a cackhanded way. One characteristic of the Conservative team in opposition was the effort it put in to ensure external experts backed its numbers.

Perhaps it was the pressures of office, or of putting together the chancellor’s party conference speech in haste. Perhaps, to take the Machiavellian interpretation, the chancellor’s deliberate intention was to generate maximum anger in the short-term in return for long-term gains.

That is too generous. Something went badly wrong. You did not have to be a tax expert to spot the immediate double-income flaw in the crude removal of child benefit for higher rate taxpayers - two parents earning £40,000 each get it, a single earning parent on £44,000 does not.

It was predictable that the Institute for Fiscal Studies would warn that the move “seriously distorts incentives” for families with main earners. Nobody would know this better than Rupert Harrison, George Osborne’s special adviser, who used to work at the IFS.

So the episode is puzzling, and potentially worrying, though the Treasury has time, until 2013, to straighten it out. But if so much political flak has been generated over just £1 billion of cuts, the omens on the face of it are not good for the remaining £82 billion. The other big announcement, limiting benefits to no more than average household income, is easier said than done.

The chancellor was bold enough soon after his June budget to name the date for the spending review, October 20, just as the coalition was bold enough to say the next election will be on May 7 2015.

In the case of spending, it may have been a bit too bold. There is always a scramble as the date of the review approaches but the signs from Whitehall are that a lot of big decisions are going to the wire, though the Treasury denies any ministerial cold feet about the timing of the cuts. In the past, the Treasury left naming the date of the review as late as possible. This one is set in stone.

As it is, the child benefit episode prepares us for the howls of pain that lie ahead. How serious will they be? Several people have suggested to me recently that politicians and commentators have underestimated the extent to which there will be a backlash against the cuts.

Not only is anger against bankers undiminished but politicians are seen as part of that same establishment. When the cuts bite, the argument is, the backlash will be bigger than anybody expects.

I would not dismiss this. There is anger out there. The fact Britain does not do protests in the way some other European countries do should not be taken for granted. Nor should the idea that a government that is doing the right thing by the deficit will get much support for it.

Here, the role of business could be pivotal. Not only does the private sector have to generate the jobs and employment to offset public sector cutbacks, but businesses have to be prepared for their own disappointments in the spending review.

Vicky Pryce, former chief economic adviser at the Business Department, now with FTI Consulting, says most firms are in denial about the direct and indirect impact of the cuts on their business.

Business lobby groups have been united in calling for action to cut the deficit, while at the same time urging that infrastructure spending, on roads, rail, hospitals, schools and so on, be spared the axe.

That, barring a miracle, is not going to happen. The scrapping of the Building Schools for the Future programme, an even clumsier example of policy implementation than child benefit, was a harbinger.

Gross capital spending by government will drop from almost £69 billion last year to £43 billion by 2013-14, a fall of 38% in cash terms and something approaching a halving in real terms. Net of depreciation, the capital spending fall is even bigger, from £49 billion last year to £20 billion in 2013-14.

In this area, smoke and mirrors are the norm. The prime minister, in his Tory conference speech, offered a future of superfast broadband and high-speed rail. To be fair to him, independent bodies like the Construction Products Association are optimistic about prospects for rail and energy projects, even amid the big capital spending squeeze. Business will not get all it wants from the spending review.

The bigger question is whether the economy gets what it wants. Though the unions deny it, official figures show clearly that public sector workers earn more on average than their private sector counterparts. The bigger the sacrifices on pay, the more public sector jobs - which the Office for Budget Responsibility expects to drop by 600,000 - can be preserved.

The more reforms to public sector pensions are pushed through, in line with the recommendations of former Labour minister John Hutton, the more the public finances will be sustainable in the long-term.

On the face of it, the challenges do not look as great as they have been portrayed. The government’s overall spending will continue to rise in cash terms over this parliament, though it will be severely squeezed in real terms, particularly non-ringfenced departments.

The coalition’s aim, of returning public spending to the equivalent of just under 40% of gross domestic product by 2015-16 does not look hugely demanding; that is where it was in 2003-4. But the composition of spending has changed. What Gordon Brown used to call the bills of failure, debt interest and unemployment-related spending, takes a much bigger share of the cake. Capital spending, as noted, is being slashed. Public spending needs rebalancing as much as the economy does.

My regular Sunday Times piece is available to subscribers on the paper's website www.thesundaytimes.co.uk - this is an extract.

At present, you would want to be a fly on the MPC wall. On one side is Andrew Sentance, who wants to raise rates because the economy is recovering and inflation has been above target too long.

On the other is Adam Posen, the MPC’s American member, who dismisses inflation fears and is minded to vote for further quantitative easing to prevent a Japanese-style lost decade for Britain. He did not have to say it explicitly but clearly believes talk of a rise in interest rates is barking.
was done.

Posen is an accomplished economist and specialist on Japan and a veteran of the Washington policy circuit, though he was giving his speech at Hull City’s football ground.

The lessons of Japan, he says, are that economies can become locked unnecessarily into periods of weak economic growth and low inflation, even deflation, because of the timidity of policymakers.

“The risks I believe we face now are of sustained low growth turning into a self fulfilling prophecy, and/or inducing a political reaction that could undermine our long-run stability and prosperity,” he warned. “Inaction by central banks could ratify decisions both by businesses to lastingly shrink the economy’s productive capacity, and by investors to avoid risk and prefer cash. Those tendencies are already present, and insufficient monetary response is likely to worsen them.”

America in the 1930s and Japan in the 1990s stand as monuments to the kind of
errors that can be made, he argued. Not only would it be a mistake to tighten monetary policy prematurely by raising rates but it would be a mistake for the Bank not to respond with further easing. That might be simply a question of adding to the existing £200 billion of quantitative easing, by purchasing government bonds, gilts.

But there could also be a need for what Posen calls a “Plan B”, large-scale asset purchases, co-ordinated with the Treasury, what he calls “direct credit market intervention” and “fiscal measures supported by the Bank’s actions and implementation”. The Bank would pump taxpayers’ money into the economy, a much more explicit boost than anything attempted so far.

Posen has has been building up to this speech for some time. Is he right? The first thing is that, while many are worried about the recovery, there is no evidence Britain is following the Japanese path of the 1990s. For one thing it is far too early to say. For another, some indicators, not least a sharp rise in “money” GDP - growth plus inflation - are distinctly unJapanese.

Posen’s view is that the economy’s ability to grow has not been adversely affected by the crisis and that it would be a crime to hold it back. The Bank’s task is therefore to pump it up to full capacity.

But if the supply-side of the economy has been damaged, all that pumping will not drive it faster. The drivers of economic growth are fundamental. Pumping money into an economy in these circumstances could lead to sustained high inflation. Weak growth and high inflation can co-exist. Posen has provided an alternative view but it is also a stab in the dark. To use it to extend the Bank’e easing policy would be a mistake, possibly a dangerous one.

There is a respectable argument for extending quantitative easing which is distinct from Posen’s. Most members of the shadow MPC, which meets under the auspices of the Institute of Economic Affairs, favour more asset purchases by the Bank, with the consensus being around £50 billion on top of the existing £200 billion. Three also vote for an immediate rate hike to 1% which, as noted last month, would be an unusual policy combination.

The shadow MPC has a monetarist bias and its concern is the weakness of the money supply. It does not believe there can be a serious inflationary threat when the money supply (M4) has an annual growth rate of less than 2%.

Even monetarists are not singing from the same hymn-sheet. Simon Ward of Henderson notes underlying money supply growth has accelerated to a 4.5% annual rate in the past three months. The velocity of money is accelerating, as in the past when real rates were negative.

These are uncertain times. It is possible Britain is turning Japanese but I don’t think so. It is possible the money supply will be so weak it will need a further leg-up from the Bank but we are not there yet.

Many people - including many in business - are uneasy about what the Bank has done already. Some see it as Zimbabwe-style printing of money, with inevitable inflationary consequences. Others do not distinguish between a fiscal and a monetary stimulus and worry the Bank’s actions are adding to government debt.

Surely central banks are meant to try complex things that people do not understand? Yes, but one crisis lesson was that mistakes are made when institutions embark on things when they themselves cannot be sure of the consequences.

The Bank was right to embark on quantitative easing as part of its emergency actions to stabilise the economy 18 months ago. It would be wrong to go further to try to speed an economy likely to grow more slowly than in the past for good reason.

The recovery will be uneven. There will be times when it appears to be flagging. In the past, the Bank might have responded to such weakness by cutting rates. But, while quantitative easing is a natural extension of rate cuts, it is much harder to reverse. The gilts and other assets the Bank has bought as part of the programme will have to be sold back.

It is possible to envisage a scenario where the Bank is constrained by market conditions from selling back the gilts it has bought, thus necessitating a sharper rise in interest rates when the monetary brakes have to be applied.

MPC members are right to explore all avenues. A free debate is far better than a dull consensus. On the basis of what we know now, however, further unconventional measures are not warranted.

My regular Sunday Times piece is available to subscribers on www.thesundaytimes.co.uk. This is an excerpt.

Most conversations about the housing market are dominated by prices. On this, the broad picture on the Nationwide building society measure was that prices began to fall in the autumn of 2007 when the mortgage famine hit, dropped by nearly 20% over the next 18 months but began to rise again in the early spring of 2009.

By this summer, prices were nearly 12% above their lows. They have since slipped and are currentlyabout 11% below their pre-crisis peak nationally. In some areas, notably parts of London and the south-east, prices have risen above pre-crisis levels.

That does not sound like much of a housing recession but prices, of which more in a moment, do not tell anything like the full story. For the housing sector, volumes are much more important.

The British Bankers’ Association said last week that mortgage approvals for house purchase last month were just 31,767. This was the weakest monthly figure since April 2009 but, perhaps more significantly, only half the typical level prevailing before the summer of 2007. August’s approvals were only 40% of their recent peak, in November 2006.

Other measures of volumes tell a similar story. Acadametrics, which produces a house price index for LSL Property Services, says transactions (with and without mortgages) totalled 60,600 last month, half the 120,000-plus monthly figure typical in 2006 and 2007. Transactions were 59% of their long-run August average.

A similar picture is provided by Her Majesty’s Revenue and Customs (HMRC), which records all property sales above £40,000. Compared with nearly 1.7m transactions in 2006, it will be a struggle to get much above 2009’s depressed level of 848,000 this year.

This weakness is partly explained by a reluctance to buy. The rise in unemployment in the recession was much less than feared but it happened, and fears about the impact of the government’s spending cuts are holding back some people.

By far the biggest effect, however, is on the supply side, and in particular mortgage supply. This is what drove the housing market into recession and is preventing its recovery.

Michael Coogan, director-general of the Council of Mortgage Lenders (CML), recounted last week that when the CML came to put together its annual list of top 30 mortgage lenders in Britain, it struggled.

Just three lenders, Lloyds, Santander and Nationwide, accounted for more than half the market last year. Add Royal Bank of Scotland, Barclays and HSBC and you have more than 90% of the mortgage market. Some household names, such as Standard Life and ING Direct, lent amounts last year that were barely statistically significant.

Coogan’s worry is that any benefit to lenders from the thawing of mortgage funding markets and improved savings flows into banks and building societies, will be more than offset by new tougher rules from the Financial Services Authority on regulating the mortgage market.

The CML fears that net mortgage lending this year, a mere £10 billion compared with £100 billion in 2007, could turn negative in 2011.

Does it matter? Yes. When it comes to mortgages, this situation is discriminating hugely in favour of first-time buyers who have parental funds to draw on. Existing home-owners in safe jobs and with plenty of equity win out versus the self-employed. The housing market has always been unfair but it is becoming more so.

More generally, a low-volume, near-moribund housing market is bad for the economy. It does not just affect estate agents and housebuilders. Even when the housing market turnover was much higher, Britain did not have enough geographical mobility of labour; people’s willingness and ability to move between regions in search of work. In an era where the housing stock will turn over just once every 25 years, mobility will sink further.

Would not a good, market-clearing slump in prices provide the basis for a sustained recovery in housing activity? George Buckley of Deutsche Bank, in a detailed paper, UK Housing: A Long Run View, runs through just about every measure of house price under or over-valuation. He concludes that while some measures point to a clear overvaluation, many others do not.

House prices are broadly in line with their long-run real trend, and are close to fair value against other assets such as shares and gold. If we assume that there is a gradual upward trend in the ratio of house prices to incomes, again the picture is one where there is no significant under or overvaluation.

Most people in this debate get no further than the crude ratio of house prices to earnings which, as I have pointed out on many occasions, tells us very little.

In any case, a fall in prices now would make the housing market’s problem - a lack of mortgage finance - even worse. The lenders would get even more nervous about lending, and the regulators and ratings agencies would breathe down their necks even harder. First-time buyers prayed for a fall in prices in 2007, only to see that the result was that they could no longer obtain the mortgages to take advantage of them.

So the prospect is of a housing market that remains in the doldrums, perhaps for years, never approaching the volumes that were the norm in the long run-up to the financial crisis. An over-exuberant housing market had damaging consequences for the economy then. A stagnant market will be equally damaging now.

My regular column is available to subscribers on www.thesundaytimes.co.uk. This is an excerpt.

Bank rate, reduced to a 315-year low of 0.5% as part of the authorities’ desperate bid to prevent economic and banking collapse, has now been at that level for 20 months.

There is no sign of any shift in that position. Though we will not know for sure until the minutes are published this week, the Bank of England’s monetary policy committee (MPC) is highly likely to have voted 8-1 for no change in rates, with Andrew Sentance as the only dissenter.

Mervyn King, speaking at the Trades Union Congress in Liverpool, not an easy gig, told unions the Bank could provide a further monetary stimulus (through quantitative easing not trimming Bank rate further) if “storms” facing the economy are serious enough. Martin Weale, the MPC’s newest member, concurred in evidence to the Commons Treasury committee.

Sentance has been a lone voice since June, when he first voted to hike rates, though he has support on the Institute of Economic Affairs’ shadow MPC.

Though this newspaper carried his June piece explaining why he was moving in favour of higher rates, I have tended to side with the MPC majority, because the recovery needed all the help it could get. The loosest monetary policy was needed to compensate for the big fiscal tightening (tax hikes and spending cuts) ahead.

There is still a lot in that but lone voices can sometimes be right. Sentance’s argument has four strands. Firstly, you do not maintain emergency settings once the emergency is over. There is a time to turn off the flashing blue light.

Secondly, the recovery has been stronger than most people realise. World industrial production is rising at its fastest rate since before the dot.com bubble burst, more than 10% in the past year, and has exceeded its pre-crisis levels. In Britain, manufacturing output has risen over the past year at its fastest rate since 1994.

Thirdly, there may not be as much spare capacity in the economy as thought. The latest stunning labour market figures, showing a 286,000 rise in employment in the May-July period, the biggest since records began in 1971, were overshadowed by a tiny rise in the claimant count. The job market, which performed well in the recession, is starting to tighten.

Fourthly, the longer rates stay so low, the harder it is to shift them. If the Bank had made clear 0.5% was very temporary, everybody would have been prepared for the exit strategy. The risk is that the Bank leaves it too long, having given the impression ultra-low rates are permanent, any decision to hike could look like panic.

These are good points. The case for higher interest rates is not, incidentally, based solely or mainly on the current inflation figures. The latest numbers were a touch disappointing, showing consumer price inflation stuck at 3.1% and retail price inflation only down from 4.8% to 4.7%.

The air is thick with warnings from clothing retailers about higher wage costs and the rising price of cotton, which they say could push up prices by between 5% and 8%. Significantly higher food price inflation is also in prospect, it seems, while George Osborne’s Vat hike to 20% will come through in early January.

Even after a big rise in August (which followed an even bigger fall in July) clothing prices are 1.7% lower than a year earlier. More generally, as after previous recessions, spare capacity and intense competition should bear down on prices. The prospect remains for inflation to wend its way down to the 2% target or below. Is this not game, set and match to those wanting to keep Bank rate low? Not quite.

As spare capacity left by the recession is used up, inflationary pressures will increase. The post-recession drop in inflation below 2%, which the Bank expects in late 2011 or early 2012, could be fleeting.

Given that inflation has been above the 2% target for more than three-quarters of months since mid-2005, it will need more than a fleeting drop below it to ensure the Bank retains its credibility. Its own inflation expectations survey, carried out by NOP, shows that people expect 3.4% inflation over the next 12 months.

What about the strongest argument in favour of maintaining a 0.5% Bank rate, that the recovery needs it? The Bank would not want to be blamed for tipping the economy back into recession.

It is a very good argument for doing nothing, but we have to think also about what a 0.5% Bank rate is achieving. It is doing a lot for the banks, which have increased their margins. For households, the average standard variable mortgage rate is 3.92%, the average credit card rate 16.7%, and the average overdraft rate 19.1%.

Small businesses face average rates on new loans (up to £1m) of 3.3%, though for many of them - as for households - the issue is as much the availability of credit as its price. Savers, meanwhile, are suffering. The average interest rate on a cash Isa is 0.6%. At some stage savers will have to be rewarded far better than now, which will be part of the rebalancing of the economy.

I am not suggesting the Bank needs to raise rates next month, or even in November. To do so on the eve of or immediately after the spending review on October 20 would smack of sadism.

But the Bank does need to prepare the ground. King’s public stance, that another monetary stimulus via quantitative easing is as likely as a shift towards higher interest rates, is a bit too even-handed.

More easing would only be justified if there was a second wave of the crisis. The further we move away from the emergency, the more the argument will build for normalising interest rates. That does not mean a speedy return to a 5% Bank rate. It does mean getting ready for a controlled move from the current near-zero rate.

My regular column is available to subscribers on www.thesundaytimes.co.uk - this is an excerpt.

For months a debate has been raging. In February, 20 top economists, led by former monetary policy committee (MPC) member Tim Besley, wrote to this newspaper pointing out that Britain had entered the recession with a large structural budget deficit, needed a credible plan to reduce it, and in doing so would make sustained economic recovery more likely.

Even before the ink was dry on the Sunday Times 20 letter, however, there was a riposte, led by the Keynes biographer Lord Skidelsky and Danny Blanchflower, another former MPC member. The "Financial Times 60" had three times the number of signatories, and argued that aggressive cuts were economically barbaric and would pull the rug from under the recovery.

So it has gone on, cutters versus spenders. The spenders have probably had more names, suggesting economists are still mainly Keynesian (letter-writing ones at least) — and they have a political champion in Ed Balls, former education secretary and Gordon Brown's economic guru.

He has written to Danny Alexander, Treasury chief secretary, arguing there was "an economically credible alternative" to cuts, drawing on his speech at Bloomberg, the financial news service, on August 27.

Balls's Bloomberg speech has been widely praised. For me, the surprising thing it revealed was how somebody who was at the centre of Britain's economic policy for so long is either ignorant of economic history or determined to rewrite it.

He has a dodgy view about 1931 and even more about 1981, when 364 economists famously wrote to The Times to attack Sir Geoffrey Howe's March budget. They were ignored and, according to Balls, the consequences included "the deepest recession since the second world war". I thought every schoolboy knew the point about that letter was that it coincided exactly with the start of the long recovery of the 1980s, which is why it gave such communications a bad name. Balls was a schoolboy at the time, but that's no excuse.

As for recent history, Balls's claim of "no significant structural deficit . . . until the collapse of tax revenues from the City of London in 2008" would be challenged by every serious fiscal commentator. The structural deficit, according to the Office for Budget Responsibility (OBR), averaged 2.7% of gross domestic product (£40 billion in today's prices) from 2003 onwards.

That is looking back. What about looking forward? Is the government's approach to spending "economically misguided and dangerous", as Balls suggests?

The parameters are that the coalition inherited from Labour £73 billion of fiscal tightening by 2014-15, £52 billion of it through reducing planned public spending. It added a further £40 billion of tightening, £32 billion through spending, in George Osborne's June 22 budget. We have had the details on tax but are awaiting them on spending.

There was an argument that Alistair Darling's £73 billion, which would have halved the deficit over four years, was enough. The public finances are improving faster than the Treasury predicted. The problem was that Labour ducked holding a comprehensive spending review.

The coalition went further, deciding it had to reassure the markets, and it set itself a goal of eliminating the structural current deficit by the end of the parliament.

There is plenty to criticise about having a political timetable for deficit reduction rather than an economic one. The coalition overdid the comparisons with Greece. There will some very bad decisions, as well as good ones, on October 20. But the minimum the new government could have done was implement Darling's plans, which would not have offered much additional reassurance. Osborne went for what was probably the maximum.

There was no case, however, for doing nothing. Balls, as he made clear in his speech, would not have gone as far as Darling, warning him that "trying to halve the deficit in four years was a mistake". It is not clear he would have done anything and it is not hard to imagine the consequences. If you wanted to conjure up a post-election fiscal nightmare it would have been a minority Brown government with Balls as chancellor. The AAA rating would have gone quicker than you can say Maynard Keynes.

It surprises me that commentators who back Balls's argument that there is no crisis in the public finances, as shown by low gilt yields, ignore the fact that those yields reflect, at least in part, the big fiscal tightening that has been announced.

One of the papers presented at the Jackson Hole monetary conference last month made the point that governments can only get away with big borrowing if markets are convinced it is temporary, in other words if there is fiscal credibility. Labour lost that credibility and the coalition is trying to get it back. The appointment of the Institute for Fiscal Studies' Robert Chote as head of the OBR will help.

Why not ignore the markets and ratings agencies and carry on borrowing, rather than sacrifice public services and government projects? To do so would, according to the IFS, leave the deficit at 7% of GDP at the end of the parliament and put Britain's public debt on an unsustainable path to 100% of GDP and well beyond.

What about the risk that with all countries tightening together, the recovery will peter out? It is hard to see much tightening in America — if anything, the opposite.

The Organisation for Economic Co-operation and Development, which last week said the upturn in advanced economies was slowing, acknowledged the case for countries that had "fiscal space" to slow the pace of their tightening. By that, however, it meant countries such as Germany, with budget deficits of less than 4% of GDP, not Britain, which started with an 11% deficit, one of the highest in the OECD. The legacy Balls helped create was one where Britain had no fiscal rules and had run out of fiscal space. There really is no alternative to significant spending cuts in Britain.

My regular column is available to subscribers on www.thesundaytimes.co.uk - this is an excerpt.

Such is the confusing flavour of the data over the past month that anybody responding to it is entitled to be confused. No wonder the markets have been soaring one day and diving the next.

At times like this, there is only one thing to do, and it is to look at the big picture. When the data threatens to deafen you with statistical noise, it is no bad thing to cover your ears but leave your eyes open.

The first big picture point is that the the world economy is recovering more rapidly than most people expected. The International Monetary Fund expects growth of 4.6% this year and 4.3% next. The split is dramatically in favour of emergiung economies such as China and India, over advanced economies like America and Britain - roughly 6.5% to 2.5% - but the growth is there. On Thursday the European Central Bank raised its eurozone growth forecast for this year from 1% to 1.6%.

There has been a highly encouraging upturn in global trade, which could have suffered from a 1930s-style protectionist backlash during last year’s slump but did not. The World Trade Organisation says the value of world trade rose by 25% in the first six months of this year compared with the the corresponding period of 2009.

That helps explain why Germany is doing so well, with that 2.2% jump in gross domestic product in the second quarter, but America also benefited; US exports rose by 25%. Britain, tied in to slower-growing European demand, did rather less well; exports rose by 8% in the first half.

Even so, what is true for the world is also true for Britain. The recovery has been stronger than the Bank of England, criticised for its optimism, expected, as Mervyn King pointed out recently.

It is highly likely that after the 1.2% jump in GDP in the second quarter, growth will slow to comfortably less than 1% in the third. That is what the weaker August purchasing managers’ and other surveys are telling us.

But growth of half the second quarter rate would be close to trend and probably as much as it was reasonable to expect at this stage. Growth of 0.6% is what the Office for Budget Responsibility predicts for both the third and fourth quarters.

Recoveries do not go in straight lines. There will be months when the balance of the data is weak, and there will be months when it is strong. Pockets of extreme weakness, such as the US housing market, will persist. The big picture, however, is one of recovery. That is true for the world economy, for Britain and, in an economy where the doubts are probably greatest, America.

If the recovery is intact, which I firmly believe it is, why are businesses so downbeat? There are, I think, a couple of reasons for that. One is that chief executives, in their public statements, rarely shout from the rooftops about the strength of the economy, because of the danger of appearing to underline their own efforts. Far better to be doing well in a tough and challenging environment, the phrase many of them use, than in one where the economy is growing strongly.

More importantly, and understandably, businesses think of recovery differently than economists. It is not just the first stirrings as the economy lifts of the bottom, but when order books and activity get back to normal. We are a long way from that point; probably two years, possibly more. Only when we are there will firms start to talk about a real recovery.

Though people can be wrong, and economists often are, one recovery indicator is that thoughts are beginning to turn to higher interest rates. One member of the Bank of England’s monetary policy committee (MPC), Andrew Sentance, has already voted for a rate hike on three occasions since June, and the others have discussed it.

I fully expect the Bank of leave rates on hold at 0.5% this week, and indeed for many months to come. But the fact that the discussion has begun an exit strategy from this emergency level of rates is a significant straw in the wind.

If the MPC is beginning to think about higher rates, its shadow, which meets under the auspices of the Institute of Economic Affairs, is nearly there. This month four of its members - Patrick Minford, Peter Warburton, Mike Wickens and its chairman, my near-namesake David B.Smith - vote to double Bank rate to 1%. The other five members are still happy to hold.

Smith, by the way, is to be congratulated for raising the issue of the sudden prominence the Office for National Statistics has given to the consumer prices index (CPI), which the government has taken to using for just about everything, in preference to the retail prices index (RPI), a cause that has been taken up by the Royal Statistical Society.

One of the interesting things about the shadow MPC is that two of its rate-hikers, Minford and Warburton, also think the Bank should launch “QE2”, adding to the existing £200 billion of asset purchases.

On the face of it that seems odd. Quantitative easing was launched when Bank rate was at rock bottom, 0.5%, and the expectation was that both would be unwound together. The Bank, in other words, would raise rates and sell back the gilts it had bought as two complementary parts of a monetary tightening operation.

Minford and Warburton are saying, in effect, that the two things are separate. Even ultra low interest rates are not producing enough of an upturn in the money supply, so the Bank needs to do more, acting directly through QE. Raising rates would be a signal that it still means business about inflation.

I’m not sure about this but it is an interesting idea. If I had to bet on central banks doing more unconventional easing I would put the Federal Reserve first, followed by the Bank and then the European Central Bank. If I had bet on which central banks will raise rates first, the Bank should pip the ECB, though not this year.

My Sunday Times piece is available to subscribers on www.thesundaytimes.co.uk - this is an excerpt.

Three years ago, the financial crisis broke and, it seems, blew UK economic policy off course. Even before that, however, the cracks had started to appear.

Britain’s fiscal policy was too loose in the run-up to the crisis, as is generally recognised, though the scale of the error is often overstated. It would have been better in the light of what followed to have been running big budget surpluses at the time but the current budget deficit, adjusted for the cycle, was only 0.4% of gross domestic product in 2006-7.

There was also, however, evidence of a monetary policy problem. In that period, starting in 2005 but continuing for much of 2006 and 2007, inflation had begun to move higher, an upward creep identified recently by Adam Posen, a member of the Bank’s monetary policy committee.

From May 1997 to July 2005, consumer price inflation was never above the current 2% target. Since then, it has been above it four-fifths of the time, often significantly, despite the recession. We cannot know what might have happened in the absence of recession.

In August 2007 the Bank had just raised interest rates to 5.75% and predicted that inflation would stay close to its 2% target for the next three years, alongside economic growth of 2.5% to 3% a year.

The reality was very different. Thanks to the recession, the economy has shrunk by at least 10% relative to what it was expected to be, yet inflation has been uncomfortably high.

We are in a different world from August 2007. Bank rate is 0.5% rather than 5.75%, and the Bank’s latest inflation report suggests it will stay at this record low level for some time to come, despite above-target inflation.

The point is not to revisit the crisis and all its horrors, or attack the Bank for its forecasting record, for which it has taken enough punishment for now. Everybody got the economy wrong, to a greater or lesser degree, over the past three years.

The point, instead, is that it is easy to think that the crisis was a nasty interlude between periods of low-inflation stability and guaranteed steady economic growth. My argument is that the great moderation was exceptional; the likes of which we will not see again, and that it was starting to break down even before the financial crisis.

It included 16 years - 63 successive quarters - of economic growth in Britain. Quarter after quarter, Britain’s economy trundled along in perfect Goldilocks fashion, neither too hot nor too cold. Inflation was never more than a percentage ppoint away from its current target for more than 14 years. Monetary policy appeared to operate with slide-rule precision.

What kind of world will we have when the dust settles this time? It will be one, I can guarantee, where we do not have 16 successive years of economic growth. I do not think the next recession is around the corner but it will be s surprise if there is not one over the next 8-10 years. That, by the way, increases the argument for ensuring the public finances are robust enough to withstand the next downturn.

As for inflation, there are those who would combine failed Russian grain harvests, other upward pressure on commodity prices and the temptations of inflating our way out of debt into a re-run of the inflation of the 1970s.

That is to misunderstand the process by which Britain got to high inflation then; the dangerous combination of runaway growth in the money supply, broadly measured, and a wage-price spiral. These days, even the Bank’s best efforts cannot get broad money, M4, growing by more than 3% annually, and average earnings growth is just 1.3%. Inflation has been disappointingly high, and as the Bank told us last week will take time to come down below target. But it is hard to see it taking off.

Much more likely is that it will be a lot more volatile than we have been used to. Sometimes it will surge higher on higher energy or food prices, bringing fears of its return. Other times it will lurch lower, raising the spectre of deflation.

The Bank, as is its wont, predicts a return to the 2% target over the medium-term, after a period both above and below it. It still thinks in terms of the world of the great moderation. I think that world has gone. King described the outlook for recovery as “choppy”. Choppy, or volatile, is likely to be the shape of things in the longer-term too.

My Sunday article is available to subscribers on www.thesundaytimes.co.uk - this is an excerpt.

Nerves are jangling, reflected in a drop in both consumer snd business confidence. The latest purchasing managers’ index from the services sector shows that, while it is still expanding, business expectations have suffered a fall of around 10 percentage points since the spring.

There has been a similar drop in consumer confidence, as monitored by GfK NOP for the European Commission. It has dropped by eight points from pre-election levels even as, on official figures, the economy has picked up speed and unemployment fallen.

Why might this be? Markit, which produces the purchasing managers’ index (it measures business to business activity in the sector) puts the blame squarely on the government

“Behind the weaker growth profile for the service sector is a failure of confidence to rebound from the record fall seen in the aftermath of the emergency budget,” said Paul Smith, an economist with Markit. “Expectations about prospects for the coming year appear to have down-shifted in response to the austerity measures announced in June.”

The drop in consumer confidence appears to have similar causes. Talk of austerity has dominated the coalition government’s short life, both before and since the June 22 budget.

Next, the clothing retailer, reported a “noticeable cooling” of demand since early May, when David Cameron and Nick Clegg strode into Downing Street, not quite hand in hand.

In general, despite one or two wobbles, the coalition has done very well. Compared with the warnings about the dangers of a hung parliament ahead of the election, and all that nonsense from Pimco about Britain sitting on a bed of nitroglycerine, things have been remarkably calm. Sterling is up and so are gilts.

The government had to set out a clear plan for cutting the budget deficit, and did so. Labour, had it been re-elected, would have had to carry out a much more bloodthirsty spending review than it had let, and raise taxes, despite protestations to the contrary from some of its leadership candidates.

The problem is not the policy itself but the way it is being presented, as I touched on in a couple of recent talks at the Institute of Economic Affairs and Reform. The £32 billion of additional spending “cuts” over the next four years was on top of £52 billion inherited, but not yet implemented, from Labour.

None of this has yet been delivered, or negotiated. There are three stages to the public spending process - set the envelope, negotiate the cuts to stay within that envelope, then deliver the cuts.

The first is easy. The second a little more difficult. But it is only during the third that you know whether you can do it or not. The government is encouraging people to look towards the end of a process that will take several years. It is also generating its own scare stories.

The more you say things are going to be horrendous, and that spending cuts will change everybody’s lives beyond recognition, the more people will believe it. When the Treasury asks most Whitehall departments to come up with potential real cuts of 40%, not only is the departmental response likely to be less than rational but the impression is created of an irresponsible slash and burn process embarked upon with great relish by the governmment’s young Turks.

Fun though it is for newly-appointed ministers to be so macho, it is also undermining confidence. Even some Tory MPs are uneasy about it, while their Liberal Democrat confreres can only watch as their poll ratings collapse.
Are not ministers just being straight with voters, telling it like it is? What would the alternative have been?

What I would do, and it is not too late to start, is firstly remind voters, and government departments, that we have just been through the biggest spending splurge in our history. If there is a good time to diet it is after a feast, not a fast.
Then I would point out that even the government’s savage spending envelope allows for public sector current expenditure to rise from £600 billion in 2009-10 to £711 billion in 2015-16, a cash rise of 18.5%.

Between 1994-5 and 1999-2000, current public spending in the UK went up by just 14.9%, a comparable rate of increase to tht planned now. There was no talk then of 40% cuts or Canadian-style surgery on the public finances, but it was achieved - Britain went from a budget deficit of 8% of GDP to a surplus over five years.

I am aware, of course, that £36 billion of the spending increase to 2015-16 is taken up by additional interest payments on government debt. The Office for Budget Responsibility has also pointed out that so-called “resource” limits for departments in 2015-16 will be 12% lower than if they had merely kept up with inflation. For capital spending the gap is even greater; 30%.

That, however, adds to the argument for looking for bigger savings elsewhere. The big cash increases over the next few years are social security, up £30 billion, tax credits, up £6 billion, public sector pensions, £7 billion, and even contributions to the EU, £4 billion.

There are two dangers of huffing and puffing too much about cuts. One is that consumer and business gloom becomes self-fulfilling, restricting the economy’s ability to grow its way out of debt.

The other is that the government gets a reputation for savage cuts but fails to deliver, the worst of both worlds. That was the fate of the Thatcher government in the early 1980s. Surely history won’t be allowed to repeat itself.

Ministers need to lighten up on the austerity message. Otherwise they will end up with an austere economy.

My Sunday Times piece is available to subscribers on www.thesundaytimes.co.uk - this is an excerpt:

The monetary policy committee (MPC) will meet this week, as it has done since 1997, setting interest rates and occasionally resorting to unconventional measures such as quantitative easing, to achieve its 2% inflation target.

It is not the only committee in town. To the MPC are being added, courtesy of the new government, two additional policy-making committees. Everybody by now will have heard of the Office for Budget Responsibility and its interim chairman Sir Alan Budd, who after generating more headlines and comment than is fair for a new body, is heading back to the quiet life in the West Country, leaving things to his permanent successor.

The OBR’s decision-making body is the budget responsibility committee (BRC), a three-member body including the chairman, which will be responsible for official economic and fiscal forecasting, for assessing the long-term sustainability of the public finances and for telling the politicians when they are playing fast and loose. You can have some innocent fun imagining life on the BRC during phases of Gordon Brown’s chancellorship.

As if this is not enough, another powerful committee is being set up, within the Bank, the financial policy committee (FPC), responsible for so-called macroprudential regulation. A Treasury consultation paper last week said a “strong” FPC would have “ultimate authority to identify imbalances, risks and vulnerabilities in the financial system and take decisive action to mitigate these in order to protect the wider economy”.

Is this proliferation of committees a good thing, or could it be a case of too many cooks spoiling the broth?

In the case of the two committees in the Bank, I think it is. In all the inquests about the crisis, and role of the authorities leading up to it, one thing was clear; inflation-targeting was fine as far as it went but it needed to be augmented. In particular, more attention had to be paid to the growth of credit and the prices of assets such as housing, even if they did not directly impact on the target measure of inflation.

This augmenting of inflation-targeting had to go well beyond merely including house prices in the consumer prices index. It had to involve new macroprudential tools (or resurrecting tools used in the past) so that action could be taken to limit the growth of credit in a boom and, by contrast, encouraging its growth in a slowdown. Varying the capital requirements on the banks to take account of the cycle might be one such tool. More direct restrictions on the growth of credit, an echo of the banking “corset” of the 1970s, might be another.

In all the discussion over this, however, the assumption was that these extra tools would be handed to the MPC. Instead the new FPC will get them. The two committees will include the governor and his two current deputies; which implies a big concentration of power in their hands. Otherwise their membership will be different.

No doubt the work of the two committees will be co-ordinated, so one is not cutting interest rates while the other is trying to clamp down on credit growth. I can’t helping thinking, however, that this is an unnecessary complication which increases the chances of policy errors in future.

Sushil Wadhwani, a former MPC member, agrees. In a chapter in the London School of Economics’ Future of Finance report, he thinks the MPC wwas partly to blame in the run-up to the crisis; it could have done more, through interest rates, to restrict the rise in debt and asset prices.

By the same token, however, he thinks it is “odd” not to give the MPC responsibility for the new macroprudential tools. “Standard economic theory suggests that when one has two instruments and two targets, then it is, in general, more efficient to set the instruments simultaneously,” he writes. I think he is right.

What about the other new committee, the BRC? Despite teething problems, some of are due to a new body taking on an independent fiscal role at a time of unusual political change and with a large budget deficit to deal with, it and the OBR look like a welcome change.

We will not really know how it performs until it gets beyond the government’s honeymoon and into some political battles - which could mean it telling the chancellor in a couple of years he has to go further with tax hikes and spending cuts - but it should soon get beyond its shaky start.

For it to do so, it has to make sure it gets the right people on the three-member BRC, and there is a danger that in terms of pay at least, the government is setting the bar too low.

No doubt mindful of his own dictum that public servants should not in general be paid more than the prime minister, George Osborne has set the salary of the OBR chairman at a “full-time equivalent” of up to £142,500, while the two committee members have a full-time equivalent salary of up to £115,000.

The job specification talks of these “high profile and influential roles” taking up an average of roughly three days a week, which is where the full-time equivalent bit comes in.

Let us assume three days a week. That would reduce the OBR chairman’s salary to £85,500, while those of his fellow committee members would be £69,000. These are decent salaries on most measures but, if Budd’s experience is anything to go by, do not begin to compensate for the flak and baggage the job carries with it.

In larger private sector firms, such salaries for very senior posts would be laughable. Tony Hayward can look forward to a £600,000 a year BP salary even after flopping in his handling of the US oil spill, more than six times what the OBR chairman can expect for standing up to the government, being grilled by MPs and filleted by the media.

Nor do OBR salaries stack up well against the other committees. Over at the Bank, Mervyn King enjoys salary and benefits of £305,764, while his deputy governors, Charlie Bean and Paul Tucker, get £254,292 and £257,664 respectively. Members of the MPC, who work an average three-day week, get £131,771 (actual, not full-time equivalent).

Over at the soon-to-be-abolished Financial Services Authority, rewards are even greater. Hector Sants, chief executive, who will join the Bank as a third deputy governor with responsibility for supervision, threatens to blow a hole in its pay structure. His pay, bonus and benefits for 2009-10 totalled £742,011. Lord Turner, the chairman, who will not be joining the Bank - as far as we know - got £482,442.

Money isn’t everything, and there will no doubt be public-spirited and talented people out there who would want to run this important fiscal policy body whatever the salary. But this seems badly skewed.

My full Sunday Times article is available to subscribers on www.thesundaytimes.co.uk. This is an excerpt.

The fall in bank lending to businesses has been extraordinary. Lending growth peaked within a whisker of 20% in early 2007. Annual growth in lending to firms turned negative in June last year and in May was falling at 4.3% annually (6.1% in June according to partial data from the British Bankers’ Association).

This is a huge change, raising many questions. One of which is how to square this with the better than expected recovery. The 1.1% rise in GDP in the second quarter was roughly double what analysts expected. It is possible, of course, that the Office for National Statistics has had a rush of blood to the head and, after several quarters of producing unexpectedly weak numbers, has overcompensated.

Taking the figures at face value, however, this was a solid, across the board pick-up, with manufacturing up 1.6%, services 0.9% (including a 1.3% rise in business services and finance) and, the star of the show - and perhaps the most suspicious aspect of all - a 6.6% leap in construction output.

That will not be maintained, and neither will quarterly growth of 1.1%, but an upward surprise in the numbers was always on the cards. I mentioned recently that the monthly numbers were starting to point to growth closer to 2% than 1% this year. The forces that combined to produce a savage downturn in the autumn and winter of 2008-9, most notably de-stocking and the collapse of world trade, were always likely to result in a snapback in growth when they reversed themselves.

Can the economy build on this and enjoy sustained recovery with business lending so weak? Will the regulatory response — forcing banks to hold more capital while weaning them off emergency support — put the kibosh on any lending recovery?

The government is exercised about weak lending, particularly to small and medium-sized firms. This week it will publish a green paper. Vince Cable, the business secretary, pre-empted it last week with a warning last week that “the recovery could be aborted if we don’t get on top of this”.

The Bank of England’s monetary policy committee (MPC) caused a stir when it revealed in its minutes that “a further modest monetary stimulus” — more quantitative easing — could be needed. The Bank also touched on the chicken-and-egg question. Is lending falling because banks won’t lend or because firms won’t borrow?

Some of the lending drop is because firms are obtaining finance elsewhere. It is no bad thing businesses are weaning themselves off excessive reliance on bank borrowing. The corporate sector is running a big financial surplus and is cautious about spending at this stage of the cycle, so there are both demand and supply-side explanations for lending weakness.

As an aside, and I will return to this another day, I would be careful about adding to the existing £200 billion of quantitative easing, and not just because of the strong GDP numbers (though I would also not be raising interest rates). Whether the Bank intended it or not, people got the initial impression that quantitative easing would increase lending to cash-strapped firms. Plainly, that has not occurred.

The Bank has instead emphasised a different transmission mechanism, which is that £200 billion of asset purchases have kept bond yields low and led to improvements across a range of markets, making it easier and cheaper for the private sector to raise finance. All that remains in place.

Only if the Bank could come up with an alternative stimulus, which fed through direct to those bits of the economy that cannot access capital markets — the small and medium-sized firms — would it be worth doing. I have seen no evidence yet of this additional shot in the locker.

It is perhaps not surprising lending is so weak, given the scale of the crisis and recession. This is the phenomenon of the “creditless” recovery, identified by the International Monetary Fund and others, where it takes several quarters after the economy has turned before lending turns positive.

If the squeeze on bank lending continues indefinitely, however, it will be hard for smaller firms, drivers of employment growth and ultimately the economy, to get the finance they need for expansion.

Everybody knows banks need higher levels of capital and liquidity. In his chapter for the London School of Economics’ report The Future of Finance, Lord (Adair) Turner commendably cut through the verbiage. By all means debate “narrow” banking and Volcker rules that stop risky behaviour, he said, but in the end only two things really matter: getting banks to hold more capital and liquidity, and introducing new “macro-prudential” tools to allow the authorities to stop credit and asset price booms, partly by varying capital requirements across the cycle.

The question is when. “There is a fundamental conflict between efforts to make the banks safer and our wish to get them lending more,” Cable said last week.

This is not the only conflict. Lenders face huge refinancing pressures from the phasing out of the Bank’s emergency credit guarantee and special liquidity schemes, starting next April. Nomura reported that banks will need to refinance £390 billion next year. Banks commissioned Price Waterhouse Coopers, for a “Project Oak” exercise, to show how moving too rapidly to higher capital when special schemes are ending will cause a £1 trillion financing and refinancing headache.

Those in authority insist they are aware of this. One reason for the Bank’s hard line on ending special schemes was that some banks were making no preparations for a life without official support. The authorities will not push insistence on higher capital to the point where weak lending tips the economy back into recession.

Still, the worry is there, even amid the warm glow of an economy recovering faster than expected. Strong growth alongside very weak lending adds up to a creditless recovery. The question is how long this creditless growth can continue.

This is an excerpt from today's Sunday Times piece, available to subscribers on www.thesundaytimes.co.uk.

Can we, despite the gloom on public-sector job cuts, look forward to a strong rise in employment? Can Britain's private sector more than make up for the drop in public-sector employment?

It has proved to be the most controversial area for the new Office for Budget Responsibility (OBR) under its temporary chairman, Sir Alan Budd. He has packed more excitement into his short tenure than many manage in a career.

The OBR's budget forecast, seized on by the government, was for a significant rise in the number of people in work in this parliament despite more than 600,000 public-sector job losses.

The disconnect between official figures for the recession and those for employment has been stark. Revised gross domestic product figures, released last week, now show the economy's peak-to-trough decline was 6.4%, rather than 6.2%, making it the worst post-war recession (pending further revisions).

Despite this, the decline in employment to its low this January was only 2.5%. Employment has dropped a lot less than would have been expected. As noted here before, this reflects a combination of genuine job-market flexibility and government measures.

The contrast with previous recessions is striking. In the early 1980s, the economy contracted by 6% and employment by 6.5%, with jobs continuing to be lost two years into the recovery. The early 1990s was even more extreme, a modest 2.5% slide in GDP leading to a 6.1% fall in employment.

This takes us back to the OBR. It predicts a rise in the overall number of jobs in the economy from 28.89m at the end of the current financial year, 2010-11, to 30.23m by the end of 2015-16, an increase of 1.34m.

That does not sound too testing, assuming the recovery continues. Except that over the same period, the OBR predicts a drop of 601,000 in "general government" employment, from 5.53m to 4.92m from the end of 2010-11 to the end of 2015-16. Add in a few thousand public-sector workers not in this definition, but vulnerable to losing their jobs, and the challenge is laid bare. The private sector needs to create 2m new jobs over the next five to six years.

Is it possible? Contrary to the general impression, Britain's private sector is a formidable job-creation machine. Between 1991-92 and the eve of the recession in early 2008, employment rose from 25.3m to 29.5m, an increase of 4.2m. Over that same period, perhaps surprisingly, public-sector employment fell from 6m to 5.76m. In net terms, then, all the jobs created in Britain, almost 4.5m, were in the private sector.

It was a game of two halves. From 1991 until about 1998 public-sector employment dropped sharply, from 6m to below 5.2m, before its subsequent rise under Gordon Brown which — with the inclusion of nationalised bank staff — has seen it back above 6m. Even while the public sector was in a hiring frenzy, there was still plenty of private-sector jobs growth — 2.3m between 1997 and early 2008.

We should look at the 1990s recovery, when the public sector was cutting back sharply. How many private-sector jobs were created then? The answer may surprise. Over the first six years, once the job market turned in 1993, private-sector jobs grew by 2m, exactly what the OBR is predicting for the next few years.

That not only suggests the private sector can more than compensate for direct public-sector job losses but also for losses in private firms with public-sector contracts.

So should we relax about the outlook for jobs, knowing the private sector will take care of it? There are a couple of caveats. Geoffrey Dicks, Budd's colleague on the budget responsibility committee, told the Treasury committee that the recovery the OBR is forecasting is a "pale shadow" of the 1990s. If he is right, achieving a similar rate of job creation will be difficult.

The other point is that although employment fell much less than feared in the recession this does not necessarily mean it will be easier for it to grow during the upturn. If firms have been hoarding labour, with people on reduced hours, this slack will need to be taken up before employment rises meaningfully.

It is not remotely implausible to predict a rise in employment and a fall in unemployment in the coming years, despite public-sector cutbacks. Whether it will happen quite as strongly as the government's new forecaster hopes is more doubtful.

This week's Sunday Times piece looks at market fears of a dive back into recession and also at the implications of public sector job losses for the UK's regions. It is available, to subscribers, on The Sunday Times website, here.

Today's Sunday Times piece, again behind the paywall I am afraid, looks at the extent to which George Osborne's budget strategy is reliant on a generally upbeat economic forecast from the Office for Budget Responsibility. It also looks at interest rates, in the context of Andrew Sentance's decision to vote for a hike earlier this month. It is available here to subscribers.

Tomorrow, at 10am to be precise, something rather special will happen. For the first time the official forecast for Britain's economy will be produced by an independent body, the Office for Budget Responsibility (OBR).

The OBR, headed by Sir Alan Budd, assisted by Geoffrey Dicks and Graham Parker, is set to become almost as important an acronym as the MPC (the Bank of England's monetary policy committee). Budd may become the second most famous "Sir Alan" in Britain. He, rather than the chancellor, will be responsible for the forecast, breaking a decades-long tradition.

Though forecasts were around before the 1975 Industry Act, it was this that first required the Treasury to "keep a macro-economic model suitable for demonstrating the likely effects on economic events in the UK of different assumptions".

In case of misunderstandings, the act said the model should be on a computer — pretty radical in those days — made available to outside users, hence the Item (independent Treasury economic modellers) club. It also required the publication of a forecast "not less than twice a year".

Without digressing too much into history, it seems successive chancellors broke the law, for the act said they should present forecasts on the basis of alternative assumptions. Though there has been a bit of this in recent years, mostly chancellors have given us a single forecast.

Anyway, from tomorrow the forecasting task is the OBR's. There will be an 80-page report, "fan" charts to reflect the uncertainties and some commentary on the long-term sustainability of the public finances. It does not mean the Treasury model has been pensioned off after 35 years' service — the new body has been using it and, indeed, has borrowed a team of Treasury officials to run it.

How scary will the OBR's pre-budget forecast be? David Cameron has been preparing us for something bloodcurdling, beginning in this newspaper last week. The most obvious change between the forecasts Alistair Darling presented in his pre-election budget and tomorrow's figures will be in the growth numbers.

The March budget predicted growth of between 3% and 3.5% next year, rising to 3.25% to 3.75% in 2012. Even the cautious assumptions used for the public finances were for growth to average 3.25% a year through to 2014-15. If that was cautious, you might wonder what they might have come up with if they had really let rip.

The OBR, as you might expect, is not leaking its predictions. It will be a surprise, however, if its growth forecasts, and the assumptions it uses for the public finances, do not have a "2" rather than a "3" in front of them for the forecast period. It may base its projections for the budget deficit on numbers up to a percentage point weaker, each year, than in March.

Does this mean the hole in the public finances will be even larger? Could Budd unnerve the markets by suggesting Britain's debt and deficit problems are not just formidable, but insurmountable?

On this, things are not all going in the wrong direction. The 2009-10 budget deficit, £156 billion, came in £11 billion lower than predicted in March. That lowers the starting point for future borrowing. On top of that, the government announced a net £5.7 billion of spending cuts for 2010-11, though they won't be included in the OBR's base-line projections.

The recent numbers may be testimony to something Treasury officials were keen to establish in the past couple of years, a "de-linking" of the borrowing and growth forecasts. The future fall in borrowing did not, in other words, stand or fall on over-optimistic growth assumptions. Tomorrow's projections should be bad but not dreadful.

That does not mean everything is hunky dory. John Hawksworth, head of macroeconomics at Price Waterhouse Coopers, expects that borrowing this year will be £155 billion, only just below last year's outturn, falling to £80 billion by 2014-15, £6 billion higher than the March projections.

Malcolm Barr of JP Morgan is a little more optimistic for this year, £145 billion, but expects the OBR to predict £72 billion in 2014-15, close to the existing forecast and not enough of a reduction for the new government, the markets or ratings agencies. The key will be what the OBR says about the "structural" deficit.

That is when things enter a second phase. After tomorrow, Budd and his team will have just a few days to assess whether the measures the chancellor intends for his June 22 budget mean there is a better than 50% chance of the government achieving its fiscal mandate.

Set out like that, it sounds very simple, except that the OBR does not yet know what the fiscal mandate is. Nor does it yet know the size of measures in the budget, which will include both tax changes and the spending totals for the next three years, to be filled in by hard bargaining over the summer and early autumn.

The coalition agreement between Conservatives and Liberal Democrats pledges to "significantly accelerate the reduction of the structural deficit over the course of a parliament" compared with Labour.

In