Optimism that the worst of the recession is over is giving way to uncertainty about what shape the recovery might take. The events of the past two years have taken us into uncharted territory. What will the route back to normality be like?

The Organisation for Economic Co-operation and Development concluded in its latest outlook that the worst of the recession for advanced economies was over but cautioned against putting up the bunting.

“OECD activity now looks to be approaching its nadir, following the deepest decline in post-war history,” it said. “The ensuing recovery is likely to be both weak and fragile for some time. And the negative economic and social consequences of the crisis will be long-lasting.”

For Britain, which the OECD predicts will see a 4.3% drop in gross domestic product this year, followed by a flat 2010 (though with a pick-up through the year) those consequences will include dealing with a budget deficit it expects to see hit 14% of gross domestic product next year.

Robert Chote of the Institute for Fiscal Studies, at the annual conference of the Society of Business Economists, pointed out that Treasury plans imply fiscal tightening building up to £90 billion, £2,840 per household, over the next eight years.

Some of that, though I will say it quietly unless Gordon Brown hears, involves savage cuts in government capital spending and real cuts just about everywhere else.

Whether departmental spending falls nearly 7% in real terms in the three years from 2011, which assumes the reductions are equally shared, or most departments drop 9.7% (if health and overseas aid are spared), or most drop 13.5% (if schools also escape the axe), we are looking at a dramatic, though necessary, reversal.

The IFS says it represents the biggest real spending cuts in any three-year period since Labour was forced to turn to the International Monetary Fund in 1976. It may even be a little purist in only claiming that much. It is probable, though discontinuities in the data do not allow a definitive answer, that cuts in prospect are more pronounced than in the Healey-Callaghan era.

Spending cuts like this, of course, can only be accompanied by reductions in public sector manpower. A real freeze on public spending for much of the 1990s resulted in a drop in public sector employment from 6m in 1991 to under 5.2m by 1998 (it is now back at 6m). A tightening of fiscal policy - higher taxes as well as spending cuts - is not the only headwind.

Mervyn King told the Commons Treasury committee he had never been more uncertain about the outlook. If the Bank, with its army of economists and agents does not know, what hope is there for individuals and businesses who, through their actions can either make recovery happen or keep the economy becalmed.

The Bank’s particular concern in about the effect of weak bank lending on the supply-side of the economy. If companies cannot get the funds to invest, a state of atrophy could occur or, at the very least, much slower growth in the economy’s productive capacity than we have been used to.

One effect of this, which is occupying the Bank, is that inflationary pressures could re-emerge sooner than normal after a recession. Interest rates are not going to rise for some time but when they do it could be more sharply than people expect.

This supply-side damage, together with drastic fiscal surgery, could have long-term implications. The Treasury assumes once recovery takes hold, growth will return to its “trend” rate of 2.75% a year. Ross Walker of Royal Bank of Scotland, adapting the Treasury’s numbers to take into account of changed circumstances, including the weaker boost to population and labour supply from net migration, argues that a figure closer to 2% is more likely.

We will only know when the economy has been recovering for a while. What kind of recovery can we expect? Cambridge Econometrics looked at three recovery scenarios for the coming years: “renewed confidence”, “sharper cycle” and “doldrums”.

In all three, not much happens until next year but then paths start to diverge, depending on what happens to consumer spending, business investment and global growth, the latter as the driver of UK trade. Public spending cuts and tax hikes are built in, though of varying severity.

What happens to consumer spending, 62% of gross domestic product last year, is pivotal. In Cambridge’s “renewed confidence” scenario, households repair their finances quite quickly and consumer spending resumes. World trade comes back, promoting export growth.

In the “sharper cycle”, it takes longer to get a recovery but when it comes it is stronger, for consumer spending, investment and world trade. A deep fall is followed by an equally impressive bounce.

If the economy stays in the doldrums, however, we are looking at a period in which the world economy is slow to come out of recession, consumer spending falls this year, next year and in 2011 and only picks up slowly thereafter and business investment is feeble. Recovery would only really kick in by 2012, and then feebly. Britain would start to feel like Japan in its lost decade, though with less of a cushion of prosperity to draw on.

Which will it be? There are arguments in favour of all three scenarios. The damage to the banking system and the sheer scale of the fiscal adjustment required argue for a very weak recovery. This would fit with the findings of the often-quoted research by Carmen Reinhart and Kenneth Rogoff that recoveries from banking crises are slower than from normal recessions.

On the other hand, most UK recoveries in the past have been V-shaped and pretty strong, even when circumstances have appeared to suggest otherwise.

The Bank governor does not know and, in truth, nobody else does either. But the difference between slow and weak recovery scenarios is profound; the latter increasing the amount of work needed to repair the public finances. Even a decent recovery will be accompanied by painful adjustments in spending and higher taxes. The slower the recovery, the deeper the pain.

PS: What of Britain’s tripartite system of financial regulation, when the participants are fighting like ferrets in a sack? Lord Turner, chairman of the Financial Services Authority (FSA) does not want his organisation neutered by a transfer of powers to the Bank of England.

The chancellor’s proposals for a beefed-up tripartite system, crucially, will not take immediate effect, starting a period of consultation taking us beyond the election. That could provide an opportunity for George “twin peaks” Osborne, not a character out of David Lynch, but the shadow chancellor’s plan to give the Bank supervisory responsibility for larger banks and institutions, while leaving the FSA with the rest and with responsibility for protecting consumers. The regulation saga has a a long way to run.

From The Sunday Times, June 28 2009

Most of the excitement in Mervyn King's speech last week was generated by his comments on banking supervision.

The Bank, if it is to carry out the financial-stability role now enshrined in legislation, wants more than the governor's eyebrows as an enforcement tool. King, while hoping for a return to economic normality, thinks it should not be business as usual for the banks, which turned his "nice" decade very nasty.

He is on the "small is beautiful" side of the debate on bank size, arguing they should not be too big to fail, holding the financial system to ransom. Alistair Darling, the chancellor, seems more laissez faire, suggesting banks can be big if they are properly run. Both agree, however, on the need to ensure big institutions can be wound down in an orderly way.

We cover these issues in detail elsewhere. But there was also, in King's Mansion House speech and other recent output from the Bank, evidence that the ground is being prepared for a shift of policy.

The question, which you hear a lot, is how long can interest rates remain so low? Bank rate since March has been 0.5%, a level thought of as impossible even a year ago. How long, too, can other unconventional measures — quantitative easing, liquidity provision and the rest — continue?

For the markets, the question of whether the Bank will add to its £125 billion of quantitative easing — it can do another £25 billion without Treasury permission — is as important as the interest-rate issue.

King, stressing it was too soon to reverse the "extraordinary policy stimulus that has been injected into the UK economy" added it was not too soon to be preparing "exit strategies", implying the Bank is doing so.

The minutes of this month's monetary policy committee (MPC) meeting had a similar message, saying the Bank "could and would tighten policy" when necessary. What will this mean? The governor was clear: "When appropriate the MPC will raise Bank rate and gradually run down its portfolio of assets in a manner consistent with maintaining orderly markets."

Alongside this, MPC members have been defending the inflation-targeting regime, insisting it would be a mistake to throw the baby out with the bathwater.

Paul Fisher, the Bank's executive director for financial markets, told a conference that no monetary-policy regime could have prevented the current crisis or headed off the recession. Under inflation targeting "the UK experienced the most stable domestic macroeconomic conditions, in terms of low and stable inflation and steady output growth, that it has ever experienced".

When should we expect to see the start of the exit strategy, involving higher rates and then the reversal of quantitative easing?

Inflation is important. We are seeing another drawback of shifting from the old target measure to the consumer prices index (CPI). This is falling glacially and at 2.2% is still above the 2% target. RPIX inflation (the retail prices index excluding mortgage interest payments) is in contrast at 1.6%, well below its former 2.5% target and fractionally above the point where the governor would have had to write a letter explaining why it had tumbled so far.

Falling inflation will be the story for some time yet. The decline in Britain has been slower because of sterling's earlier fall, now partly reversed (the pound is up 13% this year). Eurozone inflation is zero while America's consumer price index is 1.3% down on a year ago.

This does not prevent some in the markets fearing this is the lull before the inflationary storm. But a lengthy report from Rob Carnell, chief international economist at ING, takes on these arguments. Recessions are good at destroying inflation and policymakers would have to mess up spectacularly for it to come back any time soon.

As he puts it: "There will be no Zimbabwe-style hyperinflation or 1930s Germany with wheelbarrow-loads of cash. There is probably not even going to be a significant sustained increase in core inflation from the trends preceding the current crisis — at least not unless the policymakers are extremely careless."

He sees low inflation — 2% or less — for two years at least, as does the Bank. Will rates stay at 0.5% that long? The consensus among economists is that Bank rate will be at this level at the end of the year and only creep up to 1.5% during 2010. The era of ultra-low rates, it appears, is here to stay. Until January, remember, we had not seen Bank rate below 2% for three centuries.

It may not, however, be quite so simple. The MPC has changed. By September it will have three newish members: Fisher, David Miles and Adam Posen, from Washington's Peterson Institute. We do not yet know what its "reaction function" will be.

In normal circumstances, before summer 2007, the Bank raised the rate when the economy was growing above trend — if, say, the rise in quarterly gross domestic product (GDP) was above 0.6% or 0.7%.

These days, we do not know what the Bank thinks trend growth is. We do not know if it agrees with the Treasury that the recession has caused a permanent loss of 5% of GDP. These things are important.

But there is another point. We are, as I say, in once-in-300-years territory. King and his colleagues have been the equivalents of medics in the emergency room, using paddles and injections in a desperate attempt to keep the patient alive. At some stage the economy has to come out of ER.

Put more prosaically, real interest rates are negative — Bank rate is below the rate of inflation — something the MPC is unlikely to be comfortable with for too long. Existing and past members have made speeches pointing out that monetary policy errors in the past were often made by allowing real rates to go negative and stay there.

So it seems to me the MPC may start to push rates back up towards the norm — 5% is a reasonable estimate — faster than people think. The first rises could come this year but the continued weakness of bank lending argues against it and is the main barrier to recovery. However, next year there could be a sharper rise in interest rates than the City expects.

Next week, barring unexpected developments, I shall look at recovery prospects in Britain in the light of a tightening of both monetary and fiscal policy.

PS: The political debate over public spending is an appetiser for what we can expect for the next 12 months. In the past I used to do a party political broadcast watch during campaigns, exposing statistical horrors inflicted on voters in the heat of the polling battle. These days it would be hard to keep up.

That is the challenge for Straight Statistics (http://straightstatistics.org), a campaigning body launched last week. I should declare an interest, being a member of its advisory council. This puts me under extra pressure not to commit any statistical horrors of my own.

In the meantime, here's one to get your teeth into. Who is doing better on the jobs front, people born in Britain or people born overseas? The answer, it appears, is both. UK-born employment fell to 25.28m in the first quarter, down 451,000 on a year earlier. Non-UK employment rose 129,000 to 3.81m.

If you are born in the UK, however, you have a better chance of being in work; the employment rate is 74.1%, compared with 68.4% for non-UK born. But the hardest-working group is not from here, eastern Europe, or even America. That accolade goes to Australians and New Zealanders — 85.8% of them who are of working age are in jobs. Strewth.

From The Sunday Times, June 21 2009

Had things gone a bit differently for Gordon Brown in the past few days, this could have been the first column of the election campaign. How much would we have known about Conservative economic policy? Not enough. So, armed with a speech that George Osborne, the shadow chancellor, gave last week, called A New British Economic Model, let me fill in one or two gaps.

I will deal first with what we do know. More evidence has emerged in the past week that the recession is coming to an end. Indeed, if the National Institute of Economic and Social Research (NIESR) is right, the trough was in March, even earlier than implied by the purchasing managers' surveys described here last week.

For statistical reasons, even on the NIESR figures it is quite likely we will see another fall in gross domestic product in this quarter, or at best a flat picture (its estimate for monthly GDP in May was fractionally below the first-quarter average). Unemployment figures this week will dampen optimism, though they will lag the upturn.

Even so, Osborne's team are working on the basis that the election will not be about a government and an economy mired in recession but about which party has the best policies for the recovery.

They are assuming, in other words, that the economy avoids a relapse next winter and that they will be facing a government which will claim that its prompt actions, particularly on the banking rescues, pulled the economy out of a tailspin arising from the biggest financial shock since the Great Depression, and returned it to growth.

What is more, though voters may not be inclined to give Brown a hearing, Labour will have a point. On the evidence so far, Britain will have had a recession both shorter than usual and not as deep, in terms of the peak-to-trough fall, as the first Thatcher recession of the early 1980s. So the economic debate will be an interesting one.

What we also know is that the public finances, tax and spending, will be at the heart of the election argument. Here, of course, Labour has a poor story to tell.

Two things happened last week. Andrew Lansley, the shadow health secretary, tried to be a bit too clever in an interview on the BBC Today programme and embarrassed his party. Lansley's comments were not, as one Tory aide put it, "on the grid". It was not intended he would be so candid, though the arithmetic behind his comments was straightforward.

The Institute for Fiscal Studies says the government's plans imply a cash freeze on departments for three years from 2011, after debt interest and other unavoidables. Allowing for inflation this becomes a 2.3% annual real-terms cut, 7% over three years.

If health, Lansley's brief, escapes real cuts, other departments have to bear the brunt and that gives the 10% real cut over three years he told radio listeners about, spoiling a few Tory breakfasts. More on that in a moment.

The other noteworthy development was the publication by the Office for National Statistics of new productivity estimates for the public sector. These showed that, despite a small improvement lately, productivity has fallen most years in the past decade. Calculating output is not easy, but the ONS thinks the average public-sector worker's output in 2007 was 3.2% lower than in 1998.
Contrast that with the private or "market" sector. Over the same period, again according to the ONS, market-sector productivity rose 22.8%. The difference between the two sectors is striking.

What does this mean? A great deal. By my rough calculations, if public-sector productivity had matched the private sector, we could have had the same level of public service but for almost £100 billion less than the £670 billion the government intends spending this year. We would still have a public-borrowing problem but it would pale into insignificance in comparison with the one we have.

Though Lansley was not meant to blurt out any figures, Conservative thinking is clear. The public sector has to be squeezed hard but the saving grace, at least as far as services are concerned, is that this squeeze will generate significant improvements in productivity and efficiency.

On this, the Tories are in tune with official thinking. The Treasury was always uncomfortable with being the instrument of Brown's spending largesse. Decades of experience had etched on its institutional memory the belief that the best way of achieving public-sector efficiencies was to starve departments of funds.

Given that this is in prospect whichever party wins the election, it is clear that only big improvements in productivity growth, to the kind of rates recorded by the private sector in recent years, will prevent drastic reductions in the provision of public services. Even with those improvements the "feast to famine" contrast will be stark.

If the Tories are elected next year, or sooner, they will not be content with the squeeze starting in 2011. A spring 2010 election would be followed by an emergency budget which, as well as tax increases with a strong environmental edge, would aim at "in-year" cuts in public spending in 2010-11, to rein back a planned 4.5% real rise in current outlays. If Labour defied the polls and held on it would also take emergency action, though I suspect with the emphasis on tax.

The Conservatives need to go further in reforming the public sector than merely relying on eyewateringly tight budgets. Party aides insist they are drawing on experts who know about these things. Osborne has said a lot about the process by which a Tory government would manage the public finances, including a new Office for Budget Responsibility, but has not said enough yet about which areas the state may have to withdraw from completely if government is to be put back on a sound footing.

What else do we know? A Tory government would look for new ways to fund essential infrastructure spending, including nuclear power, a high-speed rail network, a smart electricity grid and investment in carbon capture and storage. Osborne sees government enabling such investment rather than paying for it.

He has been talking to Mervyn King, the Bank of England governor, and Lord Turner of the Financial Services Authority (FSA) and is inclined to give the Bank more supervisory power at the FSA's expense. He wants to set up a "son of 3i", similar to the old Industrial and Commercial Finance Corporation, to fill the funding gap faced by new businesses. Gradually, we are finding out more.

Osborne is aware, however, that he will stand or fall on his ability to set out a coherent strategy for the public finances. That will not be easy, but it is probably the most straightforward agenda in politics.

PS: The Treasury has been cautious about going to town on the "recession is over" optimism prompted by the purchasing managers' surveys and then the NIESR. Liam Byrne, the new Treasury chief secretary, said in the Commons he was not prepared to give a "running commentary" on the forecast. Such language is normally for when the news is worse than expected. Alistair Darling says he is "confident but also cautious".

There is another reason. Dave Ramsden, the Treasury's chief economist, was around in the Norman Lamont era of the early 1990s. If the former chancellor did not invent green shoots, he popularised them. And he was lambasted for extolling green shoots in the autumn of 1991 that were genuine but withered over the winter. Once bitten, twice shy.

From The Sunday Times, June 14 2009

A couple of things became clearer last week. One is that it will be some time before we have to worry about inflation again.

The other is that a consensus is building for drastic surgery on Britain’s budget deficit, focused on cuts in public spending, given the powerful backing of the International Monetary Fund in its annual health-check on the UK economy.

It was also the view of Standard & Poor’s, the ratings agency. I was less impressed with its analysis. More on that later.

Inflation and government debt are related. Some fear the government will seek to inflate its way out of its problems. Elected politicians, given the choice between, say 5% annual inflation for a few years, and the grinding task of trying to cut public borrowing through painful measures, would surely choose inflation. So would many individuals and businesses. Inflation is good for debtors and bad for creditors.

The trouble is that it is quite hard to generate inflation after a recession. Recessions are good at destroying inflation. That is what they are there for, most of them being deliberately engineered by governments and central banks for that purpose.

Many feared that sterling’s post-1992 dive, combined with recovery, would lead to higher inflation. It did not. The early 1980s recession gave us years of low inflation. Even in the turbulent 1970s, with the wage-price spiral, recession was followed by three years of falling inflation.

Britain now has the lowest Bank rate since 1694, 0.5%. Sterling at its low point was nearly 30% down from its peak, and the Bank of England has embarked on a £125 billion programme of “creating” money through quantitative easing.

Yet inflation is falling on every measure. Retail price inflation, heavily distorted by falling mortgage rates, is negative by 1.2%. Consumer price inflation dropped from 2.9% to 2.3% last month and will drop below the 2% target in the next month or so.

There it will pretty much remain, barring a possible small blip from the increase in Vat back to 17.5% next January, until the end of 2011, according to JP Morgan. The old inflation target, retail prices excluding mortgage interest payments, is running at 1.7%, well below its old 2.5% target.

As the IMF put it in its statement on the UK, the outlook is subject to uncertainty but: “On balance the prospect is for inflation to fall and stay below the 2% target for an extended period. In this context, the Bank of England’s strategy of aggressive monetary easing is appropriate.”

Many people misunderstand the motives behind one aspect of that policy response, quantitative easing. When the Bank embarked on it in March it made no mention of deflation. When it talked about deflation in its February inflation report, it was to dismiss it as being likely in Britain.

Quantitative easing is intended to do what it says on the tin, boost the quantity of money and therefore money GDP (gross domestic product). In the unlikely event that it works too well, the Bank has a new weapon at its disposal — draining reserves from the system by exchanging them for Bank of England bills, until it can sell gilts back into the market.

So, inflation is unlikely to give the government an easy way out of its debt. What is the alternative? The nub of the IMF report was that it was right for the government to unveil a small fiscal stimulus during the recession but getting the public finances back on track should not be left too long.

It leans heavily in the direction of cutting public spending rather than raising taxes. “Expenditure-based consolidations are more durable,” it said. There are no numbers in the IMF’s report but the role-model is Canada, which over three years from the mid-1990s cut public spending by 20%. Yes, 20% of genuine reductions.

Achieving that in Britain would be asking a lot after a decade of annual real growth in public spending of between 4% and 5%. So far the Treasury is planning to freeze spending in real terms from 2011, as happened in the 1990s. Inevitably it will have to go further and impose real cuts.

That is recognised in the Treasury. The need for further action is acknowledged but officials point to practical constraints. This is not just that it will be easier to impose tough measures after the general election. It is also that, such is the fragility of the economy, announcing everything in the budget, even delayed measures, could have scuppered recovery hopes.

Officials say if they had 100% confidence that the economy will recover as they hope, such an announcement might have been feasible. But there is a chicken-and- egg argument here. There will be other opportunities, they insist, to take a scalpel to the public finances.

There is another point, not widely understood. It is quite possible for the Treasury to be both optimistic on its growth forecasts and pessimistic on its revenue and spending projections, because it is constrained by the assumptions it has to use. It has to assume, for example, unemployment does not fall even when growth resumes.

There are a lot of subtleties in this, which the IMF team explored in discussions with the Treasury, Bank and plenty of outside bodies on its visit here.

I did not detect subtleties in S&P’s report, which confirmed Britain’s AAA status but revised the outlook from “stable” to “negative”. In just over a third of cases, such a revision is followed by a loss of AAA status. Japan, the world’s second-biggest economy, has only AA status. Canada lost AAA status in 1992 but regained it after its radical fiscal surgery.

The problem with the S&P report, for all the headlines it generated, is that it is so thin. In three pages it suggests UK government debt will rise to 100% of GDP by 2013, something the respected Institute for Fiscal Studies thinks highly unlikely. It also appears to believe that any government losses on the banking rescues, which it thinks could be as large as £145 billion, will be crystallised over the next four years. Again, this is highly unlikely.

Nobody argues with the broad thrust of its conclusion, that further action will have to be taken to get the public finances back into shape. Everybody accepts that, including the Treasury. But S&P’s report provided no analysis to back up its verdict. Moody’s and Fitch last week reaffirmed Britain’s rating as stable. But S&P, I fear, did nothing to enhance the battered reputation of the ratings agencies.

PS: It is but a short flight to Dublin but there is a bigger gulf on economic policy. A few days ago I met Brian Lenihan, Ireland’s finance minister. In contrast to Alistair Darling’s budget in which pain was deferred, he gave it to the Irish economy straight, with large and immediate hikes in personal and capital taxes, alongside a squeeze on public spending.

The Anglo-Irish similarity is that public finances have proved so vulnerable in this recession. What politicians do to the economy is less important than what the economy does to them.

From The Sunday Times, May 24 2009

The role of a central banker is to take away the punchbowl just as the party gets going. Bank of England governor Mervyn King took things a stage further last week, coming close to cancelling the festivities even before the invitations have been sent.

This was a week when the National Institute of Economic and Social Research said the economy may have stopped sliding in April for the first time in a year. One City forecaster — JP Morgan — revised up its UK growth forecasts and another, HSBC, said the storm had passed for sterling. Yet the Bank of England decided to be downbeat.

There is always the possibility that the Bank knows something we do not, explaining its gloomy tone. Its intimate knowledge of the banking system — over the past 18 months at least — may have persuaded it that what it describes as "the dislocation in the financial sector" will be more of a drag on recovery than others assume.

My sense, however, is that the Bank, given a "glass half-full or glass half-empty" choice, had no incentive to be upbeat. It has taken as much of a beating as the Treasury for failing to forecast the scale of the recession (in common with everybody else) and did not want to risk its reputation further on what are still fragile green shoots.

It is in the middle of an unprecedented monetary relaxation programme, including a 0.5% Bank rate and £125 billion of quantitative easing.

Too optimistic a message, despite the "promising signs" it has detected that the pace of decline is moderating at home and abroad, would have sat uneasily alongside that and perhaps conveyed the message that a tightening of policy is on the horizon, which was not the intention.

The Bank's forecast produced the knee-jerk "another blow for Alistair Darling" response, led by opposition politicians. However, the new forecast — for the economy to decline by some 3.75% this year before rising by a shade over 1% next — was close to the Treasury's numbers.

The doubts come further out, 2011 and beyond, when the governor's "slow and protracted recovery" contrasts with the chancellor's strong rebound, which after the past few weeks he no doubt expects to be viewing from the opposition benches.

However, this is a public service column, so let me perform one by repeating to you what was the main message from the Bank last week. It was that, if you did not know it, the outlook is extremely uncertain. The Bank cannot predict the future. The governor wants every household and every business to be aware of that. If things go wrong over the next two to three years, nobody will be able to say they were not warned. If they go right, the Bank has a convincing story to tell on that too.

The uncertainties include the possibility of a short-term return to growth, resulting from the stimulus of very low interest rates and sterling's depreciation. But then it runs out of steam as the realities of postrecession adjustment kick in, the "double dipper" referred to here last week.

They include the danger of permanent rationing of credit and of the dramatic downturn in world trade — the biggest in the post-war era — failing to reverse itself. The "period of healing" from last autumn's dramatic near-collapse of the global banking system will take time.

These are big issues but there is also a significant uncertainty closer to home. What will consumers do? Will they save, rebuilding their finances but depriving the economy of spending when it needs every penny. Or will they spend, leaving their balance-sheet adjustment until later?

On the face of it, people have no choice but to cut spending. Unemployment is rising — by 244,000 in January to March, according to the Labour Force Survey — and average earnings, broadly measured, are down on a year ago. Credit availability remains tight.

We should probably treat the earnings numbers with a pinch of salt. Though the figures including bonuses are indeed down on a year ago, that merely reflects the collapse in City bonuses. Excluding bonuses, earnings were up 3%. Most people in work will see their earnings rise significantly this year in real terms, particularly when measured against retail price inflation, which is already in negative territory. The unemployment constraint on spending is genuine; the earnings constraint is not.

What about savings? As the economy turned down sharply in the final quarter of last year, the saving ratio rose strongly, to nearly 5%. Not so long ago it was less than zero. We do not have the figures yet, but it is quite likely to have risen further in the first quarter. It seems odd that people are saving more when many savings accounts pay next to nothing. It seems unlikely we have become precautionary savers.

Much more likely, and the Bank alludes to this, is that the saving ratio is rising because people are borrowing less, either because they are unable to or because activity in the housing market, always the main driver of borrowing, is only gradually recovering from very depressed levels. If that is how it turns out, the adjustment to household balance sheets could be less painful than feared. The effect of very low interest rates is important.

As the Bank puts it: "The lower level of Bank rate has reduced the debt-servicing costs faced by many households and should, in aggregate, boost household spending, given the likely higher propensity to consume from current income of borrowers, relative to savers." Against that, rising unemployment, repossessions and the fear of higher taxes may force people to rein back. Weak domestic demand could coexist with an uncertain recovery in world trade.

It could go either way and the Bank does not know which. So far, retail sales have held up better than many feared, despite a downward nudge in the official figures on Friday, though purchases such as cars have been weak and the impact of the scrappage scheme is keenly awaited. In general, though, you write off British consumers at your peril. Spending will fall this year but they may yet prove themselves to be instinctive spenders, not savers.

PS: Inflation targeting is in the dock, including in a strange Centre for Policy Studies' pamphlet, The Myth of Inflation Targeting, by Lord Saatchi. The framework the Tories created out of the wreckage of ERM (exchange rate mechanism) membership in autumn 1992, reinforced by Bank independence in 1997, is blamed for leading us up the garden path.

What we need, he said, is "augmented" inflation targeting, in which the central bank tolerates periods of very low inflation or even deflation if it thinks interest rates need to be high for other reasons. The focus should also be on a "macroprudential regulatory framework, that puts more emphasis on the health of the financial system as a whole, rather than individual institutions". We will hear a lot more of this.

From The Sunday Times, May 17 2009

It may be better not to say, for fear of jinxing it, but even before the recession ends, thoughts are turning to recovery. What kind of upturn can we expect when this is over — vigorous or insipid?

And, just as we are being programmed to expect really serious swine flu in the autumn, how big is the danger of a second wave of recession, the dreaded double-dip?

That the worst of the recession is over, a year after it began, is becoming the consensus, though the Bank of England, announcing an extension of its quantitative easing programme from £75 billion to £125 billion on Thursday, clearly believes that "promising signs that the pace of decline has begun to moderate" need further nurturing.

The monthly purchasing managers' surveys, produced by Markit for the Chartered Institute of Purchasing & Supply, get less attention than much official data, but are closely watched by economists. The latest tells us that the three main sectors of the economy — manufacturing, construction and services — saw the worst of their declines between November and February. For services, the earliest to perk up, the index tells us that the sector is within a whisker of a return to growth.

One of the interesting questions raised by these surveys is whether the current picture painted by the official statisticians is too bleak. Economists at Goldman Sachs think so, and expect the very weak gross domestic product reading for the first quarter, when there was a drop of 1.9%, to be revised up significantly.

There is a general point here. Bloodcurdling comparisons being made between the current recession and its predecessors, on the basis of the statistics now and in earlier episodes, are so badly flawed as to be almost useless. That will not stop people making them, and it probably will not stop me making them, but let me explain why.

Official statistics get revised, and they usually get revised higher. In late 1998 and early 1999 we appeared to be on the brink of the first recession of the New Labour era, with GDP first flat then down by 0.1%. Revised data now show the economy grew strongly then, up more than 1% in one quarter, and did not even flirt with recession.

Statistical revisions do not make recessions disappear, and there is no way this will be anything other than a bad year, which could retain its title as the worst in the post-war era. But it will look different in time. In March 1992, Norman Lamont had to admit Britain had suffered a 2.5% GDP decline in 1991. Current data show the fall was much less than that, 1.4%. Something similar happened in the early 1980s.

This is one to watch. Of rather more interest is the recovery. The National Institute of Economic and Social Research (NIESR), in its latest quarterly review, concurs with Alistair Darling that the economy will show year-on-year growth in 2010. But it thinks it will be weak, 0.9%, followed by a tentative 2.3% growth rate in 2011.

On that basis, it will take until the spring of 2012 to get back to where we were in the first quarter of 2008, before the recession began. The period between the Beijing and London Olympics will have been lost years for the economy.

It could be worse. Washington's Peterson Institute last month brought together two former International Monetary Fund chief economists, Michael Mussa and Simon Johnson, to debate global recovery.

Johnson said the world faced an L-shaped "recovery", the sharp downswing being followed by no upturn in 2010 and not much of one after that.

Mussa, in contrast, was in the V-shaped camp. "We will observe, as we have many times before, the Zarnowitz rule: deep recessions are almost always followed by steep recoveries," he said. Victor Zarnowitz, who died in February in his ninetieth year, was one of America's leading experts on the business cycle an an official arbiter of the length of recession. Mussa's pronounced "V" looks unlikely now, but then so did a deep recession a few months ago.

Could it be a double-dipper, in which growth appears to return, only to fall away again? Some say the chances this time are greater than usual, because governments and central banks have adopted aggressive, recession-ending measures. These, by their nature, can provide a one-off boost, but to sustain a recovery the "animal spirits" of the private sector have to take over. If they do not, economies could get a temporary lift before sagging back down again.

Double-dip recessions do occur. Based on the statisticians' current understanding of the 1970s, there were four false dawns between the onset of recession late in 1973 and the start of a sustained recovery in 1976. GDP often flattered to deceive, temporarily picking up before slipping back.

Lamont's famous green shoots were there in the autumn of 1991. But they wilted in the winter and it was not until spring 1992 that the recession was over, and a long time after that before it felt like it.

So what will the upturn be like? The Zarnowitz rule just about works in Britain. As I pointed out after the budget, UK recoveries tend to be pretty robust and there was a slightly stronger upturn after the deep recession of the early 1980s than after the milder one of the early 1990s, though in both cases average annual growth rates over five years exceeded 3%.

This time it might be different, but there is no good reason why. The recovery from the early 1990s recession was against the backdrop of rising taxes, a squeeze on public spending, a stagnant or declining housing market and a shell-shocked consumer.

The economy bounced back after the early 1980s recession, despite the loss of a fifth of manufacturing capacity — proportionately much more important than the recent damage to financial services.

When people ask what sectors will drive the recovery, the process is inevitably more dynamic than that, which is why central planning does not work. Sectors currently below the radar screen will emerge. Accountants Price Waterhouse Coopers recently had a go at picking winners from the existing crop, citing business services, high-value engineering, post and telecommunications as the likely growth leaders.

There is a double-dip risk, though not if the world economy returns to robust growth, something even a gloomy IMF expects during the course of next year. Britain is an open economy and rarely struggles when the world is doing well.

That said, unwinding the current policy stimulus will require care. If the Bank raises rates and reverses its quantitative easing programme too slowly, it could risk allowing inflation back in, though recessions are great destroyers of inflation. If it is too quick off the mark, it will risk snuffing out the recovery. Not for the first time there is a fine balance to be struck.

PS: What's worse, paying more tax, cutting public spending to the bone or working a bit longer? People will have different views but the NIESR has come up with a good scheme to close the gaping hole in the public finances.

As an analysis it makes sense. Practically, it may run up against difficulties, namely the tendency of employers to get rid of older workers first, particularly in a downturn. We saw this in the 1980s and 1990s. So far this time, employment among older workers (above 60 for women, above 65 for men) is holding up better than for other age groups.

From The Sunday Times, May 10 2009

After a huge rush of events, from banking convulsions through to the G20 and the budget, things have gone a bit quiet. It could be that nothing is happening, which would be worrying. Or it could just be that nothing bad is happening, which would be more encouraging.

Economists have had to fill in their time guessing at the costs of a swine-flu pandemic. Without wishing anybody ill, the economic effects of the flu should be containable, even if the virus itself is not.

Often these outbreaks prove the old adage that what we most have to fear is fear itself. Andrew Haldane, the Bank of England's executive director for financial stability, drew the interesting comparison in a speech last week between contagious diseases and contagious financial panics.

There were some fascinating facts in Haldane's speech, a couple of which I will share. One concerned the Sars (severe acute respiratory syndrome) outbreak of 2002-3. The death toll from Sars, almost 1,000, was small. But the economic impact, $100 billion in 2003 prices, a slowdown in Asian growth and a collapse in hotel-occupancy rates, was significant, if minor in comparison with recent financial events.

The other was a glimpse into the complexity of some of the financial instruments that have caused havoc over the past couple of years. Straightforward financial derivatives had the virtue of being easily understood. Investors in a standard residential mortgage-backed security — a bundle of mortgages — needed to read 200 pages of documentation to understand what they were letting themselves in for.

Once the complexity was piled on, however, investors were deprived of any chance of such understanding. Collateralised debt obligations (CDOs) were the most notorious of these more sophisticated instruments. So-called CDO-squared instruments multiplied their original complexity many times over.

The result, said Haldane, was that an investor would have needed to have read over a billion pages of documentation to carry out due diligence on a CDO-squared instrument. None could. None did.

Scientists are better at understanding and controlling the spread of flu viruses than bankers and regulators have been in dealing with financial contagion, though for the moment things seem to be under better control than for some time.

Let us hope so, for it would be a pity if swine flu snuffed out what appear to be hopeful signs that there is a flickering light at the end of the recessionary tunnel.

Economists are sometimes sceptical about consumer-confidence measures. What can consumers know that economists do not? In the past couple of years, however, consumer confidence has tracked the road to recession well.

Confidence began to wobble in the summer of 2007 and dived in the September when there was the run on Northern Rock. It carried on falling until last summer, when the consensus view among economists was that recession was avoidable, diving again during the near meltdown of the global banking system following Lehman Brothers' collapse in September last year.

So we should listen to consumers, and their message, according to the latest GfK NOP consumer-confidence index, prepared on behalf of the European Commission, is that things are starting to look up.

Overall, the index is up 12 points from its low point but still heavily in negative territory. However, components of the index measuring people's expectations for the coming 12 months improved significantly.

People are more optimistic about the outlook for the economy over the coming year than at any time since August 2007, pre-Northern Rock. Their optimism about their personal-financial situation over the next 12 months is at its best since the spring of last year, before the September-October banking convulsions.

This was not the only encouraging indicator. The CBI said that more retailers reported a rise in sales in April than experienced a fall. The positive balance, 3%, was the first for 13 months and chimed in with other evidence that the high street has avoided Armageddon.

The Nationwide building society, as expected, revealed that the surprise March increase in house prices was not sustained last month. But the reversal was smaller than expected, 0.4%, and did not completely cancel out the previous month's 0.9% rise. We have not seen the end of house- price falls but they are getting smaller. Bank of England data for mortgage approvals showed a 4% rise in March.

Abbey, part of the Santander Group, announced a 25% increase in profits in the first quarter and said the economy and the housing market were performing better than expected. Bank shares have been the driver of the stock market's recovery from the lows of early March.

These are all straws in the wind. Even manufacturing is through the worst of its decline, according to the latest purchasing managers' survey. But how easily could these straws be blown away? Some analysts think you can never have a recovery as long as unemployment is rising, though by that logic no recession would ever end.

The GfK NOP survey, of more than 2,000 people, was carried out before the budget, which did nothing for anybody's confidence. We might yet get panicked by swine flu, though I do not see any sign of it yet. Banking woes could re-emerge on a large scale, though recovery is at least as important to restoring banking to health as banking is to enabling recovery.

Much of the evidence now is consistent with last autumn's shock gradually abating in its impact. Businesses are starting to make decisions.

It does not mean the recession is over but it does mean we can begin to contemplate life beyond it. There is a light at the end of the tunnel.

PS: A few days ago I sat in on a meeting of the shadow monetary policy committee (MPC) at the Institute of Economic Affairs, the results of which are published this week.

Some of the assets it is acquiring, like commercial paper, will quickly mature and present no problem. But the Bank will not want to hold medium-term gilts of five years or more to maturity. So it will dribble them out into the market and almost certainly lose money, selling the gilts for less than it bought them. Let us hope by then the benefits of quantitative easing have been clearly demonstrated.

From The Sunday Times, May 3 2009

You should always play the ball not the man. Attacking Alistair Darling personally does not come easy, even for the most hardhearted commentators. He inherited a bad situation, particularly for the public finances, and it has got worse.

Few can have envied him his task over the past 22 months, which he has gone about with dignity and good grace. Few of us can imagine the intensity of the pressure he was under, particularly last autumn, and he deserves a lot of credit for his handling of the banking rescue.

There has to be a "but" to follow that and there is. I have sat through lots of budgets and last week's ranks as one of the worst. It failed on four counts, and if there were more it would probably fail on them too.

It failed to do anything to instill the confidence Darling said was essential to recovery and which was billed beforehand as one of the budget's aims. Most people and businesses will have felt less confident when he sat down than before he stood up.

It lacked a coherent theme. The hotch-potch of minor measures the chancellor announced looked like a random selection from a long list, because it was. Good budgets stay in the memory because they take a theme and run with it. This one did not, and if Darling was enthusiastic about the measures he announced, from car scrappage to wind farms to boosting capital allowances, he kept it hidden.

It further undermined confidence in politics. When, in November, he announced a new top tax rate of 45%, to take effect in April 2011, the chancellor could just about get away with saying he had not broken any manifesto pledges.

Bringing forward that rise to April 2010 and increasing the top rate to 50% is a clear breach of Labour's 2005 manifesto promise not to raise the basic or higher rates of tax. Unless, of course, Gordon Brown plans an election before April 2010.

The 50% top rate itself, apart from bucking the international trend and further undermining Britain's tax competitiveness, has proved popular among people wanting revenge on bankers who earn more than £150,000. A little further thought will surely persuade those people that what is happening to the well-off now is bound to happen to them before too long. If ever a nasty post-election budget was on the horizon, last week set it up.

This is because the budget's fourth failure was not putting an adequate plan in place to deal with the public finances. I am not particularly bothered whether public-sector debt rises to 80% of gross domestic product (GDP). I am concerned about how rapidly we get there and how dramatically the public finances have worsened.

Six months ago Darling unveiled a public borrowing projection of £118 billion for 2009-10, which most of us regarded as frighteningly bad; a few months before that a budget deficit of £50-60 billion would have been regarded as crisis territory.

Now we learn that we do not get borrowing down to £118 billion until 2012-13, after £175 billion this year, £173 billion in 2010-11 and £140 billion in 2011-12. All this assuming, of course, that the Treasury has now got to grips with the scale of the deterioration in the numbers.

The Treasury's "illustrative path" tells us it will not have got the deficit down to acceptable levels — only borrowing to fund investment — until 2017-18, by which time Brown will be drawing his state pension.

The problem with the public finances is not the easy hit that most economists and commentators have latched on to. For the purposes of the public finances, the Treasury has assumed the economy recovers by 1.75% in 2010-11 and then grows by 3.25% annually for the three years after that.

Forecasters have queued up to dismiss this as wishful thinking, because it is hard to envisage any growth, let alone more than 3%, in the depths of a recession, particularly after a 1.9% first-quarter GDP slide.

Something like this, however, usually happens after recessions. Ken Clarke, who dismissed the Treasury's numbers last week, presided over something very similar when he was chancellor, against a backdrop of rising taxes and an "eye-wateringly tight" squeeze on public finances.

Average growth over the four years from 1993 to 1997, after the last recession, was 3.1%. In the early 1980s (1982-86) it was just over 3%. Even in the turbulent 1970s, the bounce from the 1974-75 recession saw four years of 2.7% growth.

Things may be different this time, not because of the reduced role of financial services, which were only ever 8% of GDP. Research suggests that recoveries from recessions generated by financial crises are more subdued than normal.

Even here, however, the evidence is far from conclusive. Britain's economy romped ahead when recovering from the worst of the slide of the Depression years, growing nearly 5% a year for three years from 1933 through 1935.

No, the problem is more fundamental. It is what the Treasury fears will be long-term weakness of tax revenues even when growth resumes. It may have overstated it but the scary thing about the public finances is how much of the deterioration it sees as structural, or permanent.

Of this year's borrowing of 12.4% of GDP — yes 12.4% — 9.8% is reckoned by the Treasury to be structural and even after the budget and pre-budget report measures have been implemented, Britain will still have a structural deficit of 4.5% of GDP in 2013-14, when the parties will be gearing up for the election after next.

The excellent Institute for Fiscal Studies, which warned of some of the horrors the chancellor was set to unveil, says the measures detailed so far leave about half the surgery that will be needed on the public finances, some £45 billion in annual tax increases and spending cuts, as mere Treasury aspiration, to be implemented some time between 2014 and 2018.

That is too long to wait. Radical surgery will be needed on the public finances, and it will have to come sooner than that. As it is, Darling has put in place plans that imply total government spending drops by 0.1% a year in real terms for the three years from 2011, after growth of more than 4% since 1999. For the public sector, and regrettably for taxpayers, it is going to hurt.

PS: The budget, intended by Labour to be a trap for George Osborne — increase the top rate of tax and dare him to oppose it — could turn into a great opportunity. I have been critical of the shadow chancellor in the past, reflecting the doubts I hear expressed from business people.

The shadow chancellor's advisers point to groundwork he has laid in preparing people for a different era of public spending and exploring the processes to more tightly control it. Next will come detail on areas from which government will have to withdraw to slim down the state. It sounds promising.

From The Sunday Times, April 26 2009

What does Alistair Darling do this Wednesday? The economy is in deep recession and the public finances are in a mess. He has as much room for manoeuvre as an elephant in a Mini.

He says he wants to be realistic with people about the problems the economy is facing but he has to make sure, in doing that, he does not drive the nation into a state of depression.

Darling is Britain’s crisis chancellor, having been only briefly at the Treasury helm before the storm broke in the summer of 2007. That adds to the challenge he faces this week. The budget needs to inject some confidence, but this will be an uphill task for a chancellor whom the public thinks of only as the bearer of bad news.

So what can we expect from Darling in a budget that will have as its key theme “investing in recovery”? At a time when the big story will be the government’s acknowledgement of the scale of the recession and the deterioration in Britain’s public finances, the details of the budget will seem almost superfluous.

We have become used to hundreds of billions of pounds of public money being thrown around or provided to prop up banks, but it is worth remembering that most budgets are modest affairs.

Gordon Brown’s last three budgets, in 2005, 2006 and 2007, were essentially exercises in moving the fiscal furniture, sometimes with disastrous consequences, as in the abolition of the 10p starting rate of income tax. In net terms, though, none raised or lowered taxes by more than a few hundred million pounds.

Darling’s only previous budget, in March last year, was a medium-term tax raiser but again the sums were fairly modest, building up to an annual £1.87 billion by 2010-11, mainly through higher duties on alcohol, cars and biofuels.

The mould was broken by last November’s prebudget report, with a net give-away of £9.3 billion in 2008-9 and £16.3 billion in 2009-10, followed by net tax increases of £4.8 billion and £7.6 billion respectively in the two following years.

This week, unless the signals are wrong, we are back to a “normal”, tinkering budget, even though times are far from normal. That will allow the chancellor to give some modest “targeted” help for the job market to promote the government’s green agenda and to boost investment in digital technology. There may be some help for savers, though not a general income-tax exemption on savings interest.

As for any tax-raising, at this stage the aim will be to make it painless. At times like these a drive against tax avoidance is always a failsafe and Darling will be hoping to extract revenues from the worldwide clampdown on tax havens.

I do not want to say much more about what might be unveiled this week because pre-budget speculation can be tiresome and we will know soon enough. Amid the drive to boost lending to businesses, however, there are some good ideas around.

BDO Stoy Hayward says that relaxing the restrictions and increasing tax relief on the Enterprise Investment Scheme and venture-capital trusts could steer much needed funds from investors to small and medium-sized firms.

There are, though, bigger fish to fry. How does Darling generate some optimism while slashing his growth forecast? What he will do, of course, is offer hope.

The Treasury’s new forecast, which is set to treble this year’s expected drop in gross domestic product from 0.75-1.25% in November to about 3.5% now, with 1% growth next year, remains consistent with an economic picture in which the worst is behind us. Thus, the two biggest quarterly falls in GDP should be the 1.6% decline in the final three months of last year and a further fall of about 1.5% in the first quarter of this year, for which we will get official figures on Friday.

Recent economic data are consistent with those falls gradually tapering off as the year progresses, to the point where GDP is flat by the final quarter.

But there are lessons from other countries. America’s biggest quarterly fall in GDP looks to have occurred in the last three months of 2008, an annualised 6.3% (equivalent to 1.6% in the way UK figures are presented), which should have been followed by a decline of 3%-4% in the first quarter.

But the chancellor can get away with a “bad now, better later” message which, unlike some of his previous efforts, would not be met with ridicule by independent economists. Most agree that as long as banking problems do not erupt again violently, the huge stimulus being thrown at the economy – record low interest rates, the pound’s devaluation, the banking bail-outs, lower oil prices and the global fiscal stimulus, will revive growth in time.

What about the public finances? Darling will concede that borrowing at £170-180 billion will be half as much again as the £118 billion for 2009-10 he predicted in the prebudget report. But, unlike independent economists who think it will remain at these higher levels for years, he is likely to say that it will peak soon and then fall.

This is one reason why the Treasury view appears to be that this is not the time for immediate surgery to cure the public finances. If you are a believer in what economists know as “Ricardian equivalence”, after the great British economist David Ricardo, then it makes no difference whether the government announces tax hikes and spending cuts now or later – the mere existence of big borrowing numbers will make people and businesses rein back their spending. The chancellor will set out some medium-term “fiscal consolidation” measures though he probably does not expect to be around to implement them.

George Osborne is, however, sensibly starting to prepare the ground for the spending cuts that will be necessary, last week describing even the government’s 1.1% a year planned rises in spending as “not sustainable”.

This week’s budget, in most important respects, will be a holding operation. The really memorable ones will come later. And they won’t be very pleasant.

PS: I think I have discovered where Sir Fred Goodwin is hiding – page 156 of Vince Cable’s new book, The Storm, where his name has been cunningly changed to Sir Frank Godwin. The curse of the proofreader has struck the Liberal Democrat shadow chancellor. On that same page, Bob Diamond of Barclays might have something to say about being described as being as big a threat to stability as Arthur Scargill.

Since then, silence. Kenneth Clarke did not use his period in the Tory wilderness to put pen to paper. Gordon Brown has, but about other things, and I can’t say I’d relish 1,000 pages from him. So let’s hope Darling is keeping a diary.

From The Sunday Times, April 19 2009

Brian Lenihan and Sir Geoffrey Howe make unlikely bedfellows. Last week, however, Ireland's finance minister produced a powerful echo of what Margaret Thatcher's first chancellor, now ennobled, did nearly three decades ago — raising taxes in the depths of recession.

There are differences. Ireland's situation is incomparably worse than Britain's even at its low point in the early 1980s, with the economy officially predicted to plunge by 8% this year and further in 2010.

The Howe tax rises were to make room for interest-rate cuts, then in the gift of the UK chancellor, whereas nothing Ireland does will have much influence on the European Central Bank, though the austerity budget might in time bring down Irish government bond yields.

Ireland took action after a downgrading in sovereign-debt status and was under pressure from Europe to cut a budget deficit heading for 13% of gross domestic product. Howe's austerity budget in 1981 came when Britain was on the point of emerging from recession — not even an optimist would say that about Ireland today.

But the Irish example, which included a range of deficit-reducing measures, is one of which we should take heed. Lenihan succinctly summed up the situation: "The problem is our expenditure base is too high and our revenue base is too low."

That applies to Britain too. Prominent among Lenihan's measures were tax hikes from 2% of income for those on the minimum wage, to 9% for those on 300,000 euros (£270,000). What price a similar budget in Britain, not on April 22, but as the first post-election act of a new government?

As I write, the budget is being worked and re-worked in the Treasury and I shall have more to say next week. As it stands, based on the interview I and a colleague did with Alistair Darling after the G20 summit, it does not seem he is planning a big new round of medium-term fiscal-consolidation measures — tax hikes and public-spending reductions — in the budget.

The Treasury view is that there is a lot in the pipeline, including higher taxes on the better-off from 2010 and a new 45% tax band on incomes above £150,000 in 2011; a 0.5% increase in employer and employee National Insurance contributions; and slower growth in government spending.

The thinking is that there are two opportunities a year for the chancellor to have
a bite at the cherry, in the spring and autumn, and nobody is talking about the need for immediate tax rises. To announce further tax-raising measures now, even for the medium term, could be a sure-fire way to snuff out any green shoots of recovery.

Postponing the evil day makes economic sense, as long as the gilt market does not react badly to big budget deficits stretching as far as the eye can see. It makes political sense, as long as that day can be postponed until after the next election.

Last week the Institute for Fiscal Studies (IFS) set out in stark terms the challenge. The IFS is our most respected analyst of
the public finances and its projections reveal how much, and how quickly, things have changed.

Each year the IFS produces a "green" budget ahead of the actual event. Its January 2008 report, six months into the crisis, was more pessimistic than the Treasury's projections but not nearly gloomy enough.

Then it thought public-sector net borrowing, the budget deficit, would peak at £41.2 billion in the 2008-9 fiscal year and drop gradually to £32 billion, 1.8% of GDP, by 2012-13. Now its "baseline" for borrowing is £95 billion in 2008-9 (final figures will be published shortly), and annual deficits of about £150 billion for the next three years. In 2012-13 borrowing will be 8% of GDP.

That is a lot of red ink in a short time, reflecting the fact that the economy — and tax revenues — have deteriorated so much. In January last year the IFS thought government debt would reach 41.2% of GDP by 2012-13; now adding in the banking rescues it is looking for debt of 77.2% of GDP.

There is room for debate on some of these projections. Ben Broadbent of Goldman Sachs thinks the banking bailout's cost will be less than the £130 billion the IFS is assuming. But the direction is clear.

If the downturn has been so devastating for the public finances, surely the upturn, when it comes, will be a great healer? Yes, but the problem is the permanent loss of output both the Treasury and the IFS think has happened, 4% of GDP. There is a hole that has to be filled, of about £40 billion, to get the public finances back into shape and debt under control by 2015-16.

That seems a lot, though the measures Darling announced in the pre-budget report will be worth £37 billion a year when fully implemented, mainly through tighter control of spending.

I have argued before that the burden of fixing the public finances should come on the spending side — we have to cut our coat according to our cloth — but the IFS points out how tough that will be and neither party is preparing the way for a radical paring-back of the state.

Indeed, you might get the impression that the debate over the public finances is between a prime minister determined to carry on spending and a Tory opposition prioritising cuts in inheritance tax.

Already public spending is targeted to slow to 1.1% a year in real terms from April 2011, compared with growth of 4% to 5% a year from 2000 to 2008. In future, moreover, spending will have to accommodate higher outlays on debt interest and unemployment and other benefits, implying a real freeze on departmental spending.

Freezing total public spending in real terms for five years would get you to the £40 billion of reductions the IFS says are needed, but only at the cost of real-terms cuts in departmental spending. It is achievable — government spending did not rise in real terms between 1984-5 and 1989-90, or between 1994-5 and 1999-2000, but the second of those freezes owed much to reductions in infrastructure spending and both occurred when the economy was enjoying a fair wind.

What about tax? Thanks to an inadvertent leak last November, we know the Treasury was thinking about putting Vat up to 20% as part of a medium-term plan to control debt. Raising it to 25%, the maximum allowed by the European Union, would bring in an extra £37.5 billion a year. I am not advocating this, by the way.

Raising Vat was the first thing Howe did on entering the Treasury in 1979. Do you ever feel history might be repeating itself?

PS: Perhaps it was Gordon Brown's fault for unrealistically cranking up expectations of a co-ordinated fiscal stimulus. Maybe too many people look at everything through blue-tinted glasses and cannot bear to see the government do anything well. But one of the daftest criticisms of the G20 summit is that it came up with no new money for anything.

If the G20 was all smoke and mirrors, the head of the IMF would be the first to complain. Instead Dominique Strauss-Kahn, its managing director, cannot take the smile off his face as a result of what he describes as the "huge increase" in IMF resources.

From The Sunday Times, April 12 2009

So what is the verdict on the G20 meeting? Now that the international caravan has moved on, will we look back on it as a triumph, a turning point, or a strange little footnote in economic history?

Last time I was at the Excel Centre in Docklands it was for the motor show. Next year's has been cancelled because of the grim state of the global car industry. The question is whether the results of the G20 meeting will lift the black clouds.

The first thing to say is that Gordon Brown had a much better week hosting the summit than many expected. The idea that it would be a disaster was always a bit far-fetched, and so it proved. The praise from other leaders was genuine. If he was born for anything, this was it.

He was helped out by the flow of economic data and by the OECD (Organisation for Economic Co-operation and Development). The prime minister knows the recession may be his political undoing. But he also knew that most gathered round the table, certainly from western economies, were suffering similar, or worse, traumas.

Self-flagellation is one of our favourite pastimes. Something deep in the national psyche makes us want to wallow in the gloom. Being so miserable keeps us going.

But the OECD scotched the "Britain is suffering worse" myth. It said last week that Britain's recession, while serious, is far from the worst even among the big economies. Compared with the OECD's predicted drop in UK gross domestic product of 3.7% this year, four of the older G7 grouping are predicted to do worse — Japan (down 6.6%), Germany (5.3%), Italy (4.3%) and America (4%). Only France, down a predicted 3.3%, and Canada, 3%, fare better.

True, Britain's budget deficit is forecast to move much higher, to 10.5% of GDP next year. But this is less than America, 11.9%, and not dramatically above the OECD average of 8.7%. UK unemployment will remain below OECD and eurozone averages.

This is not, of course, a race to the bottom or a "your recession is bigger than mine" competition. But Brown would have found it harder to exercise his authority if Britain really was the sick man of the global economy. It also underlined the basis of the G20 meeting, which was that a dramatic synchronised global downturn demanded co-ordinated global action.

Did we get it? Having witnessed many damp squibs, and with the proviso that no single gathering could save the world economy, this one went further than most.

A $5 trillion (£3.4 trillion) fiscal stimulus is a lot of money, nearly a tenth of global GDP, even though none of it was new and most comes in the form of so-called "automatic stabilisers", the natural tendency for public spending to rise and tax revenues to fall in a downturn.

More impressive was the G20's ability to put together a $1.1 trillion package, separate from the fiscal stimulus. It consisted of a trebling of the International Monetary Fund's resources from $250 billion to $750 billion, a $250 billion allocation of IMF special drawing rights, in effect new reserves, which will allow emerging economies to survive damaging short-term capital outflows; $100 billion in new loans for the developing world, and $250 billion of new export finance to offset the credit crunch's damaging impact on world trade.

That part of the package did two things. It provided reassurance that the IMF has the resources, as do its most vulnerable members, to prevent a domino effect, in which instability in one country leads on to others. Eastern European economies were most vulnerable to these crises of financial confidence, but so were others.

A direct injection of trade finance, while small in the grand scheme of things and too late to reverse this year's dramatic contraction in world trade, was also a significant step in the right direction. Trade has become one of the credit crunch's most worrying casualties. Not all of this is hard, immediate cash but it represented good progress, particularly on IMF resources.

And there was more that was encouraging. Bank toxic assets remain a problem but countries are dealing with them, subject to domestic constraints. The G20 was never going to wave a magic wand to cure global imbalances but the recession is doing some of that, with China focusing on domestically generated growth and America's current-account deficit coming down.

Nobody would have wished for this global recession but it is possible that Brown's "new world order", if it means honest financial services, a genuine clampdown on tax havens and proper regulation of shadow banking, including hedge funds, will give us a global financial system built to last.

To the extent that the crisis has also shifted the global balance of economic power, which it has, that also represents a welcome change. Twelve members of the G20 would not have been allowed anywhere near the top table two or three years ago.

What does it mean for the immediate outlook? Forecasts are just forecasts. The interesting question is whether the recession's deadly grip is starting to ease.

The past few days brought a flurry of news that does not suggest the recession is over but implies an easing in the pace of decline. An improvement in the purchasing managers' index for manufacturing was followed by one for services.

Bank of England figures showed mortgage approvals rose to 37,937 in February, up 39% on November's low point. It is too soon for house prices to be rising, so Nationwide's 0.9% March increase was taken with a pinch of salt, and countered immediately by Halifax's report of a 1.9% fall. But Nationwide broke a relentless downward trend.

Perhaps the most encouraging development was deep in the money-supply numbers. "Broad" money, M4, adjusted for holdings by financial companies, slumped in the wake of the Lehman Brothers collapse. Its three-month annualised growth rate was negative by 5% at the end of last year. Now it has risen to an annualised 10%, even before quantitative easing. The Bank's own credit-conditions survey showed signs of a thawing of lending.

We are not through this yet. The Treasury is about to slash its forecast and thinks the first quarter will have been at least as bad as the final three months of last year, when GDP fell 1.6%. The chancellor's best guess is that we won't see growth again for another three quarters, and it will take longer before people notice it.

However, amid the gloom, one or two positive signs have started to appear and they need to be carefully nurtured. In combination with the G20 outcome, they suggest we can at least begin to hope again.

PS: What does the monetary policy committee, which meets this week, do now? The answer, according to the shadow MPC, is fret about the longer term. The shadow MPC, under the auspices of the Institute of Economic Affairs, says that at 0.5% the Bank has reached the limit of rate reductions and should press on with quantitative easing.

Permanently expanding the public sector "crowds out" the private sector and leaves a legacy of over-regulation, weak productivity and low growth. An exit strategy for fiscal policy is as important as for monetary policy.

From The Sunday Times, April 5 2009

Imagine, for a moment, you are in Germany. Some readers may already be there. You are in an economy that is still the world's biggest exporter, just beating off the challenge from China.

Manufacturing is regarded as the mainstay of the economy, as is the Mittelstand of medium-sized firms that are its backbone. While the rest of the world was enjoying a housing boom, Germany kept its feet on the ground.

German consumers kept their credit cards firmly in their wallets while most German banks avoided the over-exuberant follies of their international rivals. While the world enjoyed a champagne lifestyle, Germany stuck to Liebfraumilch.

The galling thing for Germany, however, is that this self-restraint did not spare its economy from a savage downturn. Official figures show Germany suffered the biggest decline of any European economy apart from Lithuania and Ireland in the final quarter of last year, shrinking by 2.1%.

This has given rise to some alarming predictions. Commerzbank, one of the country's leading banks, predicts a drop in gross domestic product (GDP) of as much as 7% this year and a rise in unemployment to 5m. Other forecasters are not so gloomy but see a GDP drop of 5% or more. Commerzbank also predicts a 7% drop in Japan's GDP.

The reason, of course, is that Germany is exposed to what is turning into an alarming plunge in world trade. So too is Japan, which reported last week that exports in February were no less than 49% down on a year earlier, with sales to America 58% lower. The export-led economies are discovering that what began as a banking crisis has quickly turned into the biggest reversal in world trade in living memory.

The World Trade Organisation (WTO) predicts that global trade, having grown strongly in recent years, will contract by 9% this year. This is easily the worst — barring wartime disruptions — since the big economies, led by America's abandoning of free trade, were erecting trade barriers in the Great Depression.

Indeed, the way things have been going, even a 9% world-trade decline may turn out to be over-optimistic. The crusties who will protest at this week's G20 meeting in London will, if they are articulating anything, be railing against globalisation. Given what is happening there should be a counter demonstration against the "de-globalisation" that is occurring.

Until September, more than a year into the credit crisis, most countries still faced the prospect of mild "technical" recessions. But the most deadly phase of the banking crisis, brought about by the collapse of Lehman Brothers, changed all that.

Normally there is a lag between financial-market developments and real-economy effects. This time the reaction was almost immediate. The global economy "fell off a cliff" in the fourth quarter, with GDP declines of 1.5% in the eurozone, 1.6% in Britain, 6.3% annualised in America, 2.1% in Germany, 3.2% in Japan. Even China's GDP was flat and the Asian tigers went from good growth to recession at the drop of a hat. American employment has fallen by nearly 2m in the space of three months.

Trade has been the transmission mechanism from the financial crisis to the world's factories. Pascal Lamy, the WTO's director-general, in a letter to the organisation's 153 member governments, estimates that world trade dropped by 5% in November last year, by a further 7% in December and by another 7% in January. There is no sign yet of the slide stabilising.

Why have the banking system's woes hit trade so hard and so quickly? There are four reasons. The global recession is more severe than most thought possible. In January the International Monetary Fund was apparently at its gloomiest, predicting just 0.5% global economic growth this year. Now it expects a contraction of between 0.5% and 1%.

This global recession, moreover, is unusually synchronised, certainly for advanced economies, which are all turning down together.

Second, according to the WTO, global supply chains mean that a downturn quickly spreads. Just as financial globalisation meant problems in one centre quickly led to others, so the trade interdependence of economies has rapidly transmitted the recession around the globe.

Third, and directly related to the financial crisis, trade finance has dried up. Firms have found it difficult to get export credits, without which they cannot do business.

Fourth, the global recession is breeding protectionism. Lamy identifies several types. "A pattern is beginning to emerge of increases in import licensing, import tariffs and surcharges and trade remedies to support industries that have faced difficulties," he writes. Most G20 members are doing it. Taxpayer support of troubled banks is leading to financial protectionism.

The G20 will meet in London's Docklands, an area where the cranes are now museum pieces but which owes its existence to free trade. It goes without saying that leaders of countries representing 85% of the world economy should make a firm stand against protectionism, and mean it.

Such is the collapse in global trade, however, that even rejecting protectionism is not enough. Completing the Doha trade round will help but so too will an active commitment to "re-globalising" the world economy by actively promoting trade.

A golden age of global trade — between 2000 and 2008 trade in goods and commercial services rose by 12% a year in dollar terms — has come to an abrupt end. Free trade has made the biggest contribution to more than 60 years of global prosperity. Preventing it going permanently into reverse is the G20's biggest task.

PS: Good week for Mervyn King. His comments on the inadvisability of a further big fiscal giveaway in the April 22 budget were followed by what seemed to be an immediate climbdown by Gordon Brown. The Treasury has been telling people for some time to focus on the generality of what the authorities are doing, including ultra-low interest rates, bank rescues and quantitative easing.

The government does not yet have a problem selling gilts. An auction the next day was got away easily, admittedly for index-linked stock, completing a year in which the Debt Management Office sold an astonishing £146 billion of gilts. But we could have done without the confusion. For central bankers, clear communication is everything.

From The Sunday Times, March 29 2009

When you get a bad set of unemployment data, as last week, it is tempting to think there are no jobs around, and that once handed the redundancy letter, you might as well give up.

Even when times are this hard, however, there is a two-way flow. So, perhaps surprisingly, a quarter of a million people left unemployment last month and found jobs, an increase of nearly 25% on a year earlier.

Unfortunately this was swamped by the fact that nearly 360,000 became unemployed, up by three-quarters on February last year and, as was widely reported, the claimant count surged by 138,000, the biggest monthly increase on record.

The fact that plenty of people are still leaving unemployment for work, so-called job-market “churn”, reflects a number of factors. One is that there is a bigger pool of unemployed people to place into jobs. Another is that the much-maligned Job-centres may be doing better than they are given credit for, along with private-sector recruitment firms.

John Philpott of the Chartered Institute of Personnel and Development (CIPD) also suggests the nature of the recession may mean the newly unemployed are better-qualified than in the past and easier to place in work.

But if the figures suggest that “abandon hope all ye who enter here” is not the right attitude for the unemployed, they also confirm the intensity of the downturn.

That is not so much in the Labour Force Survey (LFS) which, as expected, rose by 165,000 to 2.03m in the three months to January. Odd though it looks, it showed a 2,000 rise in employment over the period, though full-time private-sector jobs fell.

No, the really bad news was the claimant count’s 138,000 rise. This measure was discredited by frequent definitional changes under the Tories in the 1980s and Labour vowed to focus on the LFS measure. The old count still has the capacity to shock.

There is a chance we have seen the worst in the present cycle. For statistical purposes February was a five-week month and it is possible the snows made a bad situation in building trades worse and led to some additional workers signing on. But the number is the number and it adds to the tally of records this recession in chalking up.

Alongside it, vacancies dropped to 445,000, a quarter of a million down on a year earlier. Depending on which unemployment measure you choose, there are between three and five jobless people chasing every officially recorded vacancy.

One striking feature of the past few months has been the speed of follow through from the banking crisis of September to the real economy. Normally financial events take a lot longer to affect growth and longer still to hit employment.

This time the effects have been almost instantaneous. The near meltdown of the banking system hit credit – particularly trade credit – hard and walloped confidence. Business behaviour changed immediately, much more rapidly than consumer behaviour. The prospect of a mild recession turned into the reality of a deep one.

How deep and how long? There was a flutter last week when it was reported that new predictions from the International Monetary Fund would show a drop of 3.8% in Britain’s gross domestic product this year, followed by a further 0.2% drop in 2010 – a recession of two calendar years.

There may be such a forecast lurking inside the IMF but it is not yet telling us, though its projections for the UK budget deficit, 11% of gross domestic product, were bad enough. Updated projections were released but did not go down to the level of individual European economies. A proper update will be released next month.

History, though, tells us something useful about the duration of recessions. Paul Ormerod of Volterra Consulting gave a presentation last week to the Accumulation Society, an economists’ discussion group with a long history.

Ormerod presented data on advanced-country recessions dating back to 1871. Among the 17 advanced economies covered, there had been 255 recessions in the period 1871-2007, each defined as an episode in which gross domestic product falls from one year to the next.

Mostly, recessions end quickly. In 164 of the 255, 64%, there was just a single-year GDP fall. Next most common were two-year recessions, 58, 23% of the total. Three-year recessions are rare, 20, just under 8%; four-year slumps occurred on six occasions, 2%; five-year durations happened five times, also 2%. There was one example each of six and seven-year recessions.

Recessions are generally self-correcting, Ormerod argued, because they are usually inventory cycles. Firms over-produce and are forced to cut back, supplying demand out of stocks (inventories). Production cut-backs drive the economy into recession and only when stocks are so low that firms start producing again do you come out of it.

There is an element of all that in the current recession, though it is essentially the product of two big shocks to the economy: the credit crunch and last year’s oil and commodity price surge.

Nonetheless, the consensus among economists is that the one-year rule will apply – just. The latest Treasury compilation of independent forecasts shows economists are getting gloomier but still see positive growth in 2010, of 0.4%, after a 3.1% decline this year. Consensus Economics, which carries out a similar exercise, has average predictions of a 3% decline this year, followed by a 0.5% rise next.

Amid the gloom over unemployment, meanwhile, there was some good news last week. Many dismissed last weekend’s G20 gathering of finance ministers and central bankers as a waste of time. It did, however, include a commitment by central bankers to explore further ways of boosting their economies by unconventional measures.

Sure enough, last week both the Federal Reserve and the Bank of Japan announced plans to purchase bonds and boost money supply. The Bank of England could have felt lonely having already begun implementing its quantitative-easing programme. The more countries that join in, the better the chances of success.

PS: “Grumpy” is a badge of honour and Andrew Hilton has assembled centuries of collective experience to comment on today’s crisis. Grumpy Old Bankers: Wisdom from Crises Past, is published by Hilton’s Centre for the Study of Financial Innovation (csfi.org.uk) and is good.

Let me leave the last word to Albert Wojnilower, Wall Street’s original “Dr Doom”. His eight-point plan is pithy and sensible. 1: Abolish rewards for short-term gains. 2: Turn most financial firms back into partnerships – if partners carry the risk, watch their behaviour change. 3: Banks that accept insured deposits should be public utilities. 4: Short-selling is “anti-social” and should be banned (a move proposed by the former Labour minister Frank Field in a private member’s bill to be published tomorrow). 5: Severely restrict what the US mortgage guarantors, Fannie Mae and Freddie Mac, can insure. 6: If other countries choose to allow untrustworthy practices, don’t copy them. 7: Restrict damaging commodity-price speculation. 8: Take direct regulatory action to limit property bubbles. Growth depends on rewarding “long-term risk-taking, hard work and perseverance”, rather than “high-stakes short-term betting”, he says. That’s wisdom.

From The Sunday Times, March 22 2009

Next week, for the first time since February 1960, all of 49 years ago, Britain's most-watched inflation measure will go negative. The retail prices index (RPI) is expected to be 0.5% down on a year earlier, so watch out for the flood of articles and reports it provokes on deflationary Britain.

It will not end there. Negative RPI readings will be with us for the rest of this year, culminating in a deflation number of between 2.5% and 3% by September. This bout of deflation is due to various factors, including the unwinding of last year's record oil prices and sharply falling mortgage rates and house prices.

The consumer prices index (CPI), the government's target measure, does not include the last two and, as a result, may only briefly stray into negative territory. But it should be running along at close to zero for much of the second half of the year. The weaker the economy, the greater the danger of sustained CPI deflation.

And yet the worry I detect out there, certainly among business people, is not deflation but inflation. Beyond the valley of temporarily falling prices, they fear, lie the jagged peaks of a nasty inflation problem.

Partly this is a micro versus macro perspective. Many businesses have lived with falling prices for years and see it as the norm. But there is a difference between prices falling in individual sectors and across the economy as a whole. Twentieth-century deflation was mainly associated with depression and a rise in the real value of debt, something that has to be avoided.

There is, however, also some logic to these inflation worries. When does "kitchen sink" economics — throwing everything at the problem — go from being bold and aggressive to being foolhardy?

And when does a government that was quick to shelve its fiscal rules also abandon its inflation target? Could a little bit more inflation be presented as a more palatable alternative to permanently high unemployment? And haven't governments throughout history inflated their way out of debt?

The kitchen sink includes the most dramatic interest-rate cut, proportionately at least, in history. It embraces a 28% fall in sterling's average value since the credit crisis started in August 2007.

This time last year a £60 billion annual figure for public borrowing would have been unacceptably high. Now we are heading for an officially admitted £118 billion, with the City looking for more, perhaps £150 billion. It is not clear whether November's £20 billion fiscal stimulus will be followed by another significant dose in the April 22 budget, with Alistair Darling apparently resisting pressure to do much more.

Then, of course, there is the banking rescue in all its glory. If you add the cost of the banking recapitalisation to the credit-guarantee scheme, the asset-protection scheme, the long-term discount window scheme and the rest, you get to a very large number indeed; well over £1 trillion. That is not necessarily a sensible thing to do — it involves adding apples and pears — but it underlines the scale of the intervention.

The star of the show is quantitative easing, which has sparked the greatest unease among inflation fretters. It may be just that none of the other big central banks is doing it, including the US Federal Reserve. It could be because Gideon Gono, Zimbabwe's central-bank governor, has praised it and come out as its intellectual godfather. But "creating" money feels like the road to perdition for some.

So how worried should we be? The Bank, in its February forecast, predicted that negligible inflation would not just be with us for this year but beyond. If it is right, then by the time of the 2012 London Olympics we will have looked back on a long period in which CPI inflation has averaged 1%.

Is this plausible? The Bank, to be fair, has incorporated sterling's weakness into its numbers, though on the other side it also thinks consumers and businesses could get locked into a falling-price mentality that might be hard to shift.

Its main reason for thinking inflation will stay low, however, is that the recession will increase spare capacity in the economy to such an extent that even if firms wanted to raise prices they will find it hard to do so. High unemployment will tend to keep wage demands down.

History, it should be said, is on the Bank's side. Recessions are good at destroying inflation. That is why, traditionally, they were engineered by policymakers.

The last time Britain had a combination of a sharp sterling fall, plunging interest rates and big budget deficits, at the time of the pound's September 1992 exit from the European exchange-rate mechanism, the fear was also of a resurgence in inflation. But it was followed by 16 years of low and stable inflation. This time the recession started with inflation already low, hence the worries about deflation.

All that is fine, except that this time the policy response has taken us into uncharted territory. I am not so concerned about quantitative easing. It is fairly easy to unwind and the risk is that it is ineffective, not that it is excessively inflationary.

The risks come from the combination of very low interest rates, sterling's fall and big budget deficits. Fathom Consulting, in a new report, argues that the three are related, most importantly in the strong sense that the pound's weakness is directly related to a loss of credibility for Britain's macroeconomic framework. Certainly, the failure of anybody in authority to speak up for sterling is surprising.

Credibility, once lost, is not easily regained, but there are things that should be done. November's pre-budget report contained some measures for reining back public borrowing over the medium term, but there needs to be a lot more. A large part of the April 22 budget should be about medium-term fiscal consolidation, which regrettably will have to involve both higher taxes and lower government spending.

Mervyn King and his colleagues have to show there is an iron fist inside that velvet glove. From a time when tiny changes in Bank rate were thought to have a big impact, we are in an era where huge changes are assumed to have not much effect. Calibration is hard but maybe we should be a little more patient and wait for normal policy lags to work.

Most of all, 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. That won't happen for a while. But for once, when interest rates go up, it will be a cause for national celebration.

PS: Things they wish they hadn't said: Gordon Brown's "no return to boom and bust" is in a class of its own but there are a few others that some of our leading politicians might wish were forgotten.

I am not blaming him. The past is another country. We now know the regulators failed, but it is worth a reminder that it was not obvious at the time.

From The Sunday Times, March 15 2009

Many surprises have rained down on us over the past 18 months, mostly unpleasant. But among the seismic shifts in response to these shocks has been in Britain's monetary policy.

Even as recently as last summer, well into the credit crunch, we were in a familiar world. The Bank of England's monetary policy committee (MPC) met each month, deciding whether to nudge interest rates up or down by a quarter, such small moves apparently still having a big impact.

True, everyone knew the transmission mechanism from rate cuts to the economy was clogged. Irrespective of what the Bank did, lending was impaired. These things were being addressed, but separately from monetary policy, where it was business as usual. Bank rate was 5% and when I said it should be lower, people warned that inflation was so bad rates would rise sharply.

On Thursday Bank rate was cut to 0.5%, after one of the most dramatic few months for monetary policy ever. None of us has seen rates this low. When the storm passes, we may never see them as low again. Boring it isn't. The government has been interviewing for a new MPC member and probably asking "Do you own a flak jacket?"

The past 300 years have seen about a dozen significant wars (many with France), bubbles, booms and busts. There has been deflation and inflation. But until now we had never had official interest rates below 2%, let alone within a whisker of zero.

More remarkable is the Bank's view that this will not be enough. That was why we had the exchange of letters between Bank governor Mervyn King and the chancellor, Alistair Darling, authorising the Bank to press on with quantitative easing.

In normal times you would no more think of putting the subject on the front page than you would quantum mechanics. Who knows, perhaps A Brief History of Quantitative Easing could outsell Stephen Hawking. For that to happen, people would have to get over a big barrier of understanding. I have detected a condition you might call QE torpor, which is that when you try to explain it, people nod politely but their minds are elsewhere. With only a little effort you can put a whole room to sleep.

But let me try, and I'll wake you up when I've finished. Suppose up in the loft you have a couple of paintings. The Bank gets in touch, offers to buy them, and credits your account with the proceeds. Flush with cash, you go out and spend.

Now imagine you are a bank. The Bank offers to buy, not paintings but financial assets, particularly government bonds. In return, it credits the bank's account (banks have accounts at the Bank) with additional reserves. Flush with extra cash, the bank is secure, not about increasing spending, but increasing lending, and by a multiple of the increase in reserves.

This "money multiplier" in crucial. In normal circumstances an increase in reserves of £1m would lead to £20m of additional credit, though recently the ratio has been nearer one for one.

A similar effect is achieved, through a slightly more circuitous route, if Bank purchases are from institutions, such as pension funds and insurance companies, as many will be. An essential by-product of the process will be that it drives down bond yields — both government and corporate — cutting long-term borrowing costs.

The really difficult bit for most people is the question of where the money comes from. In January it was announced that the Bank would purchase assets from banks and institutions but that it would get the money — £50 billion — from the Treasury through the issue of new bills.

Now, that policy, which would have had no impact on the money supply (it was known as credit easing), is superseded by quantitative easing. Because the explicit intention is to expand the money supply, the Bank pays for its purchases by expanding its balance sheet, creating money. As I have said before, don't try this at home, only central banks can do it.

This is, for all the recent talk of rampant Keynesianism, pretty much a textbook monetarist prescription. It is hard to think of a purer monetarist policy in Britain, including the Thatcher government's monetarist experiment in the early 1980s.

With apologies for taking you back to dusty textbooks, think of the quantity theory of money, MV = PY. M is the stock of money in the economy, not just notes and coin but, in a modern credit economy, broad money, M4. V is the velocity of circulation, the speed money flows around the economy. P is the price level and Y the level of national output, or gross domestic product (GDP). Some may remember T — transactions — instead of Y.

The clear aim of quantitative easing is for the Bank to directly boost M, by "creating money" through purchasing an initial £150 billion of assets from the private sector (£75 billion in the next three months).

The quantity theory tells us how. Adjusting for the bank lending being channelled into the troubled financial sector, growth in the money supply, underlying M4, has slowed sharply. M is not increasing fast enough and neither is the right-hand side of the equation, PY — GDP in current prices or, if this is not too confusing, money GDP. The Bank's aim is to get money GDP growth up from zero to about 5%.

So quantitative easing, by boosting the money supply, ought to boost money GDP. £150 billion will boost M4 by about 7.5%, which is significant. Recovery will ensue, and we will all be happy.

The first potential problem is fundamental — the direction of causation. Everybody agrees the recession resulted from the credit crunch, a freezing of funding sources and an abrupt reduction in the availability of credit and finance.

Suppose, however, the recession itself and a lack of appetite for borrowing have taken over as the driver of the money-supply slowdown. Boosting M might thus have only a limited impact and money GDP would continue to stagnate.

Both factors are in play. Borrowing attitudes are more cautious but credit availability is a real problem. A CBI survey last week found nearly 60% of firms had greater difficulty obtaining finance in the past three months. Quantitative easing will help if it feeds through to extra lending, admittedly in a system with less capacity because some foreign banks have gone.

A second potential problem concerns bank behaviour. The Bank was not entirely flying blind with last week's announcement. It took plenty of soundings from the banks. But it remains possible that the boost in M will be entirely offset by a decline in V, velocity, as banks hoard the newly-created reserves. Velocity has been declining in recent months.

The final danger is that, now we have moved out of the monetary-policy comfort zone, calibration becomes impossible. We do not know whether £150 billion of easing will be too much — and therefore inflationary — or too little, though the Bank has the capacity to do more. The money and lending numbers will thus have to be monitored even more closely than usual. In this respect, we are all monetarists now.

PS: Sir Fred Goodwin has a lot to answer for. I am a fan of Radio 4 but if I hear another Thought for the Day sermonising on his pension I'll switch to Heart FM. The Fred retirement pot prompted an episode of the Moral Maze last week that was one of its most irritating and ill-informed — and there's quite a lot of competition. It was car-crash radio, and I nearly crashed the car listening.

The Goodwin episode has also given the impression that this is the norm for private-sector boardrooms. It is not. A survey by the Institute of Directors, to be published this week, shows that only 12% of its members are in final-salary schemes (compared with 90% in the public sector). On the question of inequality, raised by the latest outbreak of fat-cattery, things are also not what they seem. Research in the London School of Economics Centrepiece journal shows that earnings inequality was starting to decline, at least until the recession. It remains to be seen whether the downturn will be an even greater leveller.

From The Sunday Times, March 8 2009

An interview with Sir John Gieve, outgoing deputy governor of the Bank of England.

It is Friday and Sir John Gieve is clearing his desk in the Bank of England’s parlours. After three years as Bank deputy governor responsible for financial stability, this weekend marks his shift to pastures new.

While his colleagues on the Bank’s monetary policy committee were being briefed by in-house economists ahead of key decisions this week — a cut in rates is expected as well as a decision to embark on so-called quantitative easing — Gieve was readying himself for a three-month spell at Harvard.

There, as a visiting fellow, he will reflect on a banking crisis that has consumed his life for 18 months, before returning to Britain to take up a new role, as yet undecided.

The former civil servant, whose forebears were half of the Gieves & Hawkes tailoring business — he still wears the firm’s suits and once lent John Major one of its ties to present the budget — spent most of his career with the Treasury. Immediately before the Bank, he was permanent secretary at the Home Office.

At a leaving party in the Bank’s Court Room on Thursday evening, he revealed how he had welcomed the stability of the Bank after the turbulence of the Home Office, where it was branded “not fit for purpose” by its own home secretary.

For 18 months the Bank was a haven of stability and Gieve appeared to have made a shrewd choice. But in August 2007 all hell broke out in the financial markets and he was thrust into the centre of it with the rescue of Northern Rock.

He has upset Bank governor Mervyn King by saying the authorities’ footwork during that rescue “owed more to John Sergeant than Fred Astaire” but is unapologetic. “We did it clumsily,” he says. “We did not need two days of queues in the streets.”

The Northern Rock saga was all the more galling because a year earlier economists under Gieve’s wing had looked at UK banks’ vulnerability to a shift of funding conditions in wholesale money markets.

They threw up concerns about Northern Rock, Alliance & Leicester and small players in the UK mortgage market such as GMAC, which were beginning to develop a sub-prime sector in Britain. A paper was circulated and sent to the Financial Services Authority. Nothing was done. Northern Rock continued to expand aggressively.

“We should have made more of that, and they should have made more of it,” he says. “They should have been asked searching questions.”

Northern Rock probably hastened the end of his career at the Bank. When Bank officials testified to the Commons Treasury committee, MPs — some with scores to settle from Gieve’s Home Office days — reserved their toughest questioning for him.

He was accused by John McFall, its chairman, of being “asleep in the back shop while there was a mugging out front” and attacked for taking a holiday during the crisis, though it later emerged he took time off because his mother had died.

When, last summer, there were hopes in Westminster that the banking crisis would end with Northern Rock, reports suggested ministers were looking for a scapegoat and he would be it. Whether true or not, news of his departure leaked during last June’s Mansion House dinner in the City. So he has been working his notice during the biggest banking crisis in a century.

Looking back, his big regret, as with Northern Rock, was not sounding more warnings. His responsibility for financial stability included publishing a six-monthly Financial Stability Report. “If I regret anything, it’s not making more noise,” he says. “If you look back at what we said, we did point out many of the vulnerabilities — the global imbalances, the growing dependence on wholesale markets, the danger that all the credit markets would prove much less liquid than in the good times — but we didn’t bang the drum.”

Though he maintains King and other Bank colleagues were interested in financial stability, he accepts it was not seen as a priority. “Definitely, when supervision was moved out and conditions were extremely stable, it did take second place to monetary policy, there’s no question about that,” he says. “It had slipped down the agenda.”

It was a “one-and-a-half purpose Bank”, rather than a two-purpose Bank. “The new Banking Act clarifies and embodies the view that a central bank needs to have two core purposes,” he notes. “There’s been a rebalancing over the past 18 months.”

What of Gordon Brown’s decision to take away banking regulation from the Bank and put it into the Financial Services Authority? The so-called tripartite system, Gieve points out, was three years ago regarded as the best in the world.

“The vulnerability was that pressures on the FSA would come from the consumer side and they would take their eye off prudential supervision of banking in the good times, and that the Bank would retreat too far from concern about the financial sector,” Gieve says. “Both of those things happened. But both have been put right over the past 18 months.”

Lessons have been learnt, at the Bank and the FSA. “I think the FSA spent too much time looking at systems and controls and not enough time looking at the business model and the numbers, and that’s going to change,” he says.

One of the things he will be thinking about in Harvard will be the kind of system that will prevent a recurrence of the current agonies. He already has a good idea about the broad shape of it.

Leverage for the banks — the ratio of debt to capital — will have to be limited and “countercyclical” regulation introduced; possibly a variation of Spain’s dynamic provisioning model. As a back-up, he says, authorities should be able to set limits on borrowing; the size of mortgages relative to incomes and property values; loan-to-income and loan-to-value limits. Hong Kong has used these successfully.

“I think we are going to end up with a leverage limit as well as some countercyclical capital requirements and possibly some countercyclical liquidity requirements,” he says. Spain’s banks, having had what he describes as “a rip-roaring property boom and bust” are coping reasonably well.

“In our case, if you go back to 2003-4, the height of our house-price boom, both then and in 2006 we saw very rapid growth in credit and asset prices and you’d have said there were real signs that financial markets and asset prices were taking off in a worrying way,” he says. “Those are precisely the circumstances in which we’d have ramped up capital requirements on the banks and it could have had an impact.”

Gieve cites the current sharp downturns in Japan and Germany to underline that the crisis is global. But he accepts that things could have been done better in Britain. “With hindsight we should have been more worried about the growth in credit and the rise in asset prices than we were,” he says. “You’ve got to take asset prices and asset markets more seriously than we did.”

The government has suspended its fiscal targets. Is there a risk it could abandon the 2% inflation target? Gieve, a Treasury veteran, says no. “I don’t expect that to happen and it would be a mistake,” he says.

“We’ve got to hold on to the fact that inflation will be kept low,” he says. “That will require some very difficult decisions because it will require the Bank to start raising rates before it is obvious on the street that the economy is getting better.

“When the recession does come to an end, will we overshoot the inflation target? I don’t think it would be the worst thing in the world if we overshot it a bit, but I don’t want to turn this into a 1970s experience of really high inflation followed by savage measures to bring it under control.”

As he heads off to America, where talk of protectionism is rife, Gieve’s big worry is that the crisis will see globalisation go into reverse. “The risk is that we’ll see a real step back from open international financial markets,” he says. “The Asian crisis was big but didn’t lead those countries to say the free-market model is flawed. The big issue is whether we treat this global recession the same way. Is it a case of mending the system but driving forward on an open trading, free-market model, or will it go into reverse? There’s a real risk of a reversal.”

However, on an upbeat note, he thinks the worst of the banking crisis may be over. “I hope we’ve reached the bottom. This Asset Protection Scheme they have announced for RBS and will announce for Lloyds in the next few days is a convincing scheme. I hope it will provide a platform from which those two banks will be able to identify the living bits of the business and that, with what we’re doing here and what they’re doing with Citigroup and Bank of America in the US, we will see a gradual recovery,” he says.

“What would be really helpful is to see some banks get out there and raise money on the markets. That would help change the atmosphere.”

What next? Brian Quinn, a former Bank deputy governor, went on to be chairman of Celtic football club. Gieve would relish the chance to help out at his beloved Arsenal. “I’d love to do something with Arsenal but they haven’t given me the call yet,” he says. Maybe after the past 18 months, football would be just a bit too dull.

From The Sunday Times, March 1 2009

Who does well and who gets hit hardest in recessions? The impression you sometimes get is that everyone is bowled over together. But some parts of the economy are relatively recession-proof, not just the public sector, and others emerge not just standing but stronger.

We know quite a bit about the story so far, thanks to detailed gross-domestic- product figures released last week. They confirmed the economy shrank by 1.5% in the final quarter of 2008, the drop helped considerably by a big fall in inventories as firms ran down stocks rapidly.

With luck, that big inventory fall should mean subsequent quarterly falls this year are smaller, a necessary step on the road to stabilising the economy and then recovery.

Since the recession began in the middle of last year, GDP has shrunk by 2.2%, almost as much as its 2.5% peak-to-trough fall in the recession of the early 1990s. Within that 2.2% fall, however, there have been some very varied experiences.

Manufacturing, down 7% (and already in decline when the economy-wide recession started), has fared much worse than services, down less than 1.5%. But some bits of the service sector have been hit almost as hard as manufacturing, notably the wholesale and retail trade and transport. Others, however, have been surprisingly immune.

The official figures show, for example, financial intermediation — financial services — continued to expand in the second half of last year, surprisingly growing by 1.5% as the rest of the economy shrank.

Though this goes against every headline we have been reading, there is a logical explanation. Dealing in stocks, bonds and currencies was strong during the highly volatile second half of 2008. Banks increased their margins. Lending continued to grow, though slowly.

"Landlording", owning and letting out property, was also up, by 0.3%. Telecommunications (and post) is also a growth area, up 2.8% in the second half of last year.

The figures show considerable variation when it comes to spending. Some categories were weakening before mid-2008 but since then consumer spending is down 0.9%, investment 5.9% and exports 5%, though imports also fell 5.6%. If you want growth, look to the public sector, with government spending up 2% in the second half. All the figures are inflation-adjusted.

The breakdown shows that for all the talk about rebalancing the economy away from consumer and government spending, more desirable components of demand — exports and investment — are suffering the most. Similarly, rebalancing the economy towards manufacturing and away from financial services and property may happen but is not happening yet.

This is a variation of what Bank of England governor Mervyn King said last month when he talked of doing things that look like the "diametric opposite" of what would normally be sensible. In current circumstances, any growth will do.

While some categories of consumer spending are clearly very weak (notably cars), retail sales have held up well in both the official figures and the surveys.

There are several possible explanations, including the Bank's dramatic reductions in interest rates and a recovery in real incomes, but anybody who thumps the table and dismisses as ineffective the Vat cut that came in on December 1 is probably revealing ignorance of the data.

Consumer spending may yet succumb more dramatically under the weight of rising unemployment, though in the last recession it began to recover even as the jobless total was rising strongly. But we'll see.

As for the split between manufacturing and services, industry's problem is that it is exposed to the full bracing effects of the global recession while significant parts of the service sector sell only in Britain and are shielded from those effects.

Economists at Price Waterhouse Coopers, in an analysis to be published this week, have re-run an exercise they last carried out at the beginning of this decade.

PWC's Michael Nowak and John Hawksworth looked at 15 different sectors of the economy and assessed their vulnerability to the downturn on the basis of a series of different measures that together add up to a sector-vulnerability index.

These fall under three headings: current financial strength, cyclicality and growth potential. The least vulnerable sector would be one that entered the recession financially strong, was not exposed to the cycle and had a history of strong growth.

The most vulnerable sector is financially weak, exposed to shrinking world markets and had a poor run of growth. It sounds simple, though the PWC economists have added on a few sophisticated statistical nuts and bolts, including what they describe as economy beta, equity beta and firms' so-called quick asset ratio (cash they can quickly lay their hands on versus current liabilities).

What they end up with confirms that this is not a great time to be making things, particularly metal things. The most vulnerable sector is metal products, with engineering at No. 4. Also in the top five most vulnerable sectors are financial services — suggesting a big hit is coming its way — hotels and restaurants, and transport.

At the other end of the scale, utilities are least vulnerable, followed by food retailing and, also among the five least vulnerable, food manufacture. Surprisingly, chemicals and non-food retailing also feature. There may be a "survival of the fittest" element; some of the retailers that have already failed were probably past their sell-by date.

Some precedent may be useful. In the last recession in the early 1990s utilities increased their output by 10%, chemicals and food retailing by 5% each, and food manufacturing by 3%.

Just to complete the picture, sectors with middling vulnerability are post and telecommunications; construction (supported by infrastructure spending); oil, gas and mining; textiles; and business services.

Such exercises are useful, to remind us that all recession experiences are not equal. As always, though, individual businesses vary widely, even in the same sector. Nobody should throw in the towel, even in the most vulnerable spots.

PS: This week could be historic. It may mark the low point for interest rates in the present cycle — the last of the cuts — and the beginning of a new phase of monetary policy, quantitative easing, boosting the quantity of money.

One thing that sticks in my craw is people saying the government should not encourage banks to lend because we have enough debt already. That misunderstands where we are. We had too much lending in the past but too little recently — ask any business that has had its overdraft facility cut off or cannot get finance for working capital. There is nothing irresponsible about restoring a normal level of lending.

From The Sunday Times, March 1 2009

Economics has not covered itself with glory in predicting the situation we find ourselves in. The bankers' models did not work and neither did those of economists.

Economics also struggles when it comes to defining its own language. So let me start this week with an extended throat-clearing exercise, defining a few terms.

Then I'll come on to explaining some of the "unconventional" things the Bank of England is about to embark on to try to resuscitate the patient.

Everybody knows what a recession is, do they not? Last month's publication of figures showing a 1.5% drop in gross domestic product in the fourth quarter — its second successive fall — was accompanied by any number of headlines and broadcasts showing Britain to be "officially" in recession.

Except there is no generally accepted definition of recession. The National Bureau of Economic Research in America defines it as "a significant decline in economic activity spread across the economy, lasting more than a few months, normally visible in real GDP, real income, employment, industrial production, and wholesale-retail sales".

While this has advantages over the two-quarter definition, it is rather imprecise, so some economists focus on unemployment, and a rise of 1.5 to 2 percentage points in the jobless rate over 12 months. But that would mean Britain is not yet in recession — on both measures unemployment has yet to increase that much — and might be considered too backward-looking.

That leaves us with, in my view, the most robust recession definition, used by the late Christopher Dow in a book called, appropriately, Major Recessions. He pointed out that you could have a "growth recession", a period of very weak growth within a rising trend. Even this can hurt. As I have pointed out before, it is the "lost" growth you normally expect that makes recessions so painful.

For him, however, a recession worthy of the name was one featuring a "clear absolute fall in GDP between one calendar year and the next", usually but not always followed by a second fall. Big recessions had the characteristic of a "sharp descent" followed by a "protracted recovery".

So we are in a big recession or, as Mervyn King described it last week, "deep". More on that in a moment. But what about the word that dare not speak its name — depression — except when let slip by Gordon Brown or implied by his former chief economic adviser, Ed Balls?

Saul Eslake, ANZ Bank's chief economist, had a good go at this in a recent paper, entitled What is the difference between a recession and a depression? Economists think they know, because they think of the 1930s, so a peak-to-trough GDP fall of 10% or more, or a decline lasting three to four years, or both, fit the bill.

In that respect, the Great Depression of the 1930s was not one as far as Britain was concerned. GDP fell by just over 5% and the decline lasted only two years. The period 1919-21, when there was a fall of nearly 25%, was much worse.

Eslake, however, thinks the key distinction between recessions and depressions is their cause. Brown always reminds us the causes of this downturn are not the usual ones. Maybe he knew more than he let on using the D word.

"The distinction hangs on the causes and other characteristics of the downturn," Eslake writes. "In particular, a recession is nearly always the result of a period of tight monetary policy, while a depression entails a significant and protracted asset-price cycle; it involves a contraction in credit or debt (thus potentially rendering monetary policy impotent); and it is characterised by a decline in the general price level as well as in economic activity."

You can have mild depressions as well as big ones, he notes. But if another common theme is that policymakers are required to do something they would not do in a normal recession, maybe we should not shy away from the D word, though the fear of reawakening the ghosts of the 1930s is understandable.

What about that other D word, deflation, a fall in the general price level? There is good and bad deflation. The sharp fall in commodity and energy prices boosting real income growth is good deflation, not least because it is temporary. The Bank's view is that there will be good deflation this year, as those big price rises unwind, but "the likelihood of a persistent period of deflation in the UK is judged to be small".

It is partly to head off that risk that the Bank, having done quite a lot of unconventional things already, including swamping the banking system with liquidity and cutting interest rates to 1%, is prepared to walk even further on the wild side.

The message of its inflation report last week was that at its meeting in early March the Bank's monetary policy committee will decide whether to embark on so-called quantitative easing, boosting the "broad" money supply by buying in gilts, corporate bonds and other assets from the private sector and paying for it by expanding the Bank's balance sheet.

Quantitative easing should be distinguished from credit easing or its close relative, "qualitative" easing. The £50 billion asset-purchase facility the Bank has started comes under these headings. It involves the purchase by the Bank of illiquid assets from banks, swapping them for liquid assets they can use as the basis for increasing lending. The Bank's balance sheet does not expand, though its composition changes, and there is no effect on money supply.

Some economists think the Bank should stick at that and not go down the quantitative-easing route. DeAnne Julius, former MPC member, now an adviser to Fathom, which last week launched its monetary-policy forum, urges caution.

Quantitative easing could be ineffective, as most economists think was the case in Japan in the 2001-6 period. It could end up being inflationary, hard as it is at present to see the return of inflation. Done properly, however, it could make a difference and because of that it is worth a try.

In the end, though, where we head now, and whether either of the D words becomes appropriate, depends more on the conventional than the unconventional.

A useful table in the Bank's inflation report looks at the combined economic stimulus over the 12 months to the end of last year and compares it with the run-up to previous recessions. It includes a 3.5 point cut in Bank rate, a 22% fall in sterling, a 40% drop in oil prices and a 2% easing in the government's fiscal stance.

In the run-up to the three previous big recessions, interest rates, sterling and oil had normally been rising and fiscal policy tightening. That confirms the causes of this downturn are different. But it also tells us that if all this, combined with unconventional measures, does not work, probably nothing will.

Though lags between policy changes and their impact can be long and variable, "whatever it takes" will eventually make a big difference.

PS Sorting through some stuff I came across my press badge for the Brussels summit in 1998 that launched the euro project in a fanfare. The meeting, recalled by David Marsh in his excellent new book, The Euro: The Politics of the New Global Currency (Yale University Press), was marred by a Franco-German row over who should be the European Central Bank's first president.

I'll return to the book another time, but anybody hoping the current crisis will speed UK entry will not get much succour. After talking to many people, Marsh finds the political gulf is widening and said the UK will stay outside until at least 2025. Who knows where we will be then?

From The Sunday Times. February 15 2009

Wandering round Poundland, as one does, is a bit different from the rarefied atmosphere of Davos but is an experience to be recommended.

In this Aladdin's cave, which has everything from the latest Rupert annual, six-packs of rare incandescent light bulbs and mini tool kits to household goods, toiletries and non-perishable foods, there is a sense of wonder that anybody can make this stuff for £1, let alone sell it.

The Poundland effect underlines how tough things are for higher-priced retailers, which is why it is expanding while many of them are shrinking. That, however, is not the only message.

Just down the road is a 99p shop and, unless my eyes were deceiving me, it was busier. To economists, if not to Poundland, that is gratifying. It shows price signals work, even at low prices and that the fashionable "left digit effect" is alive and well.

This is the effect that makes us more likely to buy at £9.99 than £10. By the same token, 99p is more appealing than £1. I am tempted to open a 98p shop, though experts say that to make a real difference you might have to go to 89p, if not 49p.

The real point is that one of the stories of 2009 will be that consumers can buy cheaply, if they choose to, and not just at the discounters. We are moving into a period where inflation will be negligible, and for periods negative, in spite of sterling's fall.

This, and what will be a very gloomy economic forecast, prompted the Bank to cut interest rates from 1.5% to 1%. As I wrote last week, I would not have done so at this time. But how strange it is that such low rates have become almost commonplace.

Low rates are providing a bonus for borrowers, bringing big reductions in mortgage payments. More generally, low inflation — helped by the government's temporary Vat cut — will provide a boost to real income growth. Just how big was underlined by the National Institute of Economic and Social Research in its latest review.

It predicts real household disposable income will jump 3.3% this year, well up on last year's increase of 1.5% and 2007's zero growth. If this is right, it will be the best year for income growth since 2001. We will not have had it so good for a long time.

The question is: what will people do with it? Simon Kirby and Ray Barrell, economists at the institute, are pretty sure they will not spend it. Alongside that 3.3% rise in incomes they predict a 3.8% slump in consumer spending. Saving, not spending, will be the watchword this year, they say, with the saving ratio predicted to jump from 1.3% last year to 7.1% this year.

It is an interesting forecast and a brave one. Lots of unprecedented things are happening but that would be an unprecedented divergence between income growth and spending. Barrell points out that something similar happened in the early 1990s, but spread over three years. This time, he said, the effects were coming through much quicker, with falling housing wealth and lack of availability of credit being the two main factors pushing spending lower.

Nobody expects consumer spending to be anything other than weak this year but other economists dispute the scale of the weakness. Robert Barrie at CSFB and David Miles and Melanie Baker of Morgan Stanley think spending will slip by a modest 0.5%. The things we should most worry about said Barrie, were exports and investment.

It is an interesting split, and not just for those reliant on selling into the consumer sector. CSFB and the institute have similar forecasts for this year's drop in GDP, 2.5% and 2.7% respectively, but they have very different views on its composition.

For those who think the recession should be about rebalancing the economy away from the consumer and restoring the saving ratio to something more sustainable, the institute's forecast does the trick. CSFB's story, in contrast, is one where the hit to growth comes from the depressed global economy, and there is no rebalancing.

Surely, you will say, this recession is all about households deleveraging — paying off debt — and a sharp drop in consumer spending will be a natural consequence of that. But, as I have pointed out before, consumer spending has been rising at a slower rate in recent years and was, in any case, mainly financed out of income growth.

The build-up in UK household debt was both a consequence and cause of rising house prices. It has risen in every country. It rose by more and to a higher level in the UK than in most, because Britain has a higher proportion of owner-occupiers and because house prices rose more, albeit from an undervalued position in the mid-1990s, partly because of a shortage of new homes.

We should not engage in self-flagellation over household debt, though. As Bank of England governor Mervyn King and Lord Turner, chairman of the Financial Services Authority, have pointed out, two-thirds of the rise in lending since the early 1990s was to the financial sector.

The debt story is not complete without also looking at household assets. Figures from the Organisation for Economic Co-operation and Development show UK households have far higher net wealth, as a proportion of income, than their counterparts in America, Japan, Germany and France.

There will be a two-way debt battle in the coming months, rising unemployment making it hard for a minority to service their home loans, while lower interest rates will make it easier for the majority.

Where will this leave spending? Nationwide's consumer confidence index is at a record low, though the proportion of people saying now is a good time for a big purchase has risen again. That is important. Official figures show retail sales held up pretty well through to the end of last year, but that spending on big-ticket items was very weak. Ask any car dealer.

In the end, confidence is the key. Consumer recessions are not caused by people cutting back who have to. They happen when those who are not badly squeezed decide it is prudent not to spend. This is Keynes's paradox of thrift; we would like a higher level of savings but not right now.

It could go either way. But if the institute is right in its calculation of the rise in real incomes this year, I would be quite surprised if it is also right on spending.

PS: So how much did the great snow cost us? £1.2 billion a day, you may have heard, and perhaps £3.5 billion in total. It was in every newspaper and broadcast, so must be true. The figure came from the Federation of Small Businesses (FSB), which must be congratulated on the coverage it got. The media needed a number and it supplied it. Breathless reporters warned of the impact on "productivity" (they meant production).

Weather effects are notoriously difficult to calculate. Floods and other weather events are reckoned to cost the economy 0.1% of GDP annually; about £1.5 billion. Could last week's snow really have cost twice as much as a normal year's bad weather? So how much did it cost? Let's be honest, we don't have a clue.

From The Sunday Times, February 8 2009

So did the World Economic Forum in Davos save the world? I have attended these annual gatherings in the Swiss mountains for quite a few years now, but never in conditions of such economic adversity.

Many bankers stayed away this year, but there were plenty of regulators, politicians and, yes, pundits. Those who did get some of it right, like Nouriel Roubini, aka Dr Doom, and Robert Shiller, were sought out to provide even more gloom. Were there any solutions? I don't always agree with George Soros, but he had it about right when he said Davos never solves things, it just discusses them.

The Davos meeting consists of four days of panel discussions, some of them over lunch and dinner at the ski resort's many hotels. There are also private talks among the real elite. All this is interspersed with a few formal speeches by, or interviews with, political leaders.

Bill Clinton got one of the latter, as the nearest recognisable thing in town to the Obama administration. So did Gordon Brown yesterday. And, despite a call from Klaus Schwab, its founder, for the forum to look forward, not back, much of it was looking back and everybody, pretty much, had the same analysis.

What we learnt was what we probably already knew. The banks relied on models that made them dispense with common sense. Regulators were incapable of judging whether their behaviour posed a risk to individual institutions, let alone the western banking system. Policymakers believed in a new paradigm, the "great stability".

Stable doors will be closed. In time, long before we have forgotten about this one, there will be another financial crisis; there always is. All that will be different will be the causes and, one hopes, the magnitude.

What you do genuinely get in Davos is a different perspective. When we hear Brown blaming America and the sub-prime crisis for all Britain's woes, he has a strong point but we know what he is up to. His aim, it is clear, is political. The more these outside forces can be blamed, the less will stick to him.

In the case of other leaders, however, the anger with America was palpable. Russia's Vladimir Putin said it was no time for gloating, then proceeded to gloat at Wall Street's investment banks, with the nice line that they had lost more in 12 months than their combined profits for the previous 25 years. He was concerned, only slightly tongue in cheek, about the growing influence of the state in America.

Wen Jiabao, the Chinese premier, did not name names but attacked "some economies" for "their unsustainable model of development characterised by prolonged low savings and high consumption". He clearly had America in his sights, particularly now the Obama administration has kicked off Chinese-US economic relations in the new era by accusing Beijing of currency manipulation.

His, in fact, was probably the most optimistic voice in Switzerland, saying that China would still be aiming for 8% growth this year, tough though it would be, something that most economists now think will be unattainable.

I had thought that other countries would welcome America's efforts to boost its economy and bail out the banking system. But worries over the cost of the rescues are not confined to Conservative politicians on both sides of the Atlantic or ordinary taxpayers. The fear, indeed, is that huge budget deficits in America, which will have to be funded by unprecedented issues of Treasury bonds, will replace one set of imbalances with another. Some of those bonds will be sold domestically, but they will also represent a huge drain on the world's available capital for years to come.

The fear among some emerging-market economies is that America's appetite for borrowing will "crowd out" investment in their countries for lack of capital. China is savings rich. Others are not. In the 1930s America prolonged the depression with trade protectionism. Some call what may happen as a result of this crisis unintended financial protectionism. Lending to emerging economies is set to plunge from $1,000 billion in 2007 to $150 billion this year.

Similar arguments apply in Britain, where the Institute for Fiscal Studies (IFS), in its annual "green" budget, says it will take 20 years to get back to where we were before the crisis. Public-sector debt issuance will be crowding out the private sector for a very long time. All but a small proportion of this reflects the crisis but I hope the Whitehall rumours of another giveaway in the April budget are not true. The IFS projections were based on an optimistic assessment of the scale and duration of the recession, from its partner Morgan Stanley, of the kind that is quite hard to find these days.

The International Monetary Fund, which says this will be the worst year for Britain since the second world war, predicts global growth of just 0.5% this year, well below the 2% or less that it regards as meeting the definition of world recession. That includes, by the way, a prediction of 6.7% for Chinese growth.

Goldman Sachs has 0.2% global growth and 6% for China. It has become important for China to come through all this relatively unscathed. Gerard Lyons, head of research at Standard Chartered, argues that its continued commitment to open markets, as much as America's, is one of the keys to global recovery and it is likely to come out of the downturn sooner.

But, in general, there was not too much optimism about "the post-crisis world". A disparaging view of Davos would be that if hot air alone could reflate the global economy things would be looking up quite soon. Another would be that the global business community has lurched too far from unbridled optimism to excessive gloom, in which case things might look a lot better this time next year.

PS: The Bank of England's monetary policy committee (MPC) meets this week and is widely expected to cut Bank rate from a historic low of 1.5% to an even lower 1%. Should they do so? Two things have determined the Bank's approach. One is that, given the grim outlook, there should be no limit to its efforts to provide the maximum monetary stimulus. The other is that alternative measures, whether you call them quantitative easing or credit easing, cannot really get going until interest rates are at zero, or within a gnat's whisker of it.

Do I think the Bank will cut this week? It looks as if it will. Should it pause while doing other "unconventional" things, on top of already announced corporate debt purchases? I think it probably should.

From The Sunday Times, February 1 2009

What went wrong? The past few days should have been positive for the economy and the banking system but we were plunged into a mini-crisis.

I think I know. It is easy for pundits and opposition politicians to criticise but this is difficult stuff. Governments love precedent but there was not one here for, first, a rescue of the banking system and then measures to get damaged banks lending again.

So there is bound to be trial and error, though the package announced last week was not just thrown together. I was talking to Alistair Darling many weeks ago about changing Northern Rock's role from drain on the mortgage market to net lender.

Guarantees for new mortgage-backed securities had been in the offing since Sir James Crosby recommended them in November. Other elements of the package, including Bank of England purchases of corporate bonds, commercial paper and syndicated loans, came straight out of the Federal Reserve textbook.

The problem was that the government allowed speculation to build about a "bad bank" to take on banks' toxic assets, when the work had not been done on it.

When the chancellor announced he would instead insure the banks against some losses on these toxic assets, but that it was impossible to say how big they would be, the vultures began to circle. Even that would not have raised the alarm if not for Royal Bank of Scotland's announcement of losses of £7 billion to £8 billion for 2008, plus up to £20 billion of goodwill writedowns on its ABN-Amro acquisition.

Whose daft idea was it to spoil the banking package with such dire news, which set the tone for a bad week for bank shares and the pound? I present as evidence Gordon Brown's interview last weekend when he said banks should disclose their losses, but the government insists that RBS itself felt obliged to issue its profit warning.

That said, reaction in recent days verged on the hysterical. We have not seen the last of government efforts in this field, and may see full nationalisation of some banks, plus a "bad bank". But the measures were helpful, including the Financial Service Authority's relaxation of its capital rules.

People get things wrong. One scare story is that UK banks have foreign-currency liabilities equivalent to three times gross domestic product. If the government was liable for these, we could be in trouble.

But this refers to all banks in London, whether owned by EU countries, America or Japan. These foreign-currency liabilities are £4.6 trillion, which is indeed about three times our GDP. But they also have foreign-currency assets of £4.7 trillion.

British banks account for less than a third of these liabilities, just under £1.5 trillion, with foreign-currency assets of more than £1.5 trillion. Compared with Switzerland, where such liabilities are two and a half times GDP, or Iceland's seven, the UK's liabilities — roughly equal to GDP — look comfortable.

There are others ways in which the "Reykjavik-on-Thames" suggestion is ridiculous. I am told there was never a possibility ratings agencies would downgrade the AAA rating of Britain's sovereign debt and, sure enough, Moody's reaffirmed it, saying the UK was not even an outlier among AAA economies. But the rumour was reported.

Ben Broadbent of Goldman Sachs has taken the government's "toxic" assets programme, made aggressive assumptions, and concluded the maximum liability for taxpayers could be £120 billion, 8% of GDP, spread over several years. It is a lot, but a far cry from suggestions of many hundreds of billions, and should be partly offset by profits on other elements of the rescue. Broadbent concludes that, with UK government debt low by international standards, there was no case for a downgrade.

What should we make of the views of Jim Rogers? The "investment guru" said: "I would urge you to sell any sterling you might have. It's finished. I hate to say it, but I would not put any money in the UK."

Rogers has probably taken enough punishment but, apart from the fact that it is nonsense — the world's fourth-largest reserve currency isn't finished — and puzzlement that anybody gives him publicity, I found it mildly reassuring. He said much the same about the dollar in April, since when its average value has risen 12%.

Last June he said: "The bull market for oil has many years to go before it peters out." We know what happened next. He was speaking from Singapore, where he has moved to see the Asian miracle at first hand, and where the economy is officially expected to shrink 5% this year.

The same goes for Crispin Odey, the hedge-fund manager, who said the UK was "bankrupt". Odey, who makes money from short-selling, appears to have been put on Earth to give hedge funds a bad name.

Some hedge funds and trading arms of investment banks, having wrought havoc elsewhere, now see profit in currency volatility. There is also an element of cannibalism at work, heavy selling of bank shares being often provoked by bearish research notes issued by other banks.

For some, the more mayhem the better. But it is important to inject balance and this is not political. Wishing ill on the economy, banks or currency to hasten Brown's departure is strange. Long after he has gone, we would still be suffering.

Currencies rise and fall. Sterling's problems are partly related to the curtailment of international banking flows into the City and to the view among some that Britain will suffer a much worse recession than other big economies after Friday's figures showed a 1.5% drop in GDP in the fourth quarter. But Germany and America look at the very least similarly afflicted.

Some experts such as Neil Mackinnon, chief economist at the ECU Group, also think sterling is a proxy for global financial risk. When risk aversion rises in markets, sterling gets clobbered. These things pass. The pound was once a petrocurrency.

Episodes of sterling weakness are followed by periods when it rises too much. After the 1976 IMF crisis, it rose from $1.65 to above $2.40. Between 1996 and 1998 sterling climbed 25%. Exporters hope that at least some of today's depreciation holds.

If there was a currency I would be worried about at the moment, however, it would be the euro. Three of its members, Greece, Portugal and Spain, have had their credit ratings downgraded and Ireland is on "negative watch". The European Central Bank, having started well in the crisis, is now dragging its feet and seems in a similar state of denial to the Bank of Japan in the early 1990s, before the "lost decade".

European finance ministers last week rejected proposals to co-ordinate banking bailouts. Again, this looks like foot-dragging. Britain is not Iceland. But Europe, if it is not careful, could be the next Japan.

PS: I have had requests for an update on my skip index, an informal indicator based on the number of builders' skips in my street. It held up until Christmas, based on "can't move, will improve" demand, but now stands at zero. No green shoots there.

Finally, unfinished business from last week when I presented a calculation showing a 2% interest rate with zero inflation was better for savers than 5% with 3% inflation, because of tax. Plenty of pensioners point out that this may apply to young whippersnappers wanting to increase the real value of capital but not to most pensioners, drawing down savings and wanting maximum cash income from it. An interesting debate.

From The Sunday Times, January 25 2009

Just to demonstrate how glamorous this job is, last week I squashed into a crowded lecture theatre at the London School of Economics, my view obscured by a television cameraman, to see Ben Bernanke, chairman of the US Federal Reserve.

Visits by Fed chairmen here are rare. The last I experienced was Alan Greenspan's in 2002, when he opened the Treasury's new headquarters and got an honorary knighthood "for services to global economic stability". No sniggering at the back. On that occasion, I sat through two speeches, though I cannot remember either.

Anyway, the Bernanke speech is fresh in my mind and was interesting in a number of respects. One was his listing of the "powerful tools" the Fed still has at its disposal despite zero interest rates. He chose to put most of these things under the heading of credit easing rather than the quantitative easing discussed here last week, but the distinction is not one to concern us.

What America does is important. Peter Spencer, professor of economics at York University and economic adviser to the Ernst & Young Item Club, points out that most recycling of global savings from saver economies to borrower countries is through dollar markets. So until these return to normal, ours will not either. "Credit will stay very tight in the UK until US interbank markets spark back into life," he writes.

That does not mean we can leave it all to America and Bernanke's "toolkit". However, the other interesting thing he said was the need for a credible "exit strategy".

Assuming near-zero rates are not normal, how do you get back to normal without stifling the recovery when it comes? That, notwithstanding business minister Baroness Vadera's credit-market "green shoots" remark last week, which she quickly dosed with weedkiller, is a way off and is the easy bit.

The bigger question is how you get back the hundreds of billions of taxpayers' money or guarantees. We have not seen the end of these, with the Treasury hard at work on Crosby-style guarantees for new securitisation issues, official "wrappers" around new corporate bonds and other measures to deal with "toxic assets", which we should hear about tomorrow.

I know people are confused by these very big numbers, so let me break them down. Most straightforward are those associated with the government's fiscal stimulus, the temporary Vat cut and the rest, over which so much political heat is being generated.

According to the Institute for Fiscal Studies, the government's giveaway was worth £25 billion, split between the 2008-9 and 2009-10 fiscal years. After that it would raise taxes and squeeze public spending, mainly the latter, to get back £38 billion.

Even with this the message is that it is a fast way down and a slow way back. The Treasury does not expect the budget deficit, which it thinks will hit 8% of gross domestic product in 2009-10, to get below 3% of GDP — a barely acceptable figure — until 2013-14, which is why I have argued for more aggressive spending cuts.

These things can turn round. Aggressive tax increases by Norman Lamont, Ken Clarke and Gordon Brown, coupled with the tight Tory control of public spending Labour maintained for the first couple of years in office, saw the deficit come down from 7.7% of GDP in 1993-4 to just 0.7% four years later. The important thing is not to get locked into permanently large deficits and rising debt as Japan did in the 1990s.

What about the banking rescues? These are more complex. So far we have had a £37 billion recapitalisation of the banks by the government, £9 billion in the form of 12% preference shares. We know from Lord Mandelson, the business secretary, that the terms of that recapitalisation may be revisited — as the credit guarantee scheme (CGS), a second aspect of the rescue, was in December. There may be a need for another injection of taxpayer capital.

The CGS, government-backed guarantees, for a fee, against lending, has a target of £250 billion, of which about £100 billion has so far been taken up. Without it, despite talk of the rescue being ineffective, things would be a lot worse. On top of this, the Bank of England is providing up to £200 billion of short-term liquidity to the banks.

Last week there was more — the Mandelson announcement of a £10 billion working capital scheme, intended to operate as a 50:50 partnership with the banks to guarantee £20 billion of such capital, plus other measures directed at small firms. There is, as I say, more to come.

How do we get down from all this, without leaving taxpayers lumbered for many years to come? It is important not to confuse apples and pears.

The £37 billion recapitalisation is real money which taxpayers will only get back when the stakes in the banks are sold off. In the case of Sweden in the early 1990s, which recapitalised and in many cases nationalised its banks, and took toxic assets off their books, it took 4-5 years for the government to sell off most of the assets, though mostly at a profit. There was still, however, a net cost to taxpayers.

The £250 billion CGS does not mean £250 billion of direct support and, if the terms of the scheme have been properly structured, should not result in taxpayer losses. Even so, the guarantees will run until 2014.

Least troublesome should be bank liquidity. The existing Special Liquidity Scheme expires at the end of the month, but this does not mean the end of Bank liquidity.Once markets return to something like normal, which they will do, the Bank will be able to withdraw quietly from this role.

Other aspects of the policy response to the crisis will, as noted, be around for some years. Financial crises take time to cure. A paper, Is the 2007 US Sub-Prime Financial Crisis So Different, by Carmen Reinhart and Kenneth Rogoff, the latter former chief economist at the International Monetary Fund, points out that the average GDP drop after crises is 2%, rising to 5% in the worst cases, which leaves economies hobbled by below-trend growth even three years later.

The challenge is to ensure they are not a millstone round the economy's neck as the recovery comes and not to get into generalised state support for the economy. Part-nationalising banks is one thing. We do not want to nationalise the car industry, even in part. We have been there before.

The Item forecast, gloomy about the short term, is fairly upbeat about the longer term. "If, as we assume, these policies work, we will move next year from recession into a decade of economic rebalancing rather than a decade of deflation," said Spencer. We have to hope he is right.

PS: Are lower interest rates better for savers? It seems a daft question, but let me revisit a piece of analysis by Peter Kellner, president of pollsters YouGov and an economist in his younger days.

We have not got zero inflation yet. This week should see a fall to about 2.5%, so on a backward-looking basis many savers are suffering negative real rates. Zero inflation, maybe deflation, will come later. The best outcome in theory would be zero rates, therefore no tax, alongside 2% deflation — falling prices. That, however, may be a step too far.

From The Sunday Times, January 18 2008

Every day, sometimes on several occasions, an e-mail arrives in my inbox on behalf of George Osborne, the Conservative shadow chancellor.

Issued in response to a minor economic indicator or flaky forecast, these missives, apart from rather demeaning the office of shadow chancellor, are usually harmless enough and can be safely ignored.

Last week, however, came one that summed up the Tory problem: opposition by soundbite. For weeks, a debate has raged about whether central banks should engage in "quantitative easing", the technique employed by the Japanese authorities in 2001-6 to lift their economy out of stagnation and deflation.

The US Federal Reserve, cutting its Fed Funds rate to a 0%-0.25% range last month, signalled that it would formalise quantitative easing. Once you are at zero, you need other measures. Quantitative easing is often described as "printing money", though it is not. More on this in a moment.

When, in an interview, Alistair Darling, the chancellor, confirmed that the Treasury and Bank of England were considering quantitative easing, as widely reported in recent weeks, Osborne was on the case.

"The very fact that the Treasury is speculating about printing money shows that Gordon Brown has led Britain to the brink of bankruptcy," he railed. "Printing money is the last resort of desperate governments when all other policies have failed. It can't be ruled out as a last resort in the fight against deflation, but in the end printing money risks losing control of inflation and all the economic problems that high inflation brings."

This was a silly soundbite. Apart from Fed chief Ben Bernanke, the case for quantitative easing is being pushed by most economists who think the money supply matters, which should be the Tory position.

It is favoured, for example, by the shadow monetary policy committee, which meets under the auspices of the Institute of Economic Affairs, the favourite think tank of Margaret Thatcher and her former economic adviser, the late Sir Alan Walters.

Osborne and his leader, David Cameron, have had a bad crisis. Baited by Brown as the "do nothing" party, they have been provoked into small, largely irrelevant initiatives. Even Brown's enemies do not hold him entirely responsible for the worst advanced-country downturn since 1945. Cameron and Osborne, overplaying the blame card, invite ridicule and allow Brown to get away with things he should carry the can for, such as over-spending in the good times.

A Tory shadow chancellor should be well regarded by the City. Instead, Alistair Darling is winning grudging approval. Oppositions need to make the intellectual case. The Tories, guided by Sir Geoffrey Howe, did so brilliantly during the 1974-79 crisis-hit Labour government. So far this Conservative opposition hasn't.

I write this with regret. We need a credible, constructive opposition to give people confidence that, come a change of government, the economy will be in safe hands.

Ken Clarke, ranked by readers as best chancellor over 30 years, has been a wasted asset for the Tories since May 1997. John Redwood, a former cabinet minister, appears to understand the crisis and was impressive on the radio the other day.

Economic opposition is a crowded scene. For the first time that I can remember, a Liberal Democrat shadow chancellor has made the running. I do not agree with everything Vince Cable says but he enjoys a high reputation and his manner is of a reassuring doctor — he tells you it is bad but offers prescriptions to make it better. The Tory boys do not have his bedside manner and sometimes appear to relish the gloom, which I am sure is not their intention.

Back to "printing money". The Bank limited itself to a half-point cut to 1.5% last week, though taking us, as every schoolboy knows, to the lowest rate since 1694. That seemed sensible, despite figures on Friday showing an alarming plunge in manufacturing output. It leaves shots in the locker and time to think about other measures.

"Printing money", to be clear, is not the same as printing money. This is not a cash economy. The value of notes and coins in circulation is £51.6 billion, less than 3% of £1.9 trillion of "broad" money in Britain, M4, consisting of bank deposits and the corresponding lending. Printing money means getting broad money growing faster through so-called quantitative easing.

How? One way is for the Bank to buy government bonds or commercial securities from banks or their customers. This creates a credit in the central bank's reserve account, which can then be the basis for increased bank lending. It also drives down interest rates throughout the economy.

Or, in a situation where the government is borrowing large amounts, as now, it can "underfund" its budget deficit by issuing fewer gilts than needed, or by selling them direct to the Bank. The effect is to boost broad money, M4. Or, if none of this works, the central bank can lend directly into the economy, using the banks as its agents.

None of this is easy, or inevitable. The Tories have proposed a £50 billion loan guarantee scheme for small firms, which Cameron wants to "shake the prime minister" to introduce. But Treasury officials fear that losses under such a scheme could amount to £12 billion, making guarantee costs prohibitive.

Guaranteeing issuance of new mortgage-backed and other asset-backed securities, recommended by former HBOS chief Sir James Crosby, would work a lot better if other countries did it too; the closure of these markets is a worldwide phenomenon. So far, however, there has been little discussion about co-ordinated action.

The truth is that there are many helpful things that can be done but no single silver bullet. In the meantime, we should not forget one thing. The Bank has wheeled out some pretty big guns in cutting rates from 5% to 1.5% since October. Barack Obama sketched out his huge fiscal plan last week.

As the Bank put it when cutting rates on Thursday: "The committee noted that the recent easing in monetary and fiscal policy, the substantial fall in sterling and the prospective decline in inflation would together provide a considerable stimulus to activity as the year progressed."

Policymakers need to be imaginative. But they also need to have faith in the fact that, in the end, policy will work.

PS: Thanks to the readers who submitted 2009 forecasts, to compare with the professionals. I now have a fat file to lock away and consult at the end of the year.

The real winners will come in a year's time, but books are on their way to David Appleby, for his Mandelson-Cable government of national unity, and Jonathan Grant, reminding us that "creative destruction" — pioneered by Joseph Schumpeter — is a feature of recessions. Some retailers dying this winter should have been put out of their misery years ago. Other businesses will eventually rise as these fall. We will emerge different but in some ways stronger.

From The Sunday Times, January 11 2009

Here we are, and what a challenge it is to steer through the prospects for 2009. On one side is the reality of the credit crunch. Appropriately, given that the original film came out in 1933, and that this is the worst crisis of its kind since then, Goldman Sachs dubs this King Kong.

On the other side, for the UK, is another monster, this time one that should have a big positive impact: the combination of ultra-low interest rates, a huge depreciation of sterling — 24.7% on average between the end of 2007 and the end of 2008 — the government's fiscal stimulus and, let's not forget, the fall in oil and commodity prices. These add up to what in normal circumstances would be an unprecedented boost.

This powerful force, as lovers of Hollywood B movies will recognise, is Godzilla. The battle between King Kong and Godzilla will determine the outcome for 2009.

Let me start with Kong. One or two bankers have put their heads above the parapet. Sir Win Bischoff, chairman of Citigroup, acknowledged that bankers were "partly to blame" for the crisis. John Varley, chief executive of Barclays, said banks faced a "public-relations crisis" and should share their portion of responsibility.

Brave though these two are to break cover, to suggest the banks merely played a part in the crisis is a bit like saying Hamlet had a cameo role in Shakespeare's play. This was, and is, the bankers' crisis.

The banks lost shareholders hundreds of billions investing in instruments their managements did not understand. The attitude of bank boards had not moved on from Barings in 1995 when it was brought down by the Leeson affair — Don't ask questions as long as it makes money.

The banks failed in the most fundamental way when it came to banking business — they did not ensure their lending was based on secure sources of funding. This is chapter one, line one in the banking textbook, and they screwed up. Their failure verged on the criminally irresponsible.

Yes, banks should have been better regulated and, yes, the failure of the ratings agencies was abject but we should be clear where the responsibility lies.

And, to clear up a misunderstanding I left hanging a few weeks ago, when quoting the Liberal Democrat Treasury spokesman Vince Cable, that responsibility does not lie, in my view, with bank customers, particularly personal customers. I'll return to UK household debt in the coming weeks, to correct some important misconceptions, but it was not the job of bank customers to ask whether their bank actually had the funds to lend.

But we are where we are, and the credit crunch is still biting. The Bank of England's latest credit conditions survey shows lenders tightened availability of credit to households and businesses over the past three months and expect to tighten further over the next three. The banks, by reining back, are making the economic situation, and their own, worse.

Don't get me started on the argument, from baleful bishops or anybody else, that the last thing we should be doing is encouraging more borrowing. What we are talking about is ensuring a normal flow of credit in the economy, without which it cannot function. I am not confident the bankers understand that, which is why there is a strong case for the government to lend directly or use its influence on the sector to ensure that lending flows.

What about that other monster force, the big stimulus? The contrast between Britain, with a combination of a lower pound and lower interest rates, and the eurozone, where the effects of rate cuts have been offset by the rising euro, is striking.

Add in the real income boost from lower energy prices and, for borrowers, much lower interest rates, and the scope for eventual recovery should be formidable. Consumer spending, after all, is overwhelmingly financed from income growth.

We should not ignore the effect of such a stimulus, even when all else seems lost. Even in the Great Depression of the early 1930s, Britain had a single very bad year, 1931, when gross domestic product fell by 5.1%, before embarking on a long upturn, thanks to the stimulus largely brought about by leaving the Gold Standard.

What about this year? The dirty little secret about forecasting growth is that much of the recession is already "baked in" to the outlook thanks to the economy's performance since mid-2008. GDP fell 0.6% in the third quarter and perhaps 1% in the fourth, on its way to a probable 2.5% decline by mid-2009, which will probably be roughly the 2009 outcome, even allowing for some stabilisation in the second half ahead of an upturn in 2010.

Growth this weak will mean rising unemployment. People either quote the Labour Force Survey measure or the claimant count. I prefer the latter, which will probably rise from its present 1.07m to about 1.75m. There is little sign yet that the job market safety valve, migrant workers returning home, is helping.

Very low inflation will be a feature of 2009, with the retail prices index certainly showing annual falls for at least part of the year and consumer price inflation also likely to turn negative. I would expect the latter to end the year at 1% (that weak pound must have an impact sometime) and for Bank rate to be at a similar level. One question for the Bank will be when it feels able to start restoring rates to "normal" levels.

The big surprise could be Britain's balance of payments. I think we are heading for a current-account surplus, even if we do not get there in 2009. Revised figures show the 2007 deficit at £39.5 billion, less than 3% of GDP, and the 2008 figure looks like being no more than £25 billion-£30 billion. £20 billion or less appears on the cards for 2009.

Whether this helps sterling, we will see. My view is that the pound's fall against the euro is one of those illogical "one-way bet" market movements akin to the rise in the oil price up to last summer. Logic suggests a recovery. Goldman Sachs predicts a rise from current near-parity to 1.25 over the next few months and to around $1.75.

Anyway, that is my first stab at 2009. Many have sent in projections in response to my invitation and have another week to do so. They should be sent to my e-mail address below. Entries posted as comments on Timesonline.com will not count.

PS: Will the Bank take us to a new interest-rate low this week, breaking into sub-2% territory for the first time since it was founded (by a Scot) in 1694?

Will the actual MPC follow its shadow? Maybe not. There is still a head of steam building for lower rates, and the Bank made it clear in its December minutes that it had unfinished business. Some analysts expect a full-point cut on Thursday. I think a half is more likely.

From The Sunday Times, January 4 2009

This piece really requires the accompanying table, which is now at the end of the article.

So what a horrible year that was. A full-blown credit crunch, of the kind I have never witnessed before, alongside a nasty commodity-price shock. One was the worst since the 1930s, the other the biggest since the 1970s.

The commodity shock is over but the credit crunch is still very much with us. Economists, unsurprisingly, found it a tough year to predict. That was partly because of the nature of the crunch itself.

At the start of this year we had seen two phases of the crisis, the initial August-September 2007 turbulence in the markets that did for Northern Rock and a secondary shock in December, as banks scrambled for liquidity.

But it was reasonable to think that markets would gradually thaw during 2008. That was the view of central banks and finance ministers when they gathered for the IMF’s autumn 2007 annual meetings.

Instead, things turned out gloomier than even the pessimists expected. A third phase of dislocation in the money markets came in March, claiming the scalp of Bear Stearns, and worse was to come six months later with the failure of Lehman Brothers. It was in March that the real squeeze on lending started to hit Britain’s economy.

It did not necessarily have to be like this. There were a number of ways the crisis could have played out. The route it ended up taking was close to the worst.

Forecasters always find it difficult to predict turning points in economic activity but there were other reasons why 2008 was an unusually hard year to pin down. Imagine, a year ago, somebody had told you the oil price would have collapsed from $100 to $40 a barrel, the economy would be in recession, Bank rate would be just 2% and then invited you to guess at Britain’s inflation rate in those circumstances. I would have said 1%, not the 4% (though falling) we have at present.

So any economist getting it right during 2008 would have required mystical powers of prediction. Small wonder, as I look at my annual forecasting league table, most got it wrong.

A word about the rules of engagement. Economic data get revised all the time and just before Christmas we had new figures for gross domestic product and the balance of payments; the latter suggesting that the current-account deficit is coming down sharply.

But there has to be a cut-off point and mine, as in previous years, is the December forecasting consensus for growth (0.8% for the calendar year) and the current account (a deficit of just below £40 billion). I have used the actual end-year Bank rate, and November’s inflation and unemployment figures. One or two forecasters have been slightly harmed by the use of this cut-off but nobody has been seriously wronged.

Banks have had a torrid time and have justifiably seen their reputations slide. So it is odd, then, that after a year most forecasters would prefer to forget, banks top my annual forecasting league table. Standard Chartered, whose chief economist is Gerard Lyons, was gloomier than most a year ago, predicting just 1.2% growth at a time when forecasters were clustered around 2%.

His forecast was too low on inflation — most people expected an end-year figure of 2% — but right to pick up on the downward risks to growth. Standard Chartered is downbeat on growth for 2009 — it expects the economy to contract by 2.3% before edging up by 0.6% in 2010. The fact that policy has responded quickly and commodity prices have plunged leads it to suggest a recession on the scale of the early 1990s but not as bad as the deep downturn of the early 1980s. Even so, Sarah Hewin, Standard’s UK economist, thinks the Labour Force Survey measure of unemployment will eventually hit 3.5m.

Alongside Standard Chartered, but just slightly further away from what looks like the 2008 outturn, was HSBC. Both these banks got a creditable 5 out of 10. My forecasts scored only two points.

Next in the table, intriguingly, is Lehman Brothers, whose demise caused so much trouble. Its economists had a credible story to tell about a “downward spiral” of activity hitting Britain’s economy from early in the year. The economic view was a lot more credible than some of the other things Lehman was up to.

After a year like that, how should we judge what economists are saying about 2009? Once the economy has turned into recession, forecasters are on firmer ground. They know what history tells us about the length of past “big” post-war recessions — an average length of about five quarters, though with a tendency to slip back temporarily during a weak recovery phase.

The big unknown remains the continuing impact of the credit crunch and the effect on an economy of a sudden shrinking of banking capacity.

Many economists think forecasting should not be part of their game. Others warn that precise-number forecasts will invariably be wrong and that all economists can do is lay out broad trends.

Even that, as the Bank of England has discovered with its famous fan charts, is easier said than done when things change so dramatically. And it would be a dull world if economists — and economic journalists — did not put their heads on the block and offer views on the outlook. I know some of my readers would lose their purpose in life if I deprived them of the opportunity to point out when I had been wrong.

A year ago, just about the gloomiest forecast for house prices you could find among economists was for a fall of 5% in 2008. Data from the main lenders, Halifax and Nationwide, point to a fall about three times that, though the FT-Acadametrics index is down by a more modest 8%.

In some ways it was easy to predict a house-price fall a year ago, because it had begun the previous autumn. But there had been false dusks for housing before. The savagery of the crunch-induced mortgage famine, however, meant this one was real.

Housing also eventually obeyed the normal rules. I had always argued that you needed a shock big enough to push the economy into recession to produce a big fall in house prices, and so it was. In the late 1980s it was a 15% Bank rate. This time it was the crunch. In some respects at least, the normal rules apply.

PS: Anyway, that is how the professionals fared. Now it is your turn to take part in my seasonal competition. So over the next two weeks please submit your predictions for the five variables I use to measure forecasting performance — calendar-year growth (2009’s average GDP compared with 2008); the current-account deficit/surplus; and end-year consumer price inflation, Bank rate and claimant unemployment.

The trouble with this is that it means a very slow-burn competition, which will not see its denouement for 12 months. So there is also a chance for some short-term gratification for the two people who offer the most interesting and entertaining vision of 2009. I can’t promise a DVD of my favourite piece of Christmas kitsch — the Panorama biopic of Robert Peston — but there’ll be something.

Scoring system and notes: GDP growth: 3 points for 0.4%-1.2%; 2 points for 0%-1.6%; 1 point for -0.4%-2%. Inflation: 3 points for 3.5% or above; 2 points for 3% or above; 1 point for 2.5% or above. Current account: 1 point for a deficit between £30 billion and £50 billion. Unemployment: 1 point for 0.95m or above. Bank rate: 1 point for 3% or below. Bonus point for inflation exceeding growth. Where scores are equal, forecasters are ranked by their proxomity to the growth and inflation outturns. Key: * Labour Force Survey unemployment; ** RPIX inflation

From The Sunday Times, December 28 2008

Normally at this time of year you struggle to drum up interest in the events of the past 12 months, attempting to inject a bit of excitement. This time, there is no need for any artificial injections. This year has changed everything.

When the dust settles we will have a very different economy. Recessions come to an end, and history tells us this one should after four or five quarters, but its legacy will be more economic instability than we have been accustomed to. After a 16-year “nice” (non-inflationary, consistently expansionary) run, the future looks more uncertain, even when the upturn comes. More on this in coming weeks.

Investment banks that once ran the financial world are either no longer running it or have turned into shadows of their former selves, large parts of their business model broken. Banks in general, apparently built on solid foundations, proved wobblier than the Millennium Bridge. Building societies have a long history, but demutualised societies proved to be a will o’ the wisp. Northern Rock showed the way to their demise as independent banks.

Government intervention and support, for three decades regarded as off limits, and latterly as something only the North Kor-eans did, made an extraordinary come-back. Without it we might not still have a banking system or even a partially functioning global financial system. Zimbabwe’s empty shelves and financial collapse would have become the norm.

Then there are the central banks. Who would have thought they would have cut interest rates so much, in effect to zero in the case of the US Federal Reserve, 2% and falling for the Bank of England? And, having done this, for the debate to be about what additional monetary action would be needed to boost the economy?

We used to be in a world in which, if investment bankers ran finance, central bankers ran the economy. Small touches on the interest-rate tiller had a big effect. Until we had something bigger to ponder there was a debate about whether a quarter-point cut by the Bank in August 2005 produced the last leg of the housing boom.

Now things are different. There is, as the Bank put it in this month’s minutes (when the monetary policy committee voted 9-0 to cut from 3% to 2%) “uncertainty inherent in the transmission mechanism”. The Bank cannot be sure what the effects of its actions are – whether even dramatic rate cuts will have any impact.

The Bank has yet to produce the data for November, but until the end of October its gradual rate cuts had had little effect on borrowers. Average interest rates faced by companies and mortgage borrowers were higher this autumn than in the summer of 2007, despite a 1.25 percentage point Bank rate cut in the intervening period.

We should not forget that the really big rate cut, from 4.5% to 2%, happened in the past six weeks. One key question is whether that is passed on in lower rates to borrowers; it has triggered a big fall in money-market rates. Another is how long, assuming it is passed on, it takes to have an effect. Monetary policy is always at its riskiest during the period before the lag kicks in.

A reduction in interest rates on existing borrowings is worth having. What is also needed is for money to flow through to new borrowers and those replacing existing borrowings. Sir James Crosby, in his report for the Treasury, pointed out that £160 billion of mortgage-backed securities will come up for redemption in the next two years, at a time when issuing new ones will be hard. That is why the talk is of quantitative easing. Normal monetary easing is about reducing the price of money, quantitative easing is about increasing its quantity.

Analogies about turning on the printing presses are not particularly useful. If it was that easy, central banks would do it. Literally printing money would merely fill up the cash machines and, carried to extremes, bring echoes of the worthless “wheelbarrow money” of Weimar Germany.

So quantitative easing is a bit more complicated. The money-supply numbers are subject to huge distortions because the banking system is not operating normally, but Simon Ward at New Star calculates that, after stripping out these distortions, “broad” money-supply growth is negative.

Those with memories of the Thatcher government’s monetarist experiment will remember its concern about excessive broad money growth, one reason being that the public sector was borrowing too much. It still is – public sector net borrowing in the first eight months of the 2008-9 fiscal year was £56 billion – and one easy way to boost money supply would be to “underfund” this borrowing, selling fewer gilts than needed to cover it.

That would not solve the underlying problem of strangulated bank lending. A good suggestion, set out in a paper by Kathleen McElvogue and Alistair Milne of Cass Business School (http://www.cass.city.ac.uk/cbs/activities/bankingcrisis.html), is that governments should offer, on commercial terms, insurance against systemic risk in credit markets. It is the fear of this risk that has frozen credit markets and constrained lending. Crosby proposed a local version for new UK mortgage-backed securities.

Central banks have plenty of quantitative easing weapons in their armoury, buying government bonds, asset-backed securities or other instruments, notably from the banks, with the aim of providing them with additional capacity to lend.

You can lead a horse to water but not necessarily persuade it to start glugging. In April, I suggested that direct lending by government might have to be part of the solution, and that seems even more relevant now. We have state-owned banks, such as Northern Rock, and we have majority-owned banks like Royal Bank of Scotland (RBS). So far, Northern Rock has been running down its loan book, with damaging consequences, while the approach to RBS has been hands-off. That cannot last.

Some will say the last thing government should do is force banks into “uncommercial” decisions. That’s a bit rich considering the banks’ own decisions in recent years. Their caution and funding constraints mean we have gone from feast to famine.

Others say we should just lie back and accept our punishment, because current problems built up for decades. But, while Bernard Madoff may have been scamming investors since the 1970s, in general we are talking about problems of recent origin.

US sub-prime lending only really took off over the 2003-6 period; the UK banks’ funding gap only reached problematical levels three to four years ago, and other examples of excess, such as leveraged buy-outs (all those private-equity deals), only got out of hand in 2006-7.

These problems of recent origin can be fixed, though it is not proving easy. What we should not do is give up. The transmission mechanism is damaged but this is no time to scrap the car.

PS: An old friend was made redundant last week, adding poignancy to grim unemployment figures — the claimant count rose 75,700 to 1.07m last month. The mood change since September, the worst phase of the banking crisis, is taking its toll.

Anyway, apart from wishing readers an excellent Christmas in hard times (we should all dip into Dickens), let me encourage you to come back next week. There will be the annual forecasting league table, which will be embarrassing, and a chance for readers to show they can beat the professionals.

From The Sunday Times, December 21 2008

Ever since Jose Manuel Barroso set the ball rolling earlier this month, it has been nagging away at me.

Could Gordon Brown, having abandoned his own fiscal rules, embraced bank nationalisation in a way that echoed the 1945-51 Labour government and announced a rise in the top rate of tax, produce the biggest u-turn of all? Could he, and you may want to sit down at this point, take Britain into the euro?

Euro entry is an issue that was once very hot but went into the deep freeze. In 2003 it was the biggest story in town, Brown and Tony Blair wrestling over whether to take Britain in. If it is of any comfort, the day will come when we look back on the credit crunch in a similar vein.

Until the European Commission president's remarks I had thought euro entry remained in the freezer. He said, to remind you, Britain was "closer than ever before" to joining, that "the people who matter" were thinking about it, and that those same people were also saying, "If we had the euro, we would have been better off".

It would be easy to dismiss this as simply reflecting a high-profile transfer from Brussels to London. Lord Mandelson has made no secret of his enthusiasm for sterling to take what he sees as its rightful place in the euro. He is close to Barroso, so you don't need to be a Maigret to work it out.

Last week's intervention by Peer Steinbrück, the German finance minister, will not have warmed anybody in government to Europe. There is plenty to criticise about UK policy and our soaring borrowing. But his attack, in an interview with Newsweek, was pretty lame.

The pre-budget report cut in Vat he attacked is trivial and temporary in the context of Britain's deteriorating public finances. For a finance minister to be asking whether people will buy a DVD player because it costs £39.10 rather than £39.90 shows he does not know how tax cuts work. Any cut, whether Vat, income tax or corporation tax, is small in its microeconomic impact but cumulatively can add up to a significant macro effect.

Steinbrück also misunderstands "supply-side" economics, which he said had been replaced by "crass Keynesianism". What he means, I think, is fiscal prudence. Such prudence, as we saw in Brown's early days, came alongside the higher taxes and red tape that harmed Britain's supply-side.

Actually, there is quite a lot of misinformation around, some of which has contributed to the pound's fall against the euro. Sterling traders in London don't need much excuse to sell the currency. For years it was their default position. Then the pound enjoyed a run of stability from 1996 to 2007, and the euro became the pariah currency. Now they are back in familiar territory.

There was, it should be said, a logical, credit-crisis-related reason for sterling to fall over the past year. Until summer 2007 capital flooded into Britain either because foreign companies were taking over UK firms or, more important, because some of the surplus savings from other parts of the world flowed into the City. Without these capital flows, the counterpart to which was a large current-account deficit, a lower pound has to be one of the routes to making the balance of payments balance.

As always, though, the markets take these adjustments too far. A caricature view is that Britain is worse off than the eurozone because of the importance of financial services to the UK economy.

But, as economists at Goldman Sachs point out, this importance is usually exaggerated. Financial services make up 8% of the UK economy, just over half the size of the manufacturing sector. It is bigger than the eurozone average of 5% but smaller than America (just over 8%) or Switzerland (nearly 9%).

Meanwhile, despite some awful UK manufacturing data last week, down 4.9% on a year ago, this was smaller than the eurozone's 5.3% fall. Germany's Ifo Institute predicts a 2.2% GDP fall for its economy next year, and a 0.2% drop in 2010.

Another bit of the caricature is that Britain's indebted households, government and company sector are in hock to the rest of the world, while Britain's banks have built up a reliance on international wholesale markets of Icelandic proportions.

The truth is that UK debt, whether owed by people, businesses or the chancellor, is overwhelmingly domestic. UK savers, directly or indirectly, lend the lion's share of money to UK borrowers.

UK-owned banks do have foreign current liabilities, but at £1,300 billion these are some 90% of gross domestic product, compared with about 220% of GDP in Switzerland and nearly 700% of GDP in Iceland.

Overall, since 1995 Britain has had net foreign liabilities — foreign-owned assets in Britain being worth more than UK assets abroad. Curiously, Britain still earns more income on those foreign assets than foreigners do on their UK holdings.

The latest figures for those net foreign liabilities, £309 billion, or about 20% of GDP, show a fall of about £100 billion over 12 months. This is not a huge imbalance. A side effect of the pound's fall, by increasing the sterling value of overseas assets, will be to reduce net liabilities further.

The oddest thing about the sterling story is that it stems from the idea that Britain will have a worse recession than the eurozone. Europe entered the recession with an over-strong currency and a central bank cautious about cutting rates. Britain has a weak currency and lower rates. I know which I prefer and it is why most economists think Britain will bounce back more quickly than euroland.

The recession, moreover, will expose divisions and disparities within the eurozone. Sterling will also bounce back — it is 11% below its 10 and 30-year averages against the dollar and about 15% below fair value against the euro — but for the moment its weakness is useful.

So what about that question of euro entry? Paul Mortimer-Lee, head of market economics at BNP Paribas, a French bank, has no eurosceptical axe to grind. He argues that, not only would Britain's problems have been worse had we been in the euro (think how much more powerful the housing boom would have been with interest rates significantly lower), but that this is just about the worst time to think about joining.

I agree. Britain tends to turn to Europe at times of trouble, with disastrous consequences. Entering the exchange-rate mechanism in 1990, as recession was under way, made a bad situation much worse. The same applies to the euro now.

For those who missed Brown's interview with Sir Alan Sugar in The Sun last week, the prime minister's response on the question of euro entry was "No, no, no" for "this year, next year and beyond". Euro entry should remain in the freezer. I suspect it will.

PS: It has been a statistical curiosity that until the third quarter of this year Britain had been through its longest continuous expansion on record, with GDP growing every quarter since the spring of 1992, 63 in all.

So this beats what he describes as the 16-year expansion since 1992 (or should it be 17?), which will formally come to an end when GDP falls next year. Third longest, interestingly enough, was the upturn that began in 1932 and lasted until 1943, continuing through even the Battle of Britain and the Blitz.

From The Sunday Times, December 14 2008

When the Bank of England cut interest rates from 3% to 2% on Thursday, completing a three percentage point drop in the space of eight weeks, it underlined the gravity of the economic crisis.

Very weak business surveys suggested the downturn had “gathered pace”, the Bank of England’s monetary policy committee (MPC) said in a statement. And, “despite the actions taken to raise bank capital, ease funding and improve liquidity, conditions in money and credit markets remain extremely difficult”.

The key element in the statement, however, was that it was unlikely lending would get back to anything approaching normal without “further measures”. Cutting interest rates, even to the lowest level since Churchill was reelected prime minister in 1951, would not be enough.

Central banks are not yet singing from the same hymn sheet. Sweden’s Riksbank stung markets by cutting its interest rate from 3.75% to 2% hours before the Bank’s move.

But the European Central Bank confined itself to a 0.75 point reduction to 2.5%, and appeared to deny that the credit crunch was directly affecting the eurozone economy. Jean-Claude Trichet, its president, said that until the end of October at least “there were no significant indications of a drying-up in the availability of loans”.

Nobody believes that in America, or in Britain, which is why the Federal Reserve Board and the Bank have started to look beyond interest rates to those “further measures”.

Analysts believe, with the Fed likely to cut rates further later this month from an already very low 1%, it has already begun to take unconventional steps to try to slow the slide into recession.

Figures on Friday showed how big those dangers are. Non-farm jobs in the US fell by 533,000 last month, the biggest monthly drop since December 1974, when the world was gripped by the first big postwar recession.

Already, as well as cutting interest rates, the authorities in most countries have implemented, or are about to, big fiscal packages. The French president, Nicolas Sarkozy, unveiled a €26 billion (£22.5 billion) stimulus last week, mainly aimed at supporting businesses, hard on the heels of Alistair Darling’s £20 billion boost. Barack Obama, the US president-elect, is working on an emergency fiscal boost likely to be worth at least £300 billion.

Governments have also taken unconventional steps to bail out their banks, which in Britain includes £37 billion of taxpayer-funded recapitalisation, and £200 billion each of guarantees and liquidity.

Bank sources say it is this the MPC had in mind when talking about further measures; ensuring that the bank rescues are fully implemented and combining it with “moral persuasion” by politicians and central banks to force up levels of bank lending from their current crisis lows.

There is intense interest, however, in another tool in the central-banking box, so-called quantitative easing. When interest rates cannot go any lower and other measures have failed, central banks can try to force an increase in the money supply and therefore boost both economic activity and prices.

The technique, which some call printing money and others liken to a helicopter drop of cash on the economy, would not be attempted in normal circumstances. But when the risk is of prolonged recession and deflation, such action becomes justified. It was the strategy adopted by the Bank of Japan for five years from March 2001 when, under so-called “Rinban” operations, it tried to boost the money supply by buying up a range of financial securities. Economists are split about whether it was effective.

One eventual impact, Simon Derrick of BNY Mellon points out, was to weaken the yen, while higher food and energy prices may have played a bigger part in lifting Japan out of deflation.

If Japan provided a template for responding to a credit crisis, it did so in a slow-motion way.

Its problems started with the bursting of the so-called bubble economy in 1989, but its banking recapitalisation and rescues did not come until 1997-98, followed by the quantitative easing three years later. This time, things are happening much faster.

Last week Ben Bernanke, the Fed chairman, said he was considering buying up long-term Treasury securities and other instruments in the markets to boost the money supply through quantitative easing. His speech, which had a significant impact in the markets, may have been building on what the Fed is doing anyway.

“The Fed’s balance sheet has soared since September,” said Nick Stamenkovic of Ria Capital Markets. “It is effectively engaged in quantitative easing already.”

Graham Turner of GFC Economics thinks the Treasury is more open to unconventional remedies than the Bank. Officials at the Bank deny this, but play down suggestions that quantitative easing is imminent.

Should the Bank decide to, however, it would be very easy. The simplest method would be for it to buy up some of the gilts – Treasury bonds — issued by the government. Given the scale of issuance planned, there will be no shortage of opportunities to do so.

Could the government go further? Local authorities in Essex and Birmingham plan to raise funds and set up small-scale banks to lend to small businesses. State-owned regional banks are common in most European countries.

If the credit crunch persists, they could become common in Britain.

From The Sunday Times, December 7 2008

A piece about last week's symbolic announcement of an increase in the top rate of tax

It was one of the stormiest parliamentary occasions of modern times. Twenty years ago Nigel Lawson, the Tory chancellor, was leading up to his big budget announcement that was to transform Britain from a high-tax to a low-tax economy.

As he began to outline his tax-cutting proposals, Alex Salmond, then a backbench Scottish National party MP, began shouting: “The budget is an obscenity. The chancellor cannot do this.” Salmond was suspended from the house and Lawson continued. He intended to cut the top rate of tax, then 60% and thus higher than in most countries, to 40%, and he was clear about why he was doing so.

“Excessive rates of income tax destroy enterprise, encourage avoidance and drive talent to more hospitable shores overseas,” he said. “As a result, so far from raising additional revenue, over time they actually raise less.”

Labour MPs, taking their cue from Salmond, were incensed and began chanting: “Shame.” The mood became so heated that the sitting was suspended for 10 minutes – unprecedented during a budget speech – because of the “grave disorder” in the Commons.

Lawson was able to continue his budget and deliver the cut in tax, which he later described as an essential component in the “cultural change” that Thatcherism ushered in. Gone was the envy-driven, level-down society of the past. In came a new enterprise-friendly, outward-looking country, ready to take on global challenges and to attract the world’s best to Britain.

The City of London, fresh from the “Big Bang” reforms of 1986, which opened it up to the giant investment banks from America, Japan and Europe, suddenly became the place to be. Bankers had long been deterred from basing themselves in Britain by the high tax regime. The 60% top rate of tax kicked in at the equivalent in today’s money of less than £90,000, and many remembered the 1970s, when the top rate was 83% (and as much as 98% on unearned income).

Now things were different. Britain had become a low-tax country overnight. That same year, work started on the construction of Canary Wharf.

“It added to the powerful sense that London was a welcoming place for the big players from all over the world,” says Michael Cassidy, long-time champion of the City, who has just stepped down as president of the London Chamber of Commerce. “I do think it was very important.”

Lord Young, who took the title of enterprise secretary under Margaret Thatcher, preferring it to secretary of state for trade and industry, suddenly found that the job of selling Britain as a location for international businesses was a lot easier.

The Labour party had a different idea. Neil Kinnock, the party leader, criticised for the ill-disciplined display by his members, advised them: “Don’t get mad; get even.”

Kinnock wanted to get even quickly, fighting the 1992 general election on a programme of a new top tax rate of 50%, with high earners hit by extra National Insurance contributions. He lost, and the 40% top rate stayed.

Last week Labour MPs finally did get even. When Alistair Darling announced in his prebudget report on Monday that he was putting up the top rate of income tax to 45%, along with other measures to squeeze high earners that in effect put up the rate to 60% for some, they cheered him to the rafters.

Britain’s attempt to be a low-tax country had, in truth, perished long ago under the weight of the stealth taxes introduced by Gordon Brown to pay for an eight-year public-spending splurge, but the 40% top tax rate was still an important totem, a sign that there was a settled political consensus on the need to incentivise high earners and entrepreneurs and ensure they did not take their talent elsewhere.

That consensus was not always guaranteed. Until 1997 Labour’s intentions, even under Tony Blair, were far from clear. But he and Gordon Brown knew that if they committed themselves to not raising the top rate of tax, it would also calm public fears that they planned to put up all taxes – which had been one of the Tories’ few remaining election weapons.

Philip Gould, now Lord Gould, new Labour’s strategist, later recalled the effect of the party’s announcement in January 1997. “Brown, in an audacious coup, announced, first on the Today programme and then in a speech to Labour’s Finance and Industry Group, that neither the basic nor the top rate of tax would go up under Labour,” he wrote. “The Tories were poleaxed. It was as though a political mallet had been smashed through their heads.” Three years later Blair, as prime minister, told Jeremy Paxman: “It’s not a burning ambition for me to make sure that David Beckham earns less money.”

The rate of tax was less important than whether people paid tax, he said, and he was right. The cut in the top rate to 40% had been followed by an increase in the proportion of tax coming from high earners, both because there was less incentive to take complex steps to avoid tax and because those at the top of the tree, who had done well under Thatcher, prospered even more under Blair.

So why the announcement now that in three years’ time the top rate will go up to 45%, combined with a squeeze on allowances that will mean some high earners facing a marginal tax rate – the highest rate levied on their income – of 60% or even more?

The Treasury needs the money, though the Institute for Fiscal Studies calculates that, on its own, the new 45% tax rate on incomes above £150,000 will bring in very little, prompting suspicions that this is the tip of a very large tax-raising iceberg.

Politics played a part. Lord Mandelson, the business secretary and joint architect of new Labour, insisted last week that the party had not gone back on its principles. “New Labour is about more than just the top tax rate,” he said. “It is the times that have changed, not new Labour.”

Some detect his hand in the move, designed to force the Conservatives into opposing it so they are seen to be supporting the party’s rich friends and balking at Labour’s “fairness” agenda, which the party thinks will appeal to voters when times are tough.

Underlying it, however, is a straightforward economic calculation. Treasury officials, running through their numbers, have decided that we are in a different world from that of the past two decades. The City, shrunk and chastened, will not be the same for a very long time. Many of the American, Swiss, French and German bankers who helped to fill the government’s coffers with the revenues they generated and the tax on their bonuses have scuttled home with their tails between their legs.

Having them here was great in the good times, and may be again in the future. For the moment, though, the culture of risk-taking and brash wealth creation, so powerful on the way up, has put Britain at risk of a bigger fall on the way down. Suddenly, being Europe’s financial centre is not such a good thing.

“The world has changed,” says Cassidy. “I’m pretty gloomy about it. All those things that I championed and that I thought we were good at – the bonus culture, the risk-taking, the internationalisation – are not looking so good any more. We have to go back to basics.”

Britain, far from being the enterprise capital of Europe, is struggling to stop businesses packing up and heading to Dublin or other centres. And what matters there, the Treasury has decided, is not the top rate of income tax but the deals and concessions that companies can be offered to minimise the amount of tax they pay as businesses.

WHAT does Darling’s move tell us about the kind of economy Britain will have over the next few years? Government borrowing is back to the crisis levels of the 1970s, and taxes are going up after a temporary cut. Is this the new austerity?

Martin Sorrell, chief executive of WPP, one of the world’s biggest advertising agencies, thinks the expansion of the size of the state and higher taxes – plus the huge increase in the amount of red tape imposed by government departments and Brussels over the past decade – mean Britain has taken a huge step backwards. “All the changes Margaret Thatcher made have gone,” he wrote last week. “When I visit Scotland and Wales, and see the extent to which local jobs depend on the public sector, it shows we have lost the progress made under her.

“Governments can invest plenty of money in retraining people but, unless we can change more aggressively, we will be unable to compete. We are back where we were in the 1960s and 1970s.”

Even government is stymied, notwithstanding Darling’s “giveaway” pre-budget report last week. While the political message was that the government was doing everything to help the country through the recession, such is the state of its finances that the public sector will not be a source of job growth in the future.

Over the past eight years, under Brown’s public spending boom, its growth rate has been 4% or 5% a year on top of inflation. In some areas, such as the National Health Service, “real” spending growth was more than 7% a year over the period. Around a third of new jobs in Britain in the past decade have been in the public sector, with plenty of others indirectly dependent on the government’s largesse. In some parts of the country the state has been the only serious source of new work.

Now the outlook is different. Darling, if he stays in the job, will be more like the austerity chancellors of the past, such as Sir Stafford Cripps and Roy Jenkins. Gone is the great expansion of spending, crushed by the sheer weight of borrowing – which will rise to well over £100 billion a year – that has to be reined back.

With the chancellor budgeting for a slowdown in spending growth to little more than 1% a year, and economists warning that even this may be unaffordable, the burden of providing jobs and growth will fall on the hard-pressed private sector.

“There is no magic bullet,” said John Philpott, chief economist at the Chartered Institute of Personnel and Development and one of Britain’s leading experts on the job market. “It’s difficult to identify a major generator of jobs. I can’t see any circumstances in which we are going to go back to high-employment manufacturing.

“Barack Obama and Gordon Brown talk about ‘green’ jobs, but the idea of these has been around for a long time. One area where we might get some jobs growth, paradoxically, is in private health and education, with people choosing to spend their own money as the government cuts back.”

IN one sense, the question of where the future jobs, economic growth and tax revenues will come from is impossible to answer; many will be in skills and sectors we have not yet thought about. Recessions bring about what Joseph Schumpeter called the process of “creative destruction”, an economic version of “out with the old; in with the new”.

Economies change, and they do so rapidly. When Britain emerged from its last recession in the early 1990s, Google was not even a twinkle in the eye of its founders, Larry Page and Sergey Brin. Most people had barely heard of the internet, let alone used it.

There is also a time, in every recession, when it seems impossible to detect even the faintest gleam of light at the end of the tunnel. Gloomy predictions make it onto the bestseller lists.

In 1992, miners marching through London in protest at the Tory government’s pit closures were cheered on the streets of Kensington, an echo of the Jarrow march of the 1930s. In that same year James Davidson’s and Lord Rees-Mogg’s book The Great Reckoning: How the World Will Change in the Depression of the 1990s offered the grimmest vision of what was in store.

According to one summary at the time: “We are heading for an appalling four-year economic depression in which crack-crazed armed gangs will roam the streets, the value of your house will fall to a third of its present level, terrorists will ransom the West with nuclear weapons, anybody worth more than £100,000 will employ an armed bodyguard and everybody else will carry a handgun . . .

“If you are badly in debt, you’re dead; forget it, walk away, sleep in a cardboard box if you can find one. You are about to be totalled by economic history.”

It did not happen. The 1990s, after a sputtering start, turned into what Joe Stiglitz, the Nobel prize-winning US economist, characterised as a “roaring” decade.

Prosperity came back, and it did so quickly. Fears of “jobless” growth in Britain were groundless: the long upturn created 4m new jobs and turned the country into a magnet for migrant workers.

Economies change, but they are more resilient than people think. “You could certainly say that over long periods of time the British economy has gone through many upheavals, but the growth rate doesn’t change very much,” said Nick Crafts, professor of economic history at Warwick University.

That does not mean nothing ever changes. Japan’s long period of stagnation from the late 1980s shows that economies can shift down several gears and not recover. Crafts also points out that in the 1960s and 1970s it was common to predict that Europe would close the economic gap with America. It did not happen, partly because many countries in Europe chose that moment to introduce legislation that cut working hours and increased holiday entitlement.

Perhaps this is the moment when Britain too gives up the fight and embraces the new austerity. Economists think, however, it is too soon to throw in the towel, even for those bits of the economy in the eye of the storm.

“Many people think that business and financial services – the City, banking, advertising, marketing, accountancy, consulting and the legal profession – will never come back,” says Adrian Cooper, managing director of Oxford Economics. “But when we get back to normal conditions we still think these are the areas where Britain has a comparative advantage and where we can still do well, particularly as we benefit from developments like the emergence of China.”

He may be right, but the story of the top rate of tax tells us that the government is looking forward to a very different future. The political consensus about tax has given way to the politics of envy. Rich bankers are to be bashed in any way ministers can think up.

Maybe the result will indeed be a mass exodus of talent if Labour wins the next election, as Lord Young warns. “It is the end of an era,” he says. Last week was a big moment. A totem of the past two decades was demolished in a moment. The consequences of that moment may be felt for a very long time.

From The Sunday Times, November 30 2008

Like so many things in this crisis, the story of the public finances is one that makes everything that went before seem trivial. The long debate between the Treasury and independent experts came down to whether there was a "black hole" in the government's projections that would have to be filled by a few billion of tax rises.

The context was Gordon Brown's fiscal rules which, as he put it in his final budget last year, were "the foundation of the strength of Britain's finances".

In that same speech he scoffed at "a deficit equivalent of over £100 billion in a single year in the early 1990s" and looked forward to public borrowing trending down from £35 billion, its level then, to £24 billion, comfortably meeting his golden rule.

I apologise if you wondered what the fuss was about. If Stephen Hawking has the definitive take on "black hole", I regret suggesting that what we were talking about was worthy of the name.

For what Alistair Darling unveiled last week was the biggest, scariest black hole
in modern times. As I understand them, black holes are something you can never escape from. The chancellor's numbers suggest that description fits pretty well.

Public borrowing, £37 billion last year, will be £78 billion this year, a huge £118 billion in 2009-10 and £105 billion the following year. It will rise to a modern record of 8% of gross domestic product and not drop below 3% of GDP — which should be the upper limit for borrowing — until 2013-14.

For government debt, 60% is the new 40%. The old rule of keeping public sector net debt below 40% of GDP has turned into a hope it will stay under 60%. For debt to fall, we have to wait until the Olympics, not 2012 in London but 2016 in Chicago, Madrid, Tokyo or Rio. That is when, according to the Treasury, debt will edge down from a peak of over 57% of GDP. It is also when the current budget, which in normal circumstances is supposed to be in balance, gets back there after years deep in the red.

These were X-certificate projections, the more so since they are dependent on a short and shallow recession but one which, nevertheless, results in some 4% of economic output being permanently lost.

Next year's borrowing alone has been revised up by £80 billion since the budget. Borrowing over five years is up by £295 billion, brought about almost entirely by a collapse in tax revenues, from the City, from the corporate sector and just about everywhere else. Government debt will indeed double, from £527 billion at the end of March to £1,084 billion in 2013-14.

What should be done? Public spending is part of Darling's solution, with its growth rate to slow to 1.2% a year and capital spending, previously sacrosanct, to drop as a share of GDP from 2010 onwards.

The Institute for Fiscal Studies said these adjustments mean spending will take a bigger share of the burden of getting borrowing back down than tax rises, which include, from 2011, a 0.5% rise in employer and employee National Insurance contributions and the new 45% top rate of income tax on high earners.

That may be so. But is it enough? Next year the government will have expenditure of £654 billion but receipts of only £536 billion. The recession has bitten hard into the tax base. The economy that emerges from it will have fewer revenue cash cows of the kind provided by the City and the wider corporate sector in the past.

What should you do when the tax base has been permanently damaged? We have to cut our coat according to our cloth, by reducing spending. This should not happen immediately, but it should happen. The public spending splurge of recent years was based on a false premise, which was that the revenues would always be there to pay for it. They will not be.

In past episodes of economic difficulty, it often required external voices to exert the discipline that politicians, left to their own devices, found difficult. The most famous was the International Monetary Fund bailout of Britain in 1976.

The IMF insisted on a sharp reduction in public spending, more than 4% in real terms in 1977-78. At other times, even without the IMF, public spending has been cut to rein back borrowing; between 1985 and 1990 it was reduced by 3% in real terms and between 1996 and 1999 by over 2%.

Of course this is never easy. But the new era we have entered demands that it has to happen. The question is whether the politicians are brave enough to say so.

What about the short term? The pre-budget report's centrepiece was a temporary cut in Vat from 17.5% to 15%, from tomorrow, and rarely have I heard such whingeing from retailers in response.

I hope the Treasury remembers this next time. Perhaps the chancellor should have gone straight for a 2.5 point rise in Vat, as happened in 1991.

The tax cut will not suddenly make people buy flat-screen TVs but means we will pay £12.4 billion less Vat over the next 13 months. It gives some real income growth for households. It adds to the deficit in the short term, though not much; without it next year's borrowing would have been 6.9% of GDP; with it the figure rises to 8%.

At the margin it will increase consumer spending, which has not grown as rapidly as people think. Before the downturn, spending over the latest five years had grown at only two-thirds the rate of the previous five, and slower than the five-year period before that.

The effects of the Vat cut should be compounded by further speedy interest-rate reductions. The "shadow" monetary policy committee, which meets under the auspices of the Institute of Economic Affairs, wants a full-point cut on Thursday, which would take us to 2%, equalling the lowest Bank rate since 1694.

Monetary policy is being dramatically eased. So is fiscal policy, both by accident and design. The big requirement, though, is a credible plan for getting us out of that budgetary black hole in the medium term. That has to mean lower public spending.

PS: Who was the best chancellor of the past three decades? Thanks to all who responded, and two chancellors are head and shoulders above the rest. Shading it in first place is Kenneth Clarke (1993-97), and behind him, Geoffrey Howe (1979-83). Four years in the job appears to be optimum.

Signed copies of Free Lunch, with a new introduction on the credit crunch, go to Richard Carton and Nico Ladenis. Carton gave nice pen portraits and likened Geoffrey Howe to Geoffrey Boycott. Ladenis, the former restaurateur, needs no lessons about lunch.

From The Sunday Times, November 30 2008

Say what you like about Alistair Darling but his pre-budget reports are must-see events. A year ago he tried to put the ducks in place for the election that never was with eye-catching announcements, some stolen from the Tories. How long ago that seems.

This time the run-up to the PBR has provoked intense debate about economic policy and elevated tomorrow’s statement to something extraordinarily important, economically and politically.

On one side of the policy divide you have Gordon Brown, flush with something approaching international adulation, not entirely justified, because of Britain’s banking rescue.

Last weekend’s G20 meeting in Washington gave him what he wanted. Not an agreement on a co-ordinated global package of tax cuts and increases in public spending but an acceptance that fiscal activism, where appropriate, made sense.

Brown was keen on this outcome, because it gave him political cover and because fiscal activism is more effective if many countries do it, reducing the danger that measures adopted in Britain would simply benefit other countries’ exporters.

Then we have the Treasury. A few weeks ago, even in the context of this autumn’s financial crisis and banking rescue, the word from officials was that monetary policy — interest rate cuts — should carry the weight of getting the economy out of recession. Treasury officials know they will be left with the job of clearing up afterwards and Darling did not want to go down in history as the man who presided over mind-boggling levels of borrowing.

Last week’s figures, showing £37 billion of such borrowing in the first seven months of this fiscal year suggest he would have been hard pressed to come up with a 2008-9 number much below £65 billion- £70 billion, even without additional measures this week. The numbers for 2009-10 were scarier, even before the stimulus.

Oil revenues, one source of comfort, have joined the downward trend, along with the corporate and personal tax take. Treasury officials knew they were looking at the first three-figure borrowing total in history — as in £100 billion-plus.

But words have been said and compromises reached. Tomorrow it will be hard to put a cigarette paper between Brown and Darling.

The big difference is between Labour and the Tories. In one respect, David Cameron has made a political error in recent days — he has sowed confusion. Few people have a clear idea of what the party’s policy is at the moment. I hope I have.

There are two elements. The recession-fighting element was “funded” by tax changes, such as a National Insurance holiday for firms taking on new workers from among the unemployed and a two-year council-tax freeze. But, crucially, if you believe the party’s costings, there would be no net giveaway.

The second element is Cameron’s new policy of not matching Labour spending commitments from 2010-11 onwards. This, a post-recession policy, anticipates what is likely to be a downward revision to medium-term spending projections by Darling (though starting later than 2010). It also makes the sensible point that there are ways of reining back the budget deficit in future other than pushing up taxes.

The reason the Tories have had problems is not just confusion. They are on the wrong side of a debate in which almost everybody, including the International Monetary Fund and Bank of England, thinks a fiscal stimulus is necessary. Business organisations, including the Institute of Directors with its call for a £20 billion stimulus, and the Engineering Employers’ Federation, which today calls for £30 billion, think the Tories have got it wrong.

But a consensus can be mistaken. Could the Tories have got it right? Nobody remembers better the long hangover from the recession of the early 1990s when, due to the Major government’s attempt to spend its way out of it, years of tax increases and tight public-spending constraints were needed. While the recession ended in 1992, its legacy persisted to the end of the 1990s, when infrastructure spending fell to its lowest level sice 1945.

Whether the Tories have got it right now depends what kind of recession we are in. If we are facing a short “V” shaped recession, of the kind the Bank predicted earlier this month (without assuming any fiscal stimulus), the sensible strategy for the Treasury would be to do as little in net terms as possible.

The trouble is, nobody can be sure, despite the fact that, thanks to very low interest rates and sterling’s fall, the economy is benefiting from a huge monetary stimulus. Contrast 3% Bank rate and a low pound now with a 15% rate and an overvalued sterling at the beginning of the 1990s.

So the argument for a fiscal stimulus is based on fear of something longer and deeper, akin to Japan during its “lost” decade. We do not know how big a danger this is — which is why a fiscal boost looks compelling. The fact that the banking system remains so fragile, and may not withstand a long, deep recession, adds further weight, however much the idea of the government increasing debt sticks in the craw.

For Brown there is a double advantage. If the economy pulls out of recession quickly he will be able to say it is due to the actions he took that the Tories opposed. If it does not, he will be able to claim he did everything possible to prevent it.

One thing we will get tomorrow is a plan for sorting out the public finances once the recession is over. Whether or not it is a credible plan remains to be seen.

John Hawksworth of Price Waterhouse Coopers suggests it will have to include two key elements — a stress that the tax cuts are temporary in nature and will be reversed, and a real freeze on government spending from 2011 onwards. That would allow the government’s “structural” budget deficit — as distinct from the effects of the economic cycle — to come down from a peak of more than 4% of gross domestic product to just over 1%.

As Hawksworth suggests, any plan would be more credible if it were independently policed. Keynes is much in vogue these days and we all know what he said about the long run. In the long run, one way or another, we will all have to pay for tomorrow’s announcements.

PS: The causes of recession may be different but echoes of the early 1990s are powerful. The banks’ treatment of small firms is following a very similar pattern. Then, banks faced a government investigation which resulted in a code of conduct for small-business lending, though only after the damage had been done.

Finally, last week’s competition. The challenge was to list the past seven chancellors in order, best to worst, with a tiebreaking justification for choice of champion or dud. The seven are Howe, Lawson, Major, Lamont, Clarke, Brown and Darling. The huge response warrants a league table. I’ll let it run until close of play Wednesday. Results next Sunday.

From The Sunday Times, November 23 2008

These are difficult days for the Bank of England. An institution that sets itself high standards and prides itself on its dignity and decorum is getting a battering.

Gordon Brown is making political hay out of the crisis but he is not carrying the Bank with him. For years central-bank independence was his proudest achievement as chancellor. Now I get people asking whether it was such a good idea after all.

At the stormiest press conference since independence, Bank governor Mervyn King and his colleagues were last week accused of being caught with their pants down as the financial crisis turned into an economic crisis. That is not an image I want to dwell on, or can imagine being put to Eddie George, King's predecessor, but the point was clear.

The Bank has lurched spectacularly in the space of three months in terms of its view on the economy and on interest rates. On the face of it, it was not just behind the curve but out of sight.

What is the Bank's defence? The world, said King, has changed, the outlook has been transformed. After Lehman Brothers was allowed to fail in September by the American government, the global banking system came perilously close to collapse.

Many people accept these were world-changing events. Confidence was weak but dived further. The autumn has been the closest thing to a "falling off a cliff" moment we have seen in this cycle, with very sharp falls in activity. At the same time, oil and other commodities plunged.

It was not hard to find reasons for oil to fall, of which more another time, but the drop was sudden and savage. I don't want to use that quote from Keynes again, which should be banned, but the facts changed and the Bank changed its mind.

Fair enough. Nobody could have predicted the recent events and nobody did. That explains King's robustly unapologetic tone.

Incidentally, there is a case for re-examining the piecemeal moves preceding the banking rescue, including the terms of the Bradford & Bingley rescue/nationalisation, the strategy for Northern Rock and even the Lloyds TSB-HBOS merger.

I don't have a particular problem with the last of these but the B&B rescue is imposing a severe burden on smaller lenders, which have to fund the Financial Services Compensation Scheme, and it makes little sense for Northern Rock to be running down its mortgage book aggressively.

So the past two months have changed things, and the Bank was right to cut rates more aggressively than anybody expected, or hoped. Many of the armchair generals who are now most critical of the Bank were attacking it very recently for not raising rates far enough to stop inflation rising.

I do not think, however, that the Bank should get away with it entirely. There is something to criticise and for me it is a tale of the past three Augusts.

In August 2006, the Bank's monetary policy committee surprised markets by raising rates for the first time in two years. Before then, the MPC seemed comfortable to live with a rise in inflation due to higher global food and energy prices.

The prospect, though, of King having to write an open letter explaining the missed inflation target injected steel into the MPC. Bank rate carried on rising until July last year, the eve of the credit crisis. The depressing effects of those hikes were still coming through even as the economy was being hit by the start of the crunch.

The story of August last year barely needs repeating. We know there were different views in the Bank, even at senior levels, on what the appropriate response to the emerging financial crisis should be.

However, this was not like the MPC, where everyone has a vote. The governor is responsible and he took the decisions. King was concerned about the "moral hazard" implications of bailing out banks for their irresponsible lending decisions. In a minor crisis, his would have been the textbook response. In the big crisis then developing, it was like insisting the silver was properly polished as the Titanic was sinking.

Which brings me to August this year when one MPC member, Tim Besley, voted for a rate hike and the others, with the honourable exception of David Blanchflower, showed no inclination to cut.

The mistake, in fact, was made earlier. In early April, I wrote here urging aggressive interest-rate cuts, a big liquidity injection by the Bank and direct government intervention in the mortgage market to prevent a downward spiral.

We had one small cut before most MPC members got frozen in the headlights of the summer inflation surge. The Bank's special liquidity scheme was launched. Direct government intervention, though, did not come until last month, and intervention in the mortgage market is awaited, pending Sir James Crosby's report, due with the pre-budget report on November 24.

We are where we are, as they say. Where are we heading? For me the disturbing thing about last week was that the Bank appeared to have thrown in the towel.

Its forecast is not quite as gloomy as painted, implying a 1.3% contraction in the economy next year and a peak-to-trough fall in gross domestic product of 2%, slightly smaller than the recession of the early 1990s. But it was more downbeat than even a rapidly changing consensus.

You expect a Bank governor to stand up for sterling. King, while saying he would not welcome a further sharp fall, had little to say except that these things are unpredictable. On fiscal policy, he gave a pre-budget-report boost for the economy his seal of approval. More on this next week.

None of this is necessarily wrong. You get a sense, however, that the Bank has also thrown in the towel on its ability to control or predict the economy. So not much it does will prevent the recession that is now, in its view, baked into the outlook for at least the next few months.

It is still predicting a significant bounce-back for the economy, starting in the second half of next year and strengthening thereafter. In normal circumstances that would be an easy forecast to make, such is the policy stimulus the economy is receiving. But these, as the Bank keeps reminding us, are not normal circumstances.

PS: A lot of people struggle with the basics of economics, as I know from responses to these pieces on the internet. Many readers tell me they could do with a refresher. Help is at hand.

I look forward to the responses. If we get enough, there could even be a league table. Good luck.

From The Sunday Times, November 16 2008

In recent years, when talking to younger audiences, I used to express mock wonderment that we had all become so obsessed with small changes in interest rates. This was when quarter-point changes were the norm for the Bank of England's monetary policy committee (MPC).

A quarter-point change, I suggested, would have been for wimps in the old days, when there was a lot more red meat in the policy diet. "Up by two points, down by one" was not what always happened but it was by no means unusual.

There were good reasons why there was a shift to much smaller rate changes. The general level of rates came down compared with the 1970s and 1980s, when the Bank rate was often in the mid-teens. The economy was sensitive, it seemed, to even small rate moves. The MPC's approach was incremental; monthly meetings meant small changes would cumulatively turn into larger ones quite quickly.

So where did Thursday's wimp-busting 1.5-point shocker come from? First, as I have been arguing for some time, rate cuts lost their potency because the normal transmission mechanism from Threadneedle Street to Main Street is not working. The Bank has to cut more aggressively now to get the same effect as it did two years ago.

Second, the Bank had some serious catching up to do. To wait from April until last month before cutting rates even as the economy was deteriorating fast was the equivalent of being asleep at the wheel.

Third, recent economic news has been dire. The Halifax's report of a 2.2% drop
in house prices last month dashed hopes that the pace of decline was slowing. Figures from the Society of Motor Manufacturers and Traders showed a 23% fall over 12 months in new car registrations. The home front is weak, with the Bank's own agents reporting a "continued severe contraction in the near term".

So is the global economy. The International Monetary Fund lopped a point off its 2009 global growth projection in the run-up to last month's annual meetings in Washington. Now it has taken off a further 0.75 points. The world economy will grow just 2.2% next year, it thinks, all concentrated in the emerging world. The advanced countries will decline together for the first time since the second world war and the UK economy will shrink by 1.3%. Desperate times, desperate measures.

How low will Bank rate go? That depends on how bad members of the MPC think things are. After all, Mervyn King, the Bank governor, has spoken of the banking system being closer to collapse last month than at any time since the start of the first world war and his colleague Danny Blanchflower seemed to agree, suggesting the credit crunch "may turn out to be more significant than the 1929 crash".

Charlie Bean, the Bank's deputy governor, trumped them both in an interview with the Scarborough Evening News, saying we were in "possibly the largest financial crisis of its kind in human history". They are hard to please in Yorkshire; his remarks did not make the front page.

Fantastic copy though all this is for journalists, there is a danger we might suffer from a degree of time distortion, where current events are magnified in their importance compared with those in the past.

Peter Dixon, an economist at Commerzbank, has examined the "worst in human history" claim. For the stock market, the fall from levels immediately before the credit crisis to last month's lows, 43%, is not even the biggest this century — in the early 2000s there was a drop of 52%.

Although forecasts are changing all the time, most economists are looking for a recession lasting four to five quarters, in line with the post-1970 UK average, and a peak-to-trough fall in gross domestic product of 2% or so, less than the recent average of 3.4% and modest in comparison with the early-1980s slide of 6.1%.

To be fair to the Bank trio, it is possible to talk of a financial crisis of enormous magnitude while also taking action to head off its worst effects on the real economy. The Bank's new economic forecast, to be published this week, will predict recession — after the rate cut we are all wondering how deep — but not a 1930s-style slump.

The fact there will be a significant recession is testimony to the downward pressure on the economy. The Bank's own economic model would suggest that in normal times big rate cuts and a lower pound would produce a rapid return to growth.

For those who like historical numbers, by the way, the 1930s has probably been unfairly characterised as the grimmest ever. The economy contracted 0.7% in 1930 and 5.1% in 1931 before recovering in 1932. But immediately after the first world war was worse, with declines of 10.9% in 1919, 6% in 1920 and 8.1% in 1921. No wonder people welcomed the Roaring Twenties.

Everybody knows by now that we have not had an interest rate lower than 2% since 1694. There was thought to be a minimum level of rates necessary for anybody to forgo the benefit of having cash now.

Now, of course, that 2% low may well be challenged. It would only take another move like last Thursday's, or more likely three smaller ones, to get there. The key to it is the real interest rate.

Before the dramatic cuts of the past few weeks, the MPC's modus operandi was that it was essential not to let real interest rates — the interest rate less inflation — turn negative, or at least not decisively so. That, according to some MPC members, led to the inflationary errors of the 1970s.

So even when it expected a sharp fall in inflation, the MPC was not prepared to let Bank rate, 5% as recently as last month, move too far away from current inflation, also close to 5%. That has changed. It is now prepared to run a negative real rate, a 3% Bank rate against a 5.2% inflation rate, at least on a backward-looking basis. It is confident of a very big fall in inflation and recognises the need for an unusual stimulus. If inflation is on course to drop to 1% or below, even a 3% Bank rate is high.

Last time consumer price inflation was close to zero, in the middle of 2000, Bank rate was 6%. This time interest rates will follow inflation down. We will, I think, see an interest rate beginning with a "1". Anything else would be for wimps.

PS: The emphasis leading up to Alistair Darling's pre-budget report has been on using public spending to cushion the blow of recession. Now talk is turning to tax and there is scope for some fine-tuning to make life easier for business.

There are good ideas there, some of which won't cost much, if anything, in the medium term. Over to you, Darling.

From The Sunday Times, November 9 2008

Darling, Blanchlower and King. No, not the Spurs midfield from the double-winning side of the early 1960s but just three of the characters I bring you today.

Let me start with Alistair Darling. The chancellor devoted a long lecture, the Mais lecture at City University, to tell us two things. First, he is ready to unveil some new fiscal rules, though they are not yet finalised. Second, he is not changing the Bank of England's remit from inflation to economic growth or house prices.

Why did he tell us that when nobody had any serious expectation of any change? To remind us the Bank's existing remit enables it to respond to "difficult global forces". The government, in other words, wants the Bank to cut interest rates as much as it can. Whether such pressure can be counterproductive we will know this week. More on that in a moment.

The chancellor's keenness to get interest rates down does, however, raise the question of whether people have got hold of the wrong end of the stick on the government's "Keynesian" spending intentions.

Yes, as Darling said, the government will maintain its overall spending and bring forward some already planned capital projects where possible. That task is proving easier said than done. But this is different from unveiling entirely new programmes or projects to enable the government to "spend its way out of recession".

While borrowing will rise sharply in the recession, I do not get the sense the Treasury plans to add hugely to it with a big fiscal package, hence the emphasis on rate cuts as the best anti-recession medicine.

Which brings me on to David Blanchflower. Economists do not often get to say "I was right all along" but the maverick monetary policy committee member is able to do so, no doubt to the intense irritation of Bank of England governor Mervyn King and the other MPC members.

Blanchflower, who spends half his time in the US, has long pushed the view that Britain's economy was heading the way of America's. As he put it in a recent lecture: "I have been struck by how closely the path the UK has followed resembles that of US economy about six to nine months earlier."

He consistently argued the MPC was wrong to get hung up on a rise in inflation generated by global energy and food prices, and that it was also wrong to fret about the risks of a wage-price spiral. Such risks, in his view, were negligible.
And he has been proved right. While his MPC colleague Tim Besley was voting for higher interest rates as recently as August, Blanchflower was voting for a cut. He is the MPC's superdove, voting to cut rates at all 10 of the committee meetings this year.

He is not, however, gloomy for gloom's sake. Aggressive cuts in interest rates can, he believes, prevent an unnecessarily deep and long recession and stop inflation falling into negative territory — deflation.

Modern economies are more resilient than people give them credit for and "in the medium term our economy will recover and prosperity will return".

This week he will be pushing at an open door. It will be a surprise if the MPC does not cut interest rates this Thursday, and by at least half a point, matching last month's reduction. This would be only the third time the Bank has cut by a half in the 11-year independence era. It is what the "shadow" MPC, which meets under the auspices of the Institute of Economic Affairs, expects, though some in the City think it will be bigger — 0.75 points or even a full point. The question is whether the Bank wants to use all its ammo at once.

The bigger question is whether the Bank has delayed too long, to the point where lower rates are ineffective. Its own Financial Stability Report, published last week, includes the Bank's new estimate that losses on securitised credit instruments and corporate bonds since the start of 2007 are now $2.8 trillion, (£1,700 billion), equivalent to more than Britain's annual gross domestic product, or 85% of the banks' so-called Tier 1 capital before the crisis.

Not all these losses will be realised, though a good half are likely to be, and not all of them will be borne by the banks. But these are huge numbers.

Also in the report are the makings of what the Bank will try to put in place to prevent all this happening again. Macro-prudential supervision, dynamic provisioning, capital insurance and leverage ratios are likely to become buzz phrases soon. Essentially, the Bank and other central banks will seek to ensure banks establish sufficient financial strength in the good times to be able to cope, without government bailouts, when things turn bad.

What struck me most about the Financial Stability Report, however, was its straightforward explanation of the adjustment the economy has to go through.

Seven years ago, Britain's banks funded lending almost entirely out of customer deposits. By the first half of this year they had a funding "gap" — the amount they funded mainly from international wholesale money markets — of £740 billion.

The Bank does not expect this gap to close entirely, still believing there will be a place for wholesale funding in the long term, but it does suggest it needs to narrow to 2003 levels of about £265 billion.

Achieving that over a year, which the banks might have had to do without the government's rescue package, would have required a sharp drop in lending and a very deep recession. Achieving it over three years will "smooth this slowing in lending", the Bank says, but not prevent it. There will be no return, in other words, to past rates of growth of lending.

So how do lower interest rates help? Less by stimulating new lending than by easing the pressure on existing borrowers, as long as rate cuts by the Bank are passed on by lenders. They will need to be.

PS: One of the great debates is about the impact of house prices on consumer spending. Does a fall in house prices, a record 14.6% over 12 months, according to Nationwide, cause people to spend less? Or are the two subject to similar influences, so that the crunch causing house prices to fall also hits spending?

Why? PWC's economists have adapted one of the basics of economic theory, which is that people's spending is based on "permanent" or long-run income. An unanticipated shift in house prices changes people's ideas of how much wealth they will have tied up in their houses over the long run — think of people hoping to retire on their property equity — and affects their spending now. Some people celebrate falling house prices. Retailers don't.

From The Sunday Times, November 2 2008

What's a recession like? I pose this not just as a service to younger readers but to set in context a week of confessions from Mervyn King and Gordon Brown, both of whom used the R-word ahead of Friday's figures showing that the recession has begun.

A consensus is emerging on the broad shape of that recession. Both the National Institute of Economic and Social Research (NIESR) and the Ernst & Young Item Club think that after growth of 1% this year, the economy will contract by about 1% next, before growing by a modest 1% in 2010.

Put like that, a recession does not sound so bad, more like a pause than anything more serious, so how bad can it be? And how would a recession like that compare with what Britain has suffered in the past?

We do not know if the emerging consensus will be right; to an extent forecasters have been racing to keep up with a deteriorating economy and many are busy revising down their forecasts this weekend. But suppose we do get a +1%, -1%, +1% pattern. On the face of it there will just be a temporary loss of output, spending and incomes in 2009, soon made up in 2010. How bad can that be?

The reason modest numbers are uncomfortable is that you have to compare them with what would have happened in recession's absence. Normal, "trend" growth for the economy is 2.75% a year. In the three years 2008 to 2010, GDP would have been expected to grow by a cumulative 8.5%. Instead it may grow by 1%.

By 2010 there will be a GDP shortfall, relative to what should have happened, of 7.5%, £107 billion at today's prices. That's a lot of output, income, spending and jobs, and it is why even mild recessions are painful.

How would the expected pattern compare with past recessions? It is closer than you might think to the last recession. Then, the economy grew 0.8% in 1990, shrank by 1.4% in 1991 and grew 0.2% in 1992. Many will recall there was huge pain associated with these innocuous numbers. The previous big recessions of the post-war era, 1980-81 and 1974-75, each saw two consecutive years of GDP falls.

The best way of looking at recessions, however, is the peak-to-trough fall in GDP. Where did the economy start to fall, and how much did it fall? Again, though it did not seem so then, the recession of the early 1990s was mild, with a peak-to-trough GDP fall of 2.5%, less than half of that in 1980-81, a huge 6.1%, and lower than 1974-75, 3.5%.

This time, says NIESR, the peak-to-trough fall will be 1.2%. As I say, we will notice that a lot, but it will be modest compared with past recessions.

Will it be so mild? Geoff Dicks of Royal Bank of Scotland Financial Markets, asks "Will it be worse than last time?" and says: "Conventional analysis says no. We did not have the boom of the late-1980s; inflation is 5% and falling, not heading to 10%; interest rates are 4.5% not 15%; we have not locked into the ERM [exchange-rate mechanism] at an uncompetitive rate; fiscal policy will become more expansionary."

The unknown, hard for economists to model and forecast, is the impact of banking and the lending squeeze that is part of the banks' deleveraging.

Even with that huge uncertainty, there are positives. The first quarter of recession sets the tone. The first quarterly decline in 1990-92 was its "falling off a cliff" moment, when GDP fell by 1.2%, half its entire drop during the recession. There were similar big declines at the onset of the two earlier recessions. The third-quarter drop in GDP revealed on Friday was larger than expected, but at 0.5% was not as bad as in 1990.

Second, the fact that policymakers are using the R-word is encouraging. Margaret Thatcher left office late in 1990 denying the economy was in recession. Early recognition is a prerequisite for action.

Third, every policy instrument is being thrown at it, including rate cuts, devaluation and, where possible, fiscal policy. It may not be enough to offset banking's dead hand but should limit the decline.

What about King, now he has put his name to the first recession in the Bank's independence era? I get plenty of e-mails blaming me personally for the economy's woes so I cannot imagine what his inbox is like. The Daily Telegraph has called for his immediate resignation and a guest piece in The Times, our sister paper, marred by some howlers, called for rate decisions to be handed back to the politicians. Not, I think, a good idea.

King's Leeds speech is worth reading — it's on the Bank's website. You don't often hear a Bank governor saying the banking system came within an inch of meltdown. If I have a criticism it is that he sometimes comes over as commentator rather than participant. The Bank, whose part in the banking rescue package was pivotal, hugely influences events. On interest rates, most members of the MPC, including King, were slow to spot the recessionary danger.

The NIESR's latest review, devoted to "The Great Crash of 2008", is also worth reading. We know the banks will change when the dust settles but how will the Bank change? Sushil Wadhwani, a former MPC member, argues in the review that in future the Bank should be prepared to "lean against the wind" when it comes to big rises in asset prices, such as houses.

The Alan Greenspan model of central banking, essentially adopted by the Bank, established the principle that if booms or bubbles in asset prices occur and then burst, there was no need to worry as long as it was possible to mop up easily afterwards.

That was Greenspan's view of the stock market and the Bank's view of Britain's housing market. It seemed reasonable. The economy and housing were sensitive to small changes in interest rates, allowing the Bank to manage any decline. The credit crunch has changed that, seriously reducing the Bank's ability to achieve an orderly unwinding of the house-price boom. That is one important lesson of these extraordinary times.

PS: In grim times we have to look to our brains to get us out of the mess. Fortunately, there is still good news out there. Nesta, the National Endowment for Science, Technology and the Arts, invests in early-stage, innovative companies. If the flow of new investments were drying up, you would be worried about the longer-term outlook.

We need knowledge-intensive businesses. Last week Foresight, the government think tank, published a report underlining the importance of "developing our brains from cradle to grave". Putting brains to work on new business ideas and applications has never been more important.

From The Sunday Times, October 26 2008

Economic numbers will never be the same again. A trillion here, a trillion there and soon you are talking about real money. The bank rescue pales everything else into insignificance, even if it has not yet calmed jittery markets.

Gordon Brown's blueprint is big, though his critics hate any credit going to him. After all, if you take some of those critics at face value, he created the American subprime crisis, told bankers to behave irresponsibly and set up a regulatory system that uniquely failed to spot this coming.

It is about as daft as the new fashion for blaming Bill Clinton, or even Jimmy Carter, for the American subprime lending boom of 2003-7 that triggered the crisis.

Not only has the prime minister enjoyed a political triumph beyond Downing Street's wildest dreams but the Organisation for Economic Co-operation and Development (OECD), not always a friendly voice, said last week Britain's tax burden was lower than in other EU countries and the corporate-tax regime was competitive.

Brown's critics should be more charitable. Normal political service will be resumed, and British leaders who get rave reviews abroad, from Winston Churchill to Margaret Thatcher and Tony Blair, tend eventually to get pummelled at home.

Anyway, the rescue numbers are large. It is not sensible to lump together bank recapitalisations, additional central liquidity and government guarantees of bank lending. You can get some very big figures but they do not tell us much.

But just look at the scale of the recapitalisations alone — long-term taxpayer stakes in organisations that until a few weeks ago would have regarded such things with as much enthusiasm as a drunk being invited to a temperance evening. If we take just four countries, admittedly the biggest four affected, America, Germany, Britain and France, they have between them announced $500 billion (£285 billion) of government capital injections into their banks and the process may not be over.

Typically, government guarantees of bank lending, which are dependent on banks being adequately capitalised, are five times the amount of the capital injections.

This is a big moment. But it is not the end of capitalism or the start of a new era of nationalisation. Intent is important. Neither George Bush's Republican administration nor Brown's new Labour government wanted to part-nationalise anything. All are doing it reluctantly, and of necessity.

The aim will be to sell these shareholdings back into the market as quickly as possible, ideally with a profit for the taxpayer. It was, however, a recognition that there are times when the normal tools of central banking are not adequate.

"Lender of last resort", used by the Bank of England for Northern Rock more than a year ago, is fine as far as it goes. In this situation we had to have a supercharged version going beyond bank liquidity and into solvency and capital.

As for the death of capitalism, this is the end of an extreme version of market behaviour, built around financial engineering. We are certainly moving towards more controlled banking, but we are not heading for central planning and state control of the economy's commanding heights.

The question I am asked most often about this is: What about the public finances? How can we possibly afford all this?

Maurice Fitzpatrick of Grant Thornton points out that Britain's public debt position, which is better than in any other G7 country, is a big advantage. Even a UK debt to GDP figure of between 40% and 50% of gross domestic product, which Alistair Darling is likely to admit to in his pre-budget report next month, is half the G7 average of 93%. America is on 61%, Germany 63%, France 64%, Canada 68%, Italy 104% and Japan a huge 195%.

As for the budget deficit, John Hawksworth of Price Waterhouse Coopers, notes that partial nationalisations (taxpayer stakes in banks) should be treated in an equal but opposite way to privatisations. They do not add to public-sector net borrowing — the favoured definition of the budget deficit — just as privatisations did not reduce that deficit. They are, in the jargon, below-the-line financial transactions.

This means they do not put pressure on the chancellor to raise taxes or cut spending. In his pre-budget report Alistair Darling may announce some "reprioritisation" of spending — bringing some capital expenditure forward. But he will not cut projected medium-term growth of current or capital spending. The Treasury, indeed, argues the recapitalisation will leave the economy less vulnerable to what could have been very abrupt deleveraging by the banks — reining back debt and exposure to risk.

What will hit the public finances is the economy. Figures this Friday will show the first quarterly drop in GDP since April-June 1992. Technical recession is, as they say, "baked in" to the economy, the question being whether it will be significantly worse than that, as the stock market fears.

I have referred here before to the misery index, devised by Arthur Okun, calculated by adding up the inflation and unemployment rates. It has just risen and now stands at 10.9%, its highest since 1996.

We probably do feel more miserable — and worried — than then. Are we more miserable than during the last recession, when for a time both inflation and unemployment were close to 10%, meaning an index almost double its present level?

One half of the index, inflation, will fall rapidly now, particularly with the price of oil and other commodities plunging. Capital Economics even thinks that next year inflation will turn to deflation.

Unemployment, however, will continue to generate misery. Last week's reported rise of 164,000 to 1.79m in the June-August period was bigger than expected and the largest increase since 1991. It may have been boosted by the failure of students to land vacation jobs during the summer.

But the trend is unmistakeable. John Philpott, chief economist at the Chartered Institute of Personnel and Development, is concerned that his forecast of a 2.25m total by the end of next year is now looking optimistic. That measure of unemployment peaked at 3.2m in the mid-1980s and was above 2m from 1980 to well into 1997. The hope has to be that its return to those levels is short-lived. The fear is that getting back to low unemployment will take a long time.

PS: Are we taking this crisis seriously enough? This week's Sunday Times' bestseller list shows that the book-buying public is not yet getting into the crunch, preferring celebrity autobiographies. Parky, by the former chat-show host, and Dear Fatty, by Dawn French, are preferred to economic dramas. Not a single crunch-related book makes a showing.

Somebody will write a great book about this episode. Whether it endures as long as Galbraith's classic remains to be seen.

From The Sunday Times, October 19 2008

For a time on Friday it seemed as though the end of financial civilisation was upon us. After huge falls in Asia, Europe and London, it appeared that Wall Street — which started the panic with a huge slide in the last hour of trading on Thursday — was falling off a cliff.

The first few minutes of trading on Friday morning continued Thursday’s dive, but Wall Street later came back from the edge, and by the time New York’s traders left for the bars or the suburbs, a degree of calm had returned. A day of volatility had shattered nerves but left shares a “modest” 1.5% down.

Nobody, however, believes the crisis is over. This weekend finance ministers and central bankers are trying frantically to prop up the system before the markets open. The week will not be a normal one, with public holidays in America and Japan tomorrow meaning trading on Wall Street and in Tokyo will be thin. That, however, will not provide an excuse for delay.

That was why, late on Friday night, G7 finance ministers and central bankers issued a statement promising to take “all necessary steps” to stem the crisis. Those steps include a pledge to stop key banks collapsing, a big boost to money market liquidity, putting taxpayers’ money directly into the banks as capital, protecting the deposits of savers and forcing banks to come clean on the scale of their losses.

The G7 knows that this crisis has reached a level at which mere statements are not enough. That is why Henry Paulson, the US Treasury secretary, promised to take a leaf out of Gordon Brown’s book and inject capital directly into US banks, a decision that is likely to be matched by Germany. And it is why worried eurozone finance ministers will get together in Paris this afternoon to make sure they all have their armoury in place by the time European markets open tomorrow morning.

Economists are bad at predicting stock market crashes, and those crashes are bad predictors of what will happen to the economy. Crashes have different causes and very different effects.

Black Monday, October 19, 1987, still ranks as the worst day on the market yet, when Wall Street slumped by more than 20%. It arose from international economic tensions, particularly in the foreign exchange markets. When those tensions spooked investors and led to a sudden collapse in share prices, many economists drew comparisons with 1929 and predicted a repeat of the Great Depression.

In fact, the result of the 1987 crash was more like the great inflation. Central banks, and in Britain’s case the chancellor, Nigel Lawson, cut interest rates in response to the plunging stock market. The result was the boom of the late 1980s, which turned to bust only in the early 1990s — and by historical standards it was a mild bust — when interest rates had to be hiked to combat the inflationary boom.

The stock market crash over the past week — the biggest weekly fall for America’s closely watched S&P 500 index and a drop of 21% for the FTSE 100 — may be no more a predictor of depression than 1987 was. But the circumstances are very different.

For a start, according to the Stanford University economist Nick Bloom, the recent volatility of the stock market is on a par with the 1929 crash and subsequent episodes in that period when the Depression took hold. Bloom, who spends some of his time at the London School of Economics, is one of a number of economists who think it is not the level of the stock market that counts but the extent to which it fluctuates.

Recent days have seen some of the wildest fluctuations ever, which leads him to think a bad recession is on the way. Britain, he says, could experience a 3% contraction in the economy next year. That may not sound much, but if it happens, it will count as the worst year since the 1930s.

The reason it is different this time, certainly from 1987, is that the stock market crash last week was a symptom of the wider credit crunch of the past 14 months. The most obvious effect of that crunch on the British economy has been a mortgage famine and falling house prices.

The fear gripping stock markets is that nothing governments or central banks do will prevent the banking crisis from getting worse and the credit crunch from sending the world into a deep recession, affecting all countries and all businesses. That, together with a mad scramble by under-pressure investors to liquidate all their assets, including commodity investments, produced the crash.

Where do we go from here? Simon Johnson, former chief economist at the International Monetary Fund, thinks the G7 countries did not go far enough. He wanted them to guarantee all bank deposits and set out a concrete timetable for action. Politicians, he thinks, are still held back by fears of “moral hazard” — helping out the banks who got us into this mess. “When you see the Titanic sinking, you don’t stop saving people because it is the shipbuilder’s fault,” he says. The urgent task now is to get the West’s banking system working again. As it is, much of it is barely functioning.

We will soon know whether governments can persuade the markets that they have a plan. This will probably be an international version of Britain’s £400 billion bank rescue, announced in the heat of battle last week.

If they can, it may yet be possible to avert disaster, to get the banking system working again, and for the world economy to get back to something like normal, though with painful slowdowns in Britain and elsewhere. Markets would stabilise and interest rates in the interbank markets, the key to whether the system is working, would come down. If not, economies will grind to an abrupt halt and a downward spiral will set in.

From The Sunday Times, October 12 2008

What can one say after a week like that? Dramatic market moves can be cathartic or a signal of grim times ahead. Dramatic policy moves can either be desperation or a well-judged response to prevent gloom turning to disaster. G7 promises of drastic action may be praised or dismissed as a damp squib.

If I say only time will tell, many will see it as a cop-out, but it is also the only sensible thing to say. So volatile and destructive are markets that apparent calm gives way to frenzy at the drop of a hat. Once-in-a-lifetime events happen almost daily; the unthinkable becomes routine. Huge stock-market falls become almost matter-of-fact.

The government announced on Wednesday what would have seemed unthinkable a month earlier — a mass bailout of the UK banking system, including at least £50 billion of taxpayer-funded capital injections and almost limitless provision of liquidity and official banking guarantees.

The Bank of England, caught since April between worries about inflation and the credit crunch — one member of its monetary policy committee voted for a rate hike in August — was suddenly taking part in a co-ordinated half-point rate cut with the Federal Reserve, the European Central Bank and other central banks. Even after the September 11 attacks on America, central banks did not cut rates on the same day. The ECB, making hawkish noises until a few days ago, underwent an even bigger Damascene conversion.

The stability and restructuring plan (Sarp), as Gordon Brown calls it — the name has not caught on but is better than comprehensive restructuring action plan — is bold and clever.

It ticks all the boxes of recapitalising the banks, providing them with another huge slug of liquidity — at least £200 billion under the special liquidity scheme — and up to £250 billion of government guarantees against new debt issuance by the banks. It hangs together as a package; the banks do not get the guarantees unless they agree to the recapitalisation.

It is a reminder that the policy machine can be very good indeed. The British plan will be a template for other countries and undoes some of the reputational damage suffered by the Treasury, Bank and Financial Services Authority over the past year.

Real wars are under the spotlight of 24-hour TV and so are economic wars. Policymakers, like generals, will have often thought about putting a boot through the screen in recent days. History is being made. So where does it leave us?

One quick way of assessing the economic impact of the past three to four weeks is to look at the International Monetary Fund, holding its annual meeting in Washington this weekend. On September 18 John Lipsky, its deputy managing director, gave a speech looking forward to the IMF's new forecasts.

Global growth, he said, would be 4% in 2008 and somewhat below 4% in 2009. At that time the IMF's last assessment for Britain was 1.4% growth this year, 1.1% next.

Now the air is thick with the sound of economists chopping forecasts. Global growth this year is expected to be 3.9%. "Somewhat below 4%" next year has turned into 3%. Britain is seen as growing by 1% this year and shrinking 0.1% next.

The IMF's best guess is that the crisis of the past few weeks has lopped a percentage point off next year's economic growth and, as it admits, there are considerable "downside risks" to its new projections.

Hank Paulson's decision to let Lehman Brothers fail — the first domino and a move attacked by French finance minister Christine Lagarde last week as "horrendous" — will cost the world about $650 billion (£378 billion) of lost output next year. Britain loses about £15 billion of GDP.

The shape of the IMF forecast is as it was: not much growth in advanced economies but a lot in the emerging world. All, however, are expected to be less strong than previously thought, so advanced economies as a group will grow 0.5% next year, emerging economies by 6.1%, boosted by China with 9.3% growth and India with 6.9%.

To put this in perspective, 3% global growth would be stronger than the 2001-2 world recession (which Britain escaped), and stronger than the recessions of the early 1990s, early 1980s and mid-1970s. For advanced economies taken together, however, this will be worse than the early 1990s and similar to the two earlier recessions. The world is being kept afloat by China and India.

In Britain's last big economic crisis, sterling's "Black Wednesday" plunge out of Europe's exchange-rate mechanism (ERM) in 1992, policy activism worked, though it took time for the gloom to lift.

This was when, under Norman Lamont, a new policy was built out of the ashes of the ERM disaster, focused on an inflation target. The policy — including aggressive rate cuts — led to sustained recovery.

There are big differences. Then we were at the end of a recession, now we are in the early stages. It was a European problem, rather than a global banking crisis. And, while the Bank blew Britain's currency reserves in a vain attempt to prop up the pound, the cost to the taxpayer was small.

All crises end, and this one will be no exception. The IMF predicts a recovery will "progressively take hold" next year but recovery will be "unusually gradual".

The Bank, in taking part in the co-ordinated rate cut, noted everything was weak and appeared to acknowledge recession, pointing out there was no growth in the economy in the April-June quarter and that surveys suggest a further weakening in the second half. This must also be the message from its own regional agents.

Predictions, as I say, are risky, but the "Sarp" looks the right way of ensuring the stability of the banking system — if it is put into place quickly. Stabilising the economy, after all the frights of the past month, will take longer. The kind of forecast the IMF has for Britain next year, essentially zero growth, is weak but not disastrous. If the Sarp works, and is bolstered by further bold moves on interest rates, it could be possible to avoid anything worse.

But if the events of the past month have removed any growth from Britain's economy next year, what will the next couple of months bring? Britain has come up with a good plan but remains at the mercy of the markets. They need to stabilise, and fast.

PS If there was ever a prime minister made for the Davos World Economic Forum it was Tony Blair. Some of us have had the privilege of seeing Klaus Schwab, its president, pouring his own Swiss syrup over him and probing him with questions of the "How difficult is it to be so wonderful?" variety. Even Blair blushed.

Business leaders like the flexible job market and still think we have competitive financial markets (though they have slipped from second to fifth in the world). The real dive is on the macroeconomic environment, ranked a lowly 58th, due to "low national savings, a growing public-sector deficit and consequential public indebtedness". Brown needs to do some schmoozing.

From The Sunday Times. October 12 2008

This is a piece looking at the parallels between the 1930s and current events. I should say that this is a feature, not an opinion column, and I don't expect a repeat of the Great Depression. But, as you'll see, others think we'll see its modern equivalent.

It was an era that brought some of Britain’s finest writers to a flurry of indignation. One railed against the “greedy, profit-grabbing system” and hoped to see “the people in the City all shoddy, bewildered, unhappy”. Does that sound familiar? Polly Toynbee, perhaps, turning her righteous fury on the financial masters of the universe who have pushed the banking system over the brink?

No, it was JB Priestley and the era was the Great Depression of the early 1930s, which shaped the 20th century more than any other economic event, creating the conditions for the rise of fascism in Europe.

During the financial tumult of the past three weeks a shocking question has been hanging in the air. Despite all the economic advances of the past half-century, is 2008 the start of another Great Depression? To understand the implications, one has to realise what happened nearly 80 years ago.

In depression Britain, a fifth of the workforce was on the dole. A quarter of workers in the north of England and Scotland and more than 30% of those in Wales were unemployed. Iron output fell by more than 50% and steel production by 45% between 1929 and 1932.

Britain may have been the workshop of the world but there was no world economy to sell to.

Unemployment among shipyard workers reached 60% and among miners 35%. When workers clocked off at Palmer’s yard in Jar-row after completing HMS Duchess, the owners closed the yard without notice, creating 80% unemployment in the town.

George Orwell, en route to Wigan pier, watched women and children on a slag heap “scrabbling with their hands in the damp dirt and picking out lumps of coal the size of an egg or smaller”.

“Meanwhile,” he wrote, “all around, as far as the eye can see, are the slag heaps and hoisting gear of collieries, and not one of those collieries can sell all the coal it is capable of producing.”

Yet, however searing the experience of the depression for a generation, Britain got off relatively lightly. The eye of the storm, then as now, was in America. Between the Wall Street crash of October 1929 and the end of 1933, 9,000 US banks failed. The economy shrank by 33%, an unprecedented slump in peacetime. Britain’s economy, along with others in Europe, dropped by a relatively modest 5%-6%. In Germany it suited Hitler’s political ends to call it “the Wall Street Depression”.

That was not how Herbert Hoover, America’s beleaguered president, saw it, insisting that “the European disease had contaminated the United States”. Americans faced not just unemployment but starvation and poverty, becoming economic refugees in their own country, as John Steinbeck memorably described in the great migration on Route 66 from the Oklahoma dust bowl to California.

“[Route] 66 is the path of a people in flight,” he wrote, “refugees from dust and shrinking land, from the thunder of tractors and shrinking ownership, from the desert’s slow northward invasion, from the twisting winds that howl up out of Texas, from the floods that bring no richness to the land and steal what richness is there.”

How did it happen and what are the similarities with the crisis of 2008?

The Great Depression was an economic crisis built out of a global financial crisis, not only the 1929 Wall Street crash but also the powerful shockwaves that knocked the international monetary system off its axis in 1931.

The failure of Credit-Anstalt, Austria’s biggest bank, produced something akin to the current scramble by banks to hoard cash. Sir Montagu Norman, the Bank of England governor, had to shore up Lazard’s, one of the City’s most blue-blooded merchant banks. Panic spread.

“All over Europe, banks rushed to safeguard their assets,” writes Selwyn Parker in a new book, The Great Crash, published by Piatkus. “If they could, foreign depositors withdrew funds from Austrian and European institutions, albeit too late in many cases.

“In a bid to shore up the public finances, a panicking Austrian government blocked all but essential gold and foreign exchange transactions, locking £300m of foreign deposits inside its borders. Just as had already occurred in the United States, Europe was starting to hoard capital. The fire was spreading.”

Every country looked after itself. Britain led the departure from the gold standard, not only devaluing the pound but also precipitating the collapse of the international monetary framework that had held the global economy together.

Washington had already passed the Smoot-Hawley Tariff Act, adding protectionism to the down-draught facing the world economy. Governments, then as now, stepped in, with Roosevelt’s New Deal, Hitler’s autobahns, and public works programmes in Britain. A degree of prosperity returned to some parts of some countries. House-building and a consumer boom brought Britain’s south back to life.

But for many, the miseries of the Great Depression lingered until the 1950s. The old certainties were gone. The financial system had to be torn up and recreated and it took time. And it was painful and disruptive.

Could it happen again? The man who can most lay claim to having seen the present financial crisis coming, and warned about it, is Bill White, former economic adviser to the Bank for International Settlements (BIS), the Basel-based central bankers’ bank.

White – a genial Canadian who spent time at the Bank of England as well as more than 20 years with his own country’s central bank – joined the BIS in the mid1990s. Almost immediately he and his colleagues began to be worried about what was happening. Global stock markets, in particular, appeared to be too strong in relation to underlying economic developments, and property prices were soon to follow.

It may have been a time of low inflation but it was also a time of strongly rising optimism, reflected in soaring share prices – “the Roaring Nineties” – and increased risk-taking by the banks.

Fortunately, it seemed, policy-makers had got the message. White and his colleagues were relieved when, in 1996, Alan Greenspan, then the powerful chairman of the Federal Reserve, America’s central bank, began singing from their hymn sheet. Famously, Greenspan warned of “irrational exuberance” that had “unduly escalated asset values”. These, he warned, could become “subject to unexpected and prolonged contractions as they have in Japan over the past decade”.

The bursting of Japan’s “bubble economy” in the late 1980s was the nearest modern equivalent to the depression era. An economy that had been bounding ahead and was tipped in the 1980s to challenge America for global economic dominance suddenly hit the buffers.

Tumbling property and share prices destroyed Japanese wealth, leading to three recessions in the space of little more than a decade. The big difference was that, thanks to the four decades of rising prosperity that had preceded the downturn, there was relatively little evidence of 1930s-style distress in modern Japan.

Greenspan appeared to be aware of the danger. But White watched with alarm as, each time the debt bubble threatened to burst, the Fed chairman and his fellow central bankers around the world, rather than accepting a temporary downturn in their economies, pumped up the bubble even more by cutting interest rates.

“What amazed me was how each time they managed to rejuvenate the system by reducing interest rates,” he said last week. “But in the end, if the fundamental position is that there is too much credit in the system, something has to give.”

The crunch of 1998, when financial crises in Asia, Russia and the hedge fund industry came together, was met with lower interest rates. So was the bursting of the dotcom bubble in 2000 and the crisis of confidence that followed the 9/11 attacks on America. When global share prices tumbled and economies weakened in the run-up to the Iraq war, central banks cut interest rates again: the Federal Reserve to just 1%, the Bank of England to a 50-year low of 3.5%.

Something, as White says, had to give. In June last year, two months before the present global financial crisis broke into the open with devastating effect, White warned in the BIS’s annual report that, just as “no one foresaw the Great Depression of the 1930s”, so it was possible that mainstream economic opinion was understating the dangers from toxic debt.

Nobody knew where all the bad loans were buried and there was a “high probability” of large losses.

It was a common view that “busts” could be swiftly tackled by central banks cutting interest rates, White noted. But just because that had worked in the recent past did not mean it would in the future.

Japan had cut interest rates when its bubble burst, as did America in 1930, but with limited effect. Sometimes the downward forces are just so big that even ultra-low interest rates – zero in Japan’s case – will not do the trick.

White’s views were prescient but were ignored. Parker, writing his book on the Great Crash and its consequences, questioned many senior bankers about parallels with the 1930s “but they didn’t see it at all”.

The closest parallel with that era, he thinks, has come in the past few weeks with a “domino” series of events, including the US government’s rescue of Fannie Mae and Freddie Mac, the failure of Lehman Brothers, the forced merger of Merrill Lynch, the rescue of HBOS and nationalisation of Bradford & Bingley, the bailouts of the European banks Fortis and Dexia and the struggles over America’s $700 billion “troubled asset relief programme”.

“It is when the unthinkable becomes routine that the parallels become strongest,” he says. “That happened in the early 1930s and it has happened time and again in the past two to three weeks.”

Nick Crafts, a professor at Warwick University, is one of Britain’s most distinguished economic historians. Banking crises, he says, are an ever-present risk that typically result from weak regulation.

After the banking collapse of the early 1930s, the Roosevelt administration’s eventual response was a “bank holiday”: the introduction of Federal Deposit Insurance (just as Ireland last week guaranteed all its banks’ deposits), the re-regulation of the banking system and its recapitalisation with taxpayers’ money.

“Until very recently I would have definitely said yes to the question of whether we can avoid a repeat of the Great Depression,” Crafts says. “The trouble is that these things can go horribly nonlinear.”

What he means is that initial problems in the banking sector can trigger reactions throughout the economy. An initial drop in the supply of credit spooks businesses and consumers and makes them draw in their horns. Research in recent years has uncovered a typical drop of 6% in gross domestic product as a result of a banking crisis – equivalent to the depression-era fall in Britain’s GDP.

George Magnus, a veteran City economist with UBS, sees this financial crisis as a classic “Minsky moment”, as described by Hyman Minsky, an American economist who died in the year Greenspan first warned of irrational exuberance.

A Minsky moment occurs when investors reach the point of having taken on so much risk that the returns generated on their assets are no longer enough to pay off or even service the debts they have taken on to acquire them. When that happens, lenders call in their loans and investors are forced into a fire sale of their assets.

As Magnus puts it: “For me a Minsky moment is the point at which normal lending and borrowing behaviour is interrupted or compromised such that it threatens systemic risk and leads directly to the intervention of the central bank, whose function is to restore normality and ensure that sound creditors and borrowers are not sucked into a maelstrom of credit retrenchment.”

The worrying thing about the present situation, he says, is that normal lending behaviour has stopped, affecting businesses and individuals throughout the economy. “It wasn’t the stock market crash that did the damage in the 1930s,” he says. “It was the banking collapse.”

What would a modern-day depression look like? As Japan has discovered over nearly two decades, a long period of negligible economic growth and rising unemployment is not the same now as it was in the 1930s. Welfare safety nets are in place, although they can have a devastating effect on government finances.

Britain went through a long period of rising mass unemployment in the 1970s and 1980s and suffered three big recessions between 1973 and . It may not have been a depression, but at times, particularly in the 1970s and early 1980s, it felt like one.

The structure of the economy has changed. No longer would a prolonged downturn mean men on street corners in industrial towns smoking Woodbines, or marches to London from the northeast of England. Modern, service-based economies show their pain more discreetly.

A depression, though, if it followed anything like the 1930s pattern, would be accompanied by deflation – falling prices. That, given the high inflation Britain is currently experiencing – the rate on the government’s measure is set to hit a new high of 5% this month – sounds like good news. But the combination of high levels of company and household debt and falling prices is potentially very dangerous.

Falling prices would raise the “real” level of that debt, making the true amount that people and businesses have to pay off larger. Faced with stagnant or falling incomes, weak profits and high unemployment, many would be forced to default. What started off as a financial crisis for the banking system would become one where the economic feedback effects were dangerous and uncontrollable.

So far we have merely seen the early stages of what could be a prolonged credit-induced downturn, but the effects are already dramatic. The number of new mortgages being granted has dropped by 70% over a year, bigger than the cumulative four-year fall in the housing recession of the early 1990s. On the measures produced by the Halifax and Nationwide, house prices are falling faster now than then.

Before now Britain had experienced only two periods of big house price falls: in the 1930s and the early 1990s. The economy suffered its longest postwar recession in the early 1990s but the banks came through it relatively unscathed.

CAN a modern-day depression be avoid-ed? This week the International Monetary Fund and World Bank will hold their annual meetings in Washington. Ahead of that meeting, the IMF issued research on Thursday emphasising the risks.

The IMF – whose managing director, Dominique Strauss-Kahn, has already warned that this is the worst financial shock since the Great Depression – said it was alarmed by the intensification of the banking crisis.

“The current financial market meltdown being witnessed in the United States and other advanced economies will likely lead to longer and deeper economic downturns in some of these countries,” it said.

Officials pointed out that the current combination of events was unprecedented, but that there was no known precedent in history of countries suffering banking system failures without serious economic consequences later.

If knowing the nature of the problem is part of the way to finding a solution, though, the global economy is well placed. Ben Bernanke, Greenspan’s successor at the Fed, has devoted a life of study to examining and researching the causes of the Great Depression. Understanding it, he has written, is the “holy grail” of economics.

He knows, from his research, that what caused the problem in the early 1930s was the fact that the normal credit channels closed down; and, as Milton Friedman first pointed out, the effect of massive bank failures was a devastating collapse in the money supply.

That is why Bernanke put his weight behind Hank Paulson’s $700 billion bailout plan for the banks and it is why, if he is honest, he will know that taxpayers will need to do even more.

“When you get to the stage that investors have disengaged from the market, governments have to step in,” says George Magnus of UBS. “That means we will have to have capital injections by the government and a wider use of government guarantees.”

The lesson for Bernanke is not just what got America into the Great Depression, but what got it out. By the end of the process, taxpayers owned a big chunk of the US banking system. That will probably have to happen again – beyond the $700 billion bailout – and the sooner it does, the better the chance of avoiding depression.

Most economists do not like predicting a repeat of the Great Depression, even those who have warned of the dangers.

“We’ve got to start by cleaning things up as best we can, and it isn’t going to be easy,” says Bill White. “What we have learnt is that it gets harder and harder to clean up afterwards. This is a time when we have to go to back to the prewar literature.”

Robert Shiller, a Yale University professor who took Greenspan’s “irrational exuberance” as the title for one of his books, has also consistently warned of the dangers.

“It is impossible to predict the nature and extent of the damage that the current economic and social dysphoria and disorder will create,” Shiller writes now. “But a good part of it will likely be measured in slower economic growth for years to come. We may experience several years of a bad economy.”

What applies to America may also be true here. Forecasters have already pushed out predictions of recovery to 2010 or 2011. After 16 years of economic growth, it looks like at least two to three years of cold turkey. ‘

A simple repeat of the recession of the early 1990s would see two years of a shrinking economy, a doubling of unemployment, a fall of more than a third in house prices, after inflation, and the failure of tens of thousands of small businesses. When the clouds lifted, taxpayers would be hit with higher taxes as the government scrambled to fill the black hole in the public finances.

A depression would be worse. After the initial slide into recession, the only light at the end of the tunnel would be turned down very low. Rather than bouncing back, the economy could stay in the doldrums for years, with mass unemployment again becoming the norm.

None of this is inevitable but the dangers have increased. Modern economies run on credit, much more so than in the 1930s. If the flow of credit stops, it is the economic equivalent of switching off the power supply. Nothing works. It is vital that this supply is turned on again.

Fortunately it is not all grim for the global economy. In the 1930s America, Britain and Europe were its mainstays. Now the world has become “multipolar”.

The International Monetary Fund, despite its deep worries about the financial crisis, will still predict this week that world economic growth this year and next will be not far short of 4%, nearly double the usual definition of global recession.

The G7 countries – America, Britain, Japan, Germany, France, Italy and Canada – are hamstrung by the credit crisis and will not grow much, if at all.

However, the “emerging” world, led by China, is still strong. China is slowing, but from a growth rate of 11% to something like 9%. Economies such as India, Russia and Brazil still have plenty of momentum, despite recession or near recession in the West.

We may look back on this period as the moment when China took on the economic baton. Or, at least, when a communist country that had embraced its own controlled form of capitalism kept the world afloat.

That, viewed from the glass towers of Wall Street or Canary Wharf, where the risk-taking went much too far, would be the ultimate irony.

From The Sunday Times, October 5 2008

Writing about the economy these days is a bit like being in an HG Wells novel. Everything is compressed in time. The speed of events is dizzying. We are in an economic time machine.

I wrote here on the last day of August that the case for delaying a cut in Bank rate come October could be looking very thin. Then we had a series of speeches from the Bank of England's decision-makers showing they were aware of the downside risks but were in no mood to rush things.

Now October has come and the debate is not about whether the Bank's monetary policy committee (MPC) should cut this week but by how much. The economic data have been poor, particularly the purchasing managers' surveys that provide the best snap assessment of output growth.

Official figures show the service sector has ground to a halt, with no growth in the three months to July, and only business and finance showing expansion of the five components of the index. Even that cannot last, as a sharp drop in the purchasing managers' index for services in September showed. Marks & Spencer and John Lewis, bellwethers both, are seeing sales drop.

More importantly, and this is why time has become such a factor, the disarray in the credit and money markets that swept in last month means pressure is intense on the Bank to do something, anything, to try to alleviate the danger.

That is certainly the view of the "shadow" MPC, which meets under the auspices of the Institute of Economic Affairs. Members of the shadow committee have seen a few crises and recessions in their time. They are, to borrow from the current debate between the political parties, anything but novices.

Their latest deliberations, in anticipation of this Thursday's decision by the actual MPC, show that they have come within a whisker of urging the Bank to wheel out the big gun and cut by half a point to 4.5%. Four of the shadows, Ruth Lea, Gordon Pepper, Patrick Minford and Peter Warburton, vote for this move.

Three others, Tim Congdon, John Greenwood and Kent Matthews, say the Bank should stick to its normal size of rate change and just cut by a quarter point. The two remaining members, David B Smith and Peter Spencer, opt for no change.

The four "half-pointers" make a good case of it. Lea says recession has taken over from inflation as the main risk facing the economy and that events in the financial markets which "defy hyperbole" require a radical response.

Pepper, a veteran monetarist economist who influenced Margaret Thatcher, is alarmed by a collapse in the growth of the money supply and powerful evidence of debt deflation. He admits to considering an immediate full-point rate cut, followed by two quick half-point reductions.

Minford, who has called for aggressive rate cuts for some time, sees this as the last chance to avoid a sharp recession in Britain in 2009. Warburton says the credit system has "atrophied" and also believes the deep downside risks he has been warning of for some time are now in plain view. Their full contributions, as well as those of the other members, can be read on my website (www.economicsuk.com).

What will the Bank do? Though a head of steam has built up, these things are never a done deal. Not until the Bank's governor, Mervyn King, calls for a vote on Thursday morning can we be sure of the outcome.

There will be voices arguing for delay on presentational grounds. On October 14, just a few days after this week's vote, September inflation figures will be published and are expected to show the rate rising to a high of 5%. The Bank will have that information this week and most MPC members would have preferred to wait until after inflation has peaked before cutting again.

There is also the possibility the Bank will, in what would be a searing admission, own up to its own impotence, acknowledging that a cut in rates might not do anything. Keynes identified the circumstances in the 1930s when cutting rates would be like pushing on a piece of string. Or to use a seasonal analogy, sweeping up leaves only to have them blown back in your face.

Some would say that for the Bank to cut at this juncture would be the equivalent of politicians desperate to show they are doing something: "Now is the time for a really stupid and futile gesture."

There is no doubt that the days when a deft touch on the tiller by the Bank of England sent powerful shockwaves through the economy are long gone.

The extreme weakness of mortgage lending, with virtually no net increase in August, shows how the capacity of the system to lend has been severely curtailed, even before September's financial storms.

The Bank's own credit-conditions survey, out last week, confirmed that banks had cut back aggressively on credit provision and expected to continue to do so. A shortage of funding, newly cautious lending policies and a drop in credit demand from recession-spooked borrowers are all contributing to a slump in the supply of credit into the economy. Money-market strains have been intense, pushing three-month Libor closer to 7% than 5%.

To me, this argues for more activism on policy, not less. The fact that the avenues through which monetary policy operates are clogged means that the Bank will have to turn on the siren to get through.

So this is a time not for futile gestures but bold ones. I'll repeat what I said a couple of weeks ago and say I would cut by half a point this week. Many others now agree. Whether the Bank does so, we shall see.

PS An unusually large number of readers responded to last week's column, pointing out that this "bust" was not preceded by a strong economic boom. The confusion arose, I think, because most people find it hard to distinguish an economic or spending boom from a boom in asset prices, in Britain's case, housing.

There is a debate about whether the MPC should have taken asset prices more into account in setting rates, though Steve Nickell, an MPC member then, argued it would have taken much higher rates — recessionary rates — to have done the trick. The idea that the Bank was fooled into inaction by the target switch is, however, a myth.

From The Sunday Times, October 5 2008

You know something big is happening when people who do not usually get involved in the economic and financial debate start chipping in, whether they are archbishops, bemused Newsnight presenters or politicians of every hue.

I would include taxi drivers in the list but in my experience they are always moaning about the economy.

Three themes seem to be emerging from this. The first is that governments should not bail out bankers for their irresponsible behaviour. There is nothing wrong with such a view. Indeed, the reluctance of Mervyn King, the Bank of England governor, to do anything when the credit crisis broke last summer was based on just such "moral hazard" concerns.

But things have moved on and there is a big difference between preserving the system and bailing out undeserving bankers, as no less an economist than President George Bush pointed out in his address to the nation.

There is also a fundamental difference between using hundreds of billions of government money to preserve the banking system and using it to save car factories or increasing aid to Africa, whatever unions and development charities say.

If the banking system goes, everything else does too.

The second theme is "never again". Everybody wants to lock the stable door after the horse of irresponsible banking behaviour has bolted. That means, according to one of Gordon Brown's five principles last week, "no members of a bank's board should be able to say they did not understand the risks they were running".

That sounds eminently sensible, except when you start to think about it. Is every member of a bank board expected to know the state of each trader's book at the end of the day?

Does the cabinet know precisely what risks every civil servant is taking with information on individuals' personal details or taxpayers' money? Boards can set out broad principles and discourage excessive risk-taking but cannot know the state of every contract.

Rowan Williams, the archbishop of Canterbury, appeared to be advocating an extreme version of the new era with his attack on short-sellers but also on those who are engaged in "trading the debts of others". His article is worth reading (archbishopofcanter bury.org) but his views are unrealistic, given that trading debt is what financial markets do. Things will change, and are changing fast, but we will still need markets.

The third theme, though, is one I want to concentrate on. It is that while bankers are the main villains of the piece, we are all as much to blame for being greedy. If it was not for people wanting to borrow, the banks would not have lent. So we, too, deserve to pay the price for that greed.

The extreme version of this, staying with religion, is provided by the nearest thing in politics to the grim reaper — Vince Cable, the Liberal Democrat shadow chancellor. He has been warning for years that Britain was on a debt-fuelled binge.

His diagnosis, that the government should have restrained bank lending and the Bank of England taken house prices into account in setting interest rates, does not add up to much. As the Thatcher government discovered two decades ago, it is hard to impose controls on bank lending in the absence of exchange controls because there is so much cross-border leakage.

As for the Bank, house prices were formally part of the target inflation measure until 2003 and have hardly been ignored by the monetary policy committee (MPC) since. Given the inherent volatility of house prices, as well as uncertainty over the data, replacing the inflation target with a house-price target would make no sense at all.

But the point remains. Have we, through borrowing, lived high on the hog for too long, so that boom must inevitably be followed by bust?

In the run-up to the last recession, in the early 1990s, the economy was character- ised by runaway growth in consumer spending and soaring wages. At its peak, in 1988, spending was rising by more than 8% in real terms. Average earnings growth moved into double figures. That really was an extreme overheating boom of the kind seen in the early 1970s, just ahead of the first of the big post-war recessions.

This time, however, one striking but unappreciated feature of the economy has been the absence of a consumer boom. Over the past five years the average annual rise in consumer spending has been a very modest 2.4%. The last time consumer spending was even remotely strong was more than four years ago, when it rose by 3.6% between mid 2003 and mid 2004.

What is true of spending is also true of wages, which remain very well behaved in the face of provocation from high inflation. Earnings growth is a modest 3.5%. John Philpott, chief economist at the Chartered Institute of Personnel and Development, says that in contrast to past episodes when recession and rising unemployment were needed to cool an overheated labour market, this is not the case now.

Some will say, of course, that even if there is no boom in the spending and earnings numbers, there was in the housing market, at least as far as prices were concerned, and that is what we are all paying for. If we look across the Channel, however, it is easy to see that even this explanation does not take us too far.

Economies that did not have a house-price boom, and even more muted economic growth than Britain — and not even a hint of consumer-spending strength — are suffering. A "technical" eurozone recession, in the second and third quarters, looks likely.

It may mean that Europe merely got there a quarter ahead of Britain, though we shall see what revised figures for gross domestic product bring this week. But for the big economies of the eurozone, even more than Britain, there was no boom. There may be a bit of a bust, however.

John Hawksworth of Price Waterhouse Coopers has had a look at what the next few years might bring for consumer spending. In the early 1990s there was a peak-to-trough fall of 3.5% in consumer spending.

Because of the more modest rises in spending in recent years, a smaller fall is likely this time, says Hawksworth. The good news is that, in his main scenario, spending will fall by only 0.3% next year. The bad news, perhaps, is that it will be subdued for some time after, rising by an average of only 1% a year through to 2012.

Much depends, of course, on financial rescues and their interaction with the wider economy. This is a financial recession, rather than a conventional one preceded by an economic boom. The weaker the economy, however, the harder it will be to fix the financial system.

PS: While central banks are taking drastic action to provide liquidity to the money markets, none of the big ones has yet blinked and cut interest rates. Could the Bank of England be first?

The markets think a cut could come as soon as next month, though most economists think November — when the Bank publishes its next inflation report — more likely. As long as three-month money, currently well above 6%, is so divorced from Bank rate, there may be no point in rushing it.

From The Sunday Times, September 28 2008

In America, it seems, the cycle comes round every two decades. One of the first acts of George Bush Sr when he became president in 1989 was to announce a rescue of America’s mortgage lenders, the savings and loans institutions.

The blueprint for that rescue, which set up a fund, the Resolution Trust Corporation (RTC), to bail out irresponsible lenders, was dusted off last week by his son’s Treasury secretary, Hank Paulson.

The names are different and so is the scale. “RTC II” - unveiled at the height of last week’s turbulence - is intended to rescue the US financial system. If it works, as its predecessor did, it will be seen as a triumph of pragmatism - a Republican government again showing its willingness to intervene when the market fails.

If it does not, then the comparisons will be to another US president and era: Herbert Hoover and the Great Depression.

Even hardened City professionals were shaken by the scale of the carnage last week as the world’s financial system teetered on the brink.

One economist, Ian Shepherdson of the firm High Frequency Economics, likened it to a plague of locusts cutting a swathe through the financial system. After devouring one target, they moved on to the next.

The swarm quickly crossed the Atlantic. Had it succeeded in forcing the bankruptcy or nationalisation of HBOS - Halifax Bank of Scotland - then not only would it have moved on to other UK banks but the economic consequences would have been disastrous.

Banks are not like other businesses. The closure of a big car factory hits its workers and suppliers; the failure of any bank of significant size hits the whole economy.

In recent months much of the attention of the Treasury, the Bank of England and the Financial Services Authority, the City regulator, and of their overseas counterparts, has been on getting the banking system through the crisis. Saving the system had to come first; saving the economy would follow.

How has it come to this, and what will be the consequences? Vince Cable, the Liberal Democrat Treasury spokesman, suggested at his party conference last week that this was a problem made in Britain. “New Labour incubated a culture of financial gambling with other people’s money which has contributed to the collapse of trust in financial institutions,” he said. “It also bred a dangerous dependence on debt.”

Debt has increased and the housing market is in trouble, but on their own they could not have caused the kind of problems that HBOS ran into last week. Britain’s mortgage lenders survived the housing crash of the early 1990s.

Most people know the crisis resulted from dodgy “sub-prime” mortgage loans to low-income borrowers in America. Even these loans, however, would not have been enough on their own to cause the difficulties. Direct losses on them, after repossessed properties are sold off, will probably be no more than $200 billion (£109 billion). That is a lot of money, but small in relation to the $14.3 trillion US economy.

A trillion dollars ($1,000 billion) is serious money. That is the likely extent of the losses on the so-called derivatives linked to sub-prime mortgages. These complicated financial instruments, created by investment banks using sub-prime mortgages as a base, may have generated losses of five times those on the original loans.

The reason this has come to a head can be found in a theory developed by George Akerlof, the American economist. Nearly 40 years ago he published a paper called The Market for Lemons. A lemon is something that people think is going to be trouble and, as a result, are extremely wary about buying.

Akerlof took the example of used cars. Why would anybody sell an apparently faultless car? Perhaps because they knew that the gearbox was about to seize and the engine fall out. Such fears might be unfounded, but who would want to take that risk?

The result of what Akerlof called “asymmetry” of information - sellers know more than buyers - would be that the prices of all used cars, good and bad, would be pushed lower. Only if people had a guarantee that their fears were unfounded would they be prepared to pay a fair price.

In the past few days we have seen an extreme version of Akerlof’s theory at work. It started, bizarrely, with the US government’s rescue of Fannie Mae and Freddie Mac, the bulwarks of America’s mortgage market. After an initial period of calm, buyers of bank shares decided the institutions that were most exposed to the derivative instruments linked to that market were “lemons”.

The biggest lemons, it seemed, were the Wall Street investment banks. They, unlike the big commercial banks, did not have the capital, the financial muscle, to fall back on. Not only did investors take fright but so did everybody dealing with the banks, including other banks. Investment banks rely on being able to deal with other institutions. When they can’t, they are sunk.

Lehman Brothers was sunk last weekend and Merrill Lynch lost its battle to survive as an independent bank. HBOS was seen as the biggest lemon in Britain because of its reliance on the City’s “wholesale”, or inter-bank, money markets and its exposure to falling house prices, as a result of being the country’s biggest mortgage lender.

When nobody will buy a used car at a decent price, the response of dealers is to offer a guarantee. When confidence in the banking system is shattered, only governments can offer such a guarantee.

That was the thinking behind RTC II, sketched out by Paulson on Thursday night. Although the details are still being hammered out, the outlines are clear. The US government will set up a pot worth $700 billion to buy banks’ failed assets and provide guarantees to money market funds.

Will it work? George Magnus, the veteran international economist at UBS, the Swiss bank, sees it as the “beginning of the end” of the financial turmoil. World stock markets appeared to agree and shares leapt on Friday. But Magnus also warned that we were nowhere near the end of the process in which the banks would “deleverage” - cut back on lending - and in which assets, including houses, would carry on falling in price.

America’s actions may have stopped the panic but they do not mean that the heady days before the credit crisis broke in August last year will return.

When banks failed on a grand scale in the 1930s - about a third of US banks folded - the Great Depression ensued. The consequences of the banks reining back this time may be something like the “new austerity”, a long period in which the economy grows weakly if at all. Even before the events of the past few days, economists were gloomy about the outlook, predicting 1.2% growth this year and just 0.5% next. Those numbers could prove optimistic.

It will mean higher unemployment, far beyond the direct job losses resulting from the City’s woes and the Lloyds-HBOS merger. The claimant count, now 900,000, rose by 32,500 last month. At that rate it will hit 1.4m at the end of 2009. The monthly rises may get worse over the winter. For Alistair Darling, faced this week with the most testing party conference speech for a chancellor in years, an uncomfortable job will grow even stickier.

Next month he will publish his prebudget report and be forced to cut his growth projections sharply, while acknowledging that the government has been forced into tens of billions of extra borrowing. In March he said public borrowing would drop to £38 billion next year. Instead, say researchers at the Centre for Economics and Business Research and Capital Economics, it will rise to between £90 billion and £100 billion over the next two years.

Economists say that Darling, or his successor, will have no option but to raise taxes or cut public spending. The National Institute of Economic and Social Research says he will have the choice between a 3% cut in public spending and raising taxes by the equivalent of 5p in the pound. The effects of current events will last for five to six years, it says.

“There is a choice to be made between sticking to present spending plans and raising taxes, or changing those plans,” said Ray Barrell, senior research fellow at the institute. “The world is a different place.”

Beyond the immediate crisis, the prospect is of only a slow economic recovery.The banks will remember this bloodletting and panic for years.

That will make them more reluctant to lend than we have been used to in the past 15 years. Lending feast has been replaced by borrowing famine, and that famine will last.

People in Britain have been accustomed to easy money. Over the past year they have seen the credit taps being turned down and it has hurt. Last week’s crisis tells us that is not going to change for a long time. Combine that with the likelihood of higher taxes and slower growth in government spending and it does not look like a comfortable picture. Welcome to the new austerity.

From The Sunday Times, September 21 2008

At times like this you need the still quite voice of calm, a little reflection and perspective. I would like to offer that, though after the seismic events of the past few days, it is harder than usual.

When Britain’s biggest mortgage lender can be thrust into the waiting arms of a rival by a crisis of market confidence, America has nationalised one of the world’s biggest insurance companies and the chances are diminishing fast of any investment bank surviving the carnage as an independent entity, we are talking about world-changing financial events.

If Britain and other advanced economies were facing a mild “technical” recession before, it would seem that now something deeper and nastier is in store. This looks like one of those “if the facts change, I change my mind” series of events, to quote Keynes, who knew a bit about times of dramatic economic change.

There have been several phases to the crunch. The first was in August and September of last year and claimed the scalp of Northern Rock, after which things calmed down and optimism briefly returned.

The second phase came at the end of last year, when a scramble by banks for liquidity resulted in another sharp rise in money-market interest rates, forcing central banks to pump money into the markets, as they did again last week.

Calm returned again in the early part of this year but, again, it was a false dawn. In March, not only did Bear Stearns have to be helped into the arms of JP Morgan but Britain’s lenders, realising the crunch was not going away, began to clamp down hard, particularly on mortgages. Finance suddenly became very scarce. This gave us the biggest slump in mortgage lending on record.

Until a fortnight ago it was possible to detect signs that the third phase was drawing to an end. The strains in the money markets had eased noticeably and rates available to borrowers had begun to fall.

Then, of course, came the American government’s rescue of Fannie Mae and Fred-die Mac, initially but only briefly regarded as good news, followed last weekend by Lehman’s bankruptcy, the forced sale of Merrill, the AIG rescue, the stock-market run that forced HBOS into the arms of Lloyds TSB and the pressure on Morgan Stanley and Goldman Sachs, only eased by news of the US crisis plan on Thursday night.

There are two ways of looking at this. One is that the nasty third phase of the crunch has come to an end, only to give way to an even nastier fourth phase, in which credit will be even more expensive and harder to obtain.

If that is the case, then consensus forecasts for the economy, 1.2% growth this year, 0.5% in 2009, are going to be optimistic. A ratcheting up of the credit crunch at this stage will mean an outright recession not a technical one, something we have not seen since the 1990s.

The other possibility is that the fast-paced sequence of events of recent days will prove cathartic, and signal the beginning of the end of the financial phase of the crunch. The US government rescue plan has improved the chances of this being the case.

As a young economist I was taught an important rule of thumb by my then boss, the late James Morrell, which is that financial events happen quickly but real economic changes take time.

In one respect, that is reassuring. Economies do not fall off a cliff as stock markets sometimes do. In another respect it is disturbing, for it means that the consequences of current events could be with us for years to come.

Either way, there is something lacking in the response to this. Growth is either going to be very weak or worse. Inflation should peak soon and then fall, as noted by Bank of England governor Mervyn King last week in his letter to the chancellor. Surely, interest rates have to be cut and, if necessary, cut hard?

The Bank of England cut rates aggressively in the wake of the September 11 attacks on America seven years ago. What we have seen in recent days is a kind of financial 9/11, to which a rate-cutting response is even more appropriate. The upside risks to growth or the housing market are minimal. Unemployment is rising, up 32,500 last month on the claimant count and by 81,000 over the latest three months according to the Labour Force Survey.

This is what worries the monetary policy committee’s (MPC’s) David Blanchflower who, alone among his colleagues, voted for a half-point cut in Bank rate earlier this month, and I think he is right on this one.

The banking system is vital because without it the economy stops functioning, which is why it was right to waive competition concerns over the Lloyds-HBOS deal. But what are the direct consequences for the economy of this intense consolidation in financial services we are seeing?

Merrill Lynch will always have a unique place in the City of London’s history. More than two decades ago, rumours emerged that “the Thundering Herd” intended to take full advantage of the Big Bang liberali-sation of the Square Mile and was waving a very large chequebook around. It duly arrived along with its American and international rivals, and a new era was born. Now the Thundering Herd has been cor-ralled into Bank of America.

Lehman Brothers, resplendent until last weekend in its gleaming European HQ in Canary Wharf, is no more. The City, by which I also mean its Docklands branch, will be a very different place.

The other day I heard an eminent businessman on the radio suggesting the City accounted for perhaps 20% of Britain’s economy. He was not even close. According to International Financial Services London, using official statistics, the financial sector accounts for just under 9% of the economy, measured by gross value-added.

The City’s share of that is no more than half, perhaps 4% on a generous estimate. That is consistent with the City’s small share of employment, 300,000 out of total employment of 30m, or 1%.

But while financial services are not as big or important as often supposed, the sector’s growth rate in recent years has been stunning. Over the past five years the economy has expanded by 13%, while financial services have grown by almost 50%. The party may now be over but it was a hell of a one while it lasted.

The question now is whether we will see a permanently smaller City or one that is going through one of its periodic and painful bouts of evolution, of the kind seen in the 1990-92 recession, 1994, 1997-98 and the early part of this century. It looks worse than three of those, though not necessarily the early 1990s. Either way, for the time being, a shrinking City will weigh down on an already weak economy.

PS: Mervyn King has suggested in the past that if you want a cheerier picture of the economy, you should get out of London. He has a point, with the City and Canary Wharf being scary places right now.

Financial engineering is now public enemy No 1. Could real engineering and areas like the Black Country make a comeback?

From The Sunday Times, September 21 2008

On Tuesday morning at 10.30, an hour after the release of the official inflation figures, what is becoming a familiar ritual will unfold. Mervyn King will write to Alistair Darling explaining why inflation is so much above the official target.

He may say, as at the Commons Treasury committee last week: "Provided we do not impede the required adjustment, we will come through this temporary period and resume a path of normal economic growth with inflation close to target."

The chancellor will respond, saying he understands the Bank of England governor's difficulty, but has faith in his ability to get inflation back down.

These letters, available for all to read, are not in the Robert and Elizabeth Barrett Browning class but are an important part of the policy process. Tuesday's will be only the third in more than 11 years of Bank independence, and all three will have come in the latest 18 months.

The rules require a letter each time consumer price inflation rises above 3%, followed by another three months later if it stays there and so on. King's first letter, last year, said inflation would come down quickly and it did. He wrote in April and by July inflation was below the 2% target, though this was only a temporary respite.

His second, this June, predicted inflation would rise further, to "above 4%" in the second half, before it dropped back below 3%. He laid the blame on soaring energy and food prices.

What will he say this week? Inflation is rather higher than the Bank expected in June. This week's figure should show an August rate of 4.6% or 4.7%, with the prospect of 5% when the September numbers are published in a month.

The governor will point to sharp rises in utility bills, roughly 30% for gas and 15% electricity (compared with a regulatory cap of 5% and 2%, respectively, in France), and the pass-through from oil's summer peak of $147 a barrel. He will note food prices have continued to rise strongly, and in the official figures are up 13.7% over 12 months.

What he should also be able to say is that inflation is close to a peak. Though we will not know for sure for two to three months, a September inflation rate of 5% should be the summit, after which the rate will fall first gradually and then sharply.

That will be rather good news for state pensioners and others on benefits. Their annual uprating is based on September's inflation rate, though on the retail prices index rather than the CPI (consumer prices index) targeted by the Bank. By the time that uprating comes through next April, inflation should be dropping rapidly.

How can we be sure of that? Oil deserves a column in itself but I will wait until it breaks decisively below $100 a barrel. Last week Brent crude dipped below that level, with the main US-traded oil, West Texas intermediate, also falling, prompting a cut in production quotas by the Organisation of Petroleum Exporting Countries (Opec). We have to hope this attempt by the cartel to stop prices sinking below $100 fails.

Figures last week showed output price inflation — measuring manufacturers' price rises "at the factory gate" — fell from 10.3% to 9.7%, with core inflation sliding from 6.8% to 6.4%. Industry's material and fuel costs last month were 26% up on a year earlier but this was down from the peak in June, when there was a rise of almost 31%.

So pipeline inflation pressure is starting to ease. In addition, all six of the main energy companies have announced their big price rises, to take effect either in August or September. That means a higher inflation peak than King expected in June, but also an earlier one.

It is difficult to overstate the importance of inflation peaking soon and then falling. Sharply rising prices of essentials have a bigger direct impact on most families than restrictions on the availability of credit. Falling inflation will ease the squeeze on the growth in real incomes, though not by enough to offer retailers genuine Christmas cheer this year.

A monetary policy committee confident in its forecasts should have no qualms about cutting interest rates when inflation is high and rising, but that is not how it appears to work. It is no accident there has been no cut in Bank rate since before King's June letter. The last one was in April.

The Bank wants to be sure inflation is falling and that inflation expectations have not moved permanently away from the 2% target. Its own survey of such expectations, carried out by NOP, was published last week and contained mixed results.

The bad news was that people think inflation is 5.4%, the highest since the question was first asked in 1999, and above even the rise in the retail prices index (5%), let alone the CPI. Expectations are important, but mainly reflect what is happening now. As inflation falls, so will expectations.

The good news is that people expect lower inflation, 4.4%, over the next 12 months and that by a huge margin, 76% to 3%, are committed to low inflation, believing the economy will be weaker if it is allowed to take hold. Though Bank rate has fallen, people think by 63% to 7% that rates have risen. That is the credit crunch for you.

What are the risks that September will be a false peak and that inflation is more ingrained than the Bank believes? Sterling's fall from $2 to $1.75 deprives consumers of some of the benefit from the falling price of oil and commodities, which are denominated in dollars. Imported inflation is a danger, though weak demand should limit firms' ability to pass on higher import prices. Not only that, but China's inflation rate has dropped from 9% to below 5%.

Food prices are a risk, in the light of the dreadful summer and reports of very poor grain harvests in Britain. In general, though, such prices are set globally.

Finally, higher wages are a danger, not to inflation itself — we no longer think in terms of a wage-price spiral — but if they were to constrain the Bank from cutting rates. That would make King's adjustment even more painful. So far, settlements are remarkably subdued, which is good. They should remain so as unemployment rises. But with the unions getting restive the Bank will be watching.

PS: So who won the bizarre credit-crunch headline competition? First a detour. John Longley sent a collection of photos doing the rounds on the internet, including the Queen moonlighting at McDonald's and a Dragons' Den judge with a "golf sale" placard. I think they are mock-ups but you can never be sure. Andrew Zazzi was tempted by a £3.50 "all you can eat" Credit Crunch Brunch.

The prize of a copy of The Subprime Solution by Robert Shiller goes to David Griffiths. Apart from "Noel Gallagher untroubled by credit crunch woes" and "Credit crunch desperation could be costing motorists their health", I liked a simple headline for our times: "Estate agent turns to prayer to beat credit crunch".

From The Sunday Times, September 14 2008

Friendless, lonely, unloved. No, not the opening line of my misery memoirs but poor old sterling, which is looking sicklier than an old green pound note.

Since the credit crunch broke just over a year ago sterling has been one of the casualties. Its problems were disguised by the dollar being even sicker, so as recently as July you could still get two dollars to the pound, well above its "fair value" of closer to $1.60.

But the dollar has recovered amid rising optimism about the American economy. The tide has gone out on sterling and, to paraphrase leading investor Warren Buffett, it does not appear to have been wearing any bathing trunks and has dropped below $1.80.

Is this a good old-fashioned sterling crisis, the first under this Labour administration? If so, Gordon Brown's government will be belatedly following the pattern established by all its Labour predecessors.

The Tories have had fewer, though they can claim a couple of corkers, both of which involved Europe — the short-lived flirtation with the European currency "snake" in 1972 and the ERM (exchange rate mechanism) debacle of 1992.

This time, the pound has lost more than 10% against the dollar in a month, while its average value has fallen 16% since August last year. If this is new Labour's sterling crisis what will be the consequences?

Since autumn 1996 until last summer sterling was strong and stable. Early last year its average value was its strongest since the 1980s and it stood at a 26-year high against the dollar. Sterling benefited from big flows across the exchanges, into City markets or as a result of the takeover of British firms by foreign competitors.

What changed? The flows were sharply reduced. More importantly, Northern Rock, and queues of anxious depositors, shattered the impression of a well-regulated economy and banking system. International investors who subscribe to the Blink theory — first impressions count — took a look at the run on the Rock and took flight.

The Rock was the catalyst for a rerating, downwards, of sterling. It exposed shortcomings in the Bank of England, Financial Services Authority and Treasury. It coincided with a big increase in political risk in Britain, as viewed by the markets.

When Tony Blair was in charge, investors saw Britain as politically stable, boringly so. The decade-long saga of Brown versus Blair was entertaining but irrelevant.

Under Brown, in contrast, dealers have perceived a government persistently in trouble, particularly since "the election that never was" last autumn. When the government is in trouble, the currency is usually not too far behind.

Why, apart from the dollar, has the pound taken such a dive in the past few weeks? Bizarrely, to me at least, currency dealers are still taking at face value Alistair Darling's comments last weekend that the economic circumstances faced by Britain are the worst for 60 years.

Even after a week of nervous broadcast interviews from the chancellor meant to clarify things, the perception remains that he must know something we do not — and, in an unguarded moment on his remote Scottish hideaway, blurted it out.

That was not the case. I have found myself raging at the television at his inability to get over the message that, first, global challenges may be the toughest for 60 years but, second and more importantly, Britain is not facing the biggest downturn for 60 years, and nothing comparable with the recessions of the 1970s, 1980s or early 1990s.

The chancellor has found it hard to get that over, maintaining uncertainty. Mud sticks, particularly mud thrown at a currency by the man responsible for its stability.

Adding to sterling's woes has been deepening gloom over the economy, including a prediction from the Paris-based Organisation for Economic Co-operation and Development (OECD) that Britain will be the only G7 economy to experience recession this year.

Let's take a closer look at that forecast. The OECD deals in annualised growth rates and says the UK economy will decline at an annualised rate of 0.3% in this quarter and 0.4% in the fourth. The way we do the numbers — actual rather than annualised changes — it predicts a decline of 0.075% in the third quarter and 0.1% in the fourth. My colleague Irwin Stelzer says economists use decimal points to show they have a sense of humour, in which case the OECD is having a laugh. And there's more. The OECD got to its numbers by revising its model to give house prices a bigger role.

Moreover, we are doing better than Germany. Its economy declined by an annualised 2% in the second quarter, the OECD says, and is predicted to be flat in the third. Over the two quarters, the German economy will have declined more than the Paris body expects for Britain. The same is true for France and Italy.

Britain's growth in 2008 is projected at 1.2%, stronger than France, Italy and Canada and on a par with Japan. Britain faces challenges, and avoiding some quarters of declining gross domestic product presents an enormous challenge. But the label "hardest-hit in the G7" simply does not fit. The economics points to a further fall for sterling against the dollar but suggest its drop against the euro has been overdone.

Of course there is gloom. Halifax says house prices fell 1.8% last month and more than 12% on a year ago. If you believe those numbers it is easy to be pessimistic. But the broader evidence on the economy in recent days has been mildly encouraging. All three purchasing managers' surveys — for manufacturing, construction and services — were up in August, showing that so far the economy is not falling off a cliff. Those "weakest since 1966" August car sales should not trouble us much. Until the change in the number-plate system a few years ago, August was the busiest month of the year. Now it is one of the quietest.

David Miles, Morgan Stanley's chief UK economist, in a report entitled Pessimism Becomes Excessive, has it about right. Britain is due for a period of "negligible growth, rather than protracted falls in output".

For the dealing-room boys in white socks the pound has been a screaming sell. But these things pass. In the meantime, if it does not get out of hand, sterling's fall will help both in rebalancing the UK economy away from consumer spending and getting us through these difficult global challenges. And it won't prevent the next move in interest rates from being down.

PS: I will report back on bizarre credit-crunch headlines, and a new strand — imaginative use of the crunch in advertising — soon. Keep them coming. Meanwhile, another thought.

Treasury officials are doing their best to limit the damage. The stamp-duty "giveaway" was probably the smallest they could get away with. They know they will be around to pick up the pieces.

From The Sunday Times, September 7 2008

There is no doubt that many sectors of the economy could do with the tonic of an interest-rate cut. Housebuilders, anxiously awaiting Gordon Brown's autumn rescue package (and probably prepared for disappointment), would love it.

So would Alistair "austerity" Darling - apparently reconciled to the biggest downturn in the postwar period - though I would be surprised to see that reflected in next month's Treasury forecasts.

A cut in rates would also be welcomed by retailers, manufacturers and just about every business except corporate undertakers. But how could the Bank of England's monetary policy committee (MPC) justify it? Growth may have halted but inflation has yet to peak.

Sterling, caught between seismic shifts in the dollar-euro exchange rate, looks shaky. Last week its average value dropped to a 12-year low, and the $2 pound is becoming a fading memory, with the rate down in the low $1.80s. Would not lower interest rates condemn sterling to oblivion?

In fact, finding an excuse to cut rates may not be as hard as it looks. Even sterling does not present an insurmountable obstacle. A large part of the reason for its fall, as noted, has nothing to do with Britain.

The part that does is mainly related to gloom about UK growth prospects and the perception that the Bank of England is constrained by high inflation from doing anything about it. If the Bank could demonstrate that it is free of such constraints, sterling could even benefit. It may be much too soon for some but the dollar's rise has something to do with the perception that the worst may be over for America.

One MPC member, David "Danny" Blanchflower, has no difficulty over cutting rates, stressing the extreme downside risks to Britain's economy and the urgent need for the Bank to do something about it. Last week he attacked fellow committee members for their "misguided" worries about heightened inflation expectations and said the Bank's prediction of a broadly flat economy over the next 12 months was "wishful thinking". Output would fall, he said, and inflation "plummet like a rock".

Other members, however, are a bit more squeamish. For them, the criticism they have faced as a result of presiding over inflation more than double the target is bad enough, without adding fuel to the fire by reducing rates ahead of firm evidence that inflation is subsiding.

Fortunately, there may be a way of getting there sooner. Geoff Dicks, an economist with Royal Bank of Scotland, notes that Bank governor Mervyn King and colleagues have been emphasising what is known as "money" GDP. This is just gross domestic product, or national income, in cash, as opposed to "real" GDP, which measures inflation-adjusted growth.

Money GDP featured in June, when King wrote to Alistair Darling, the chancellor, to explain why inflation had risen above 3%. "In contrast to past episodes of rising inflation, money spending is increasing at a normal rate," he said. Its rise in the year to the first quarter was 5.5%, "in line with the average rate of increase since 1997 - a period in which inflation has been low and stable".

The Bank returned to money GDP in its inflation report this month, making the same point about its growth being in line with the post-1997 average, but also noting that the way monetary policy affects inflation is through its influence on money or "nominal" demand. The weaker the growth of money GDP, in other words, the more the downward pressure on inflation.

The reason this is interesting now is that money GDP has taken a sharp downward lurch. Figures released a few days ago showed its growth rate in the second quarter had slumped to 4%, considerably weaker than its recent average. It may be telling us, more reliably than any forecast, that inflation worries are misplaced and the Bank could safely cut interest rates.

Those who have followed the monetary policy debate over the years will know money GDP has an honourable place in it. After the Tory government got into difficulty with money-supply targets, there was a campaign, led mainly by Samuel Brittan of the Financial Times, to use money GDP instead of those troublesome targets.

Pressure to switch to a money GDP target persisted, but went out of fashion after 1992 when the government successfully adopted an inflation target. I am not advocating a change in target, though money GDP, which combines inflation and growth, is worth looking at more closely.

So what of this week's rate decision? The "shadow" MPC, which meets under the auspices of the Institute of Economic Affairs, has given its verdict. Two of its members favour immediate action. Both Patrick Minford and Peter Warburton think there should be a half-point cut.

Minford castigates the Bank for implying it is powerless in the face of recession and warns that politicians may conclude it is not "fit and proper" to run monetary policy. Warburton said current inflation was "spilt milk". He wants a 1 to 1.5 percentage-point rate cut over three months.

Other shadow MPC members are less aggressive but five have a "bias to ease". Tim Congdon, Gordon Pepper, Andrew Lilico, Ruth Lea and John Greenwood all believe the Bank should be thinking about lower rates, if not immediately. Pepper thinks the bias should be towards cutting rates "sharply", while Lea would cut by half a point if the data continue to worsen.

This leaves only Trevor Williams of Lloyds TSB and my near-namesake David B Smith who think the next move should be up. The kind of debate on the actual MPC is similar, though probably less colourful than on its shadow.

The Bank's own forecasts imply "money" GDP will slow further as annual growth slows towards zero and inflation gets over its autumn hump. This week's MPC meeting is regarded in the City as a done deal, with no change expected.

October, however, could be interesting. Not only should the path of inflation be clearer but on September 30 there will be a full, extensively revised, set of GDP statistics. The argument for delaying rate cuts could be looking very thin indeed.

PS: How, in hard times, is the skip index? Pretty good; the count in my street stands at two, suggesting normal growth, though I warn again about the "staying put" distortion - people who would have moved deciding to improve.

There was a column: "We've become a nation of credit crunch cry babies". What about "Medieval living defies credit crunch" or "Credit crunch bitten by tooth fairy"? But for sheer optimism, salute the Daily Express: "Credit crunch will boost house prices". Others gratefully received. I'll offer a crunch-related book as a prize for the most bizarre.

From The Sunday Times, August 31 2008

Life does not get much better than this for the opposition. After years of seeing his predecessors baited and beaten by Gordon Brown, George Osborne is in the position of doing the goading. The job of shadow chancellor, long a poisoned chalice, has become a sparkling glass of champagne.

Brown knows what this is like. He took over as shadow chancellor after Labour's demoralising election defeat in April 1992. Many in the party thought if they could not win in those circumstances of painful recession they could never win at all.

But Brown saw the Tories' economic reputation shattered by Britain's forced exit from the European exchange-rate mechanism (ERM) on "Black Wednesday", by tax rises and by a squeeze on public spending.

The more economic misery has piled up in the past 12 months, the more the Tories have made hay. On the key opinion-poll question of "economic competence" — which party is trusted to raise living standards? — Brown and Alistair Darling enjoyed a seven-point lead over Osborne and David Cameron a year ago, according to YouGov, The Sunday Times's pollsters.

Labour's Black Wednesday moment came with the prime minister's shenanigans last autumn over whether to call an early election. That forced Darling into a shamelessly political and hastily assembled pre-budget report, including copycat announcements on inheritance tax and non-doms, which voters saw through.

Osborne and Cameron moved into the lead on economic competence, a lead that has grown in recent months and at present is a two-to-one advantage. It recalls the kind of lead the Conservatives enjoyed over Labour on this question in the 1980s.

The chapter of accidents has got longer, whether the botched nationalisation of Northern Rock, the damage of the abolition of the 10p income-tax band and changes to capital-gains tax, or the further damage of retrospective road-tax rises.

Osborne and his team acknowledge that they are beneficiaries of an economy slowing towards at best stagnation, a chronically weak housing market and a sharp squeeze on household finances. But they think the shift goes a lot further than that.

At the beginning of the year Brown and Darling stood shoulder to shoulder at Downing Street press conferences, the aim being to demonstrate that compared with their lightweight opponents, these were the men you could trust to steer the economy towards better times. As a strategy it has flopped, so far at least.

So has the idea that you should grab hold of nurse for fear of something worse. Voters may not yet know enough about how well or badly a Tory government would run the economy, but they show no sign of returning to Labour's clutches.

So Labour is trying a new tack. Last week Yvette Cooper, the Treasury chief secretary, launched an attack on what she called "Cameronomics", which she claimed was full of "risks and contradictions", including £11 billion of unfunded tax promises.

I hope she ditches the expression Cameronomics and has some better arguments. For her to accuse the opposition of unfunded promises after a £2.7 billion unfunded tax "giveaway" to buy off backbench opposition to the 10p cock-up is just silly.

The next few months will be crucial. Eric Pickles, the Conservatives' local-
government spokesman, said last week Labour could not win the next election (though he added that the Tories could still lose it), but the position is more fluid than when Brown was confidently preparing himself for office more than a decade ago.

The scenario sketched out by Bank of England governor Mervyn King this month, in which a difficult economic adjustment would play out for the next 12 months, followed by a return to a "not so bad" economy, could just play into Labour's hands in time for a May 2010 election — though it would be too close for comfort.

There is no truth in the suggestion that the Tories are getting cold feet about winning because of the state of the economy. The ideal time for an opposition to take over is when the government is seen by voters to have messed up the economy.

Labour's position is not irrecoverable but it requires just about everything to go right. Weak energy and commodity prices will be needed to ease the pressure on household finances. The rise in unemployment will need to be modest.

The government's decisions in the wake of the twin shocks to the economy, including this autumn's proposed Brown-Darling economic rescue package aimed at housing and downtrodden families, will need to look better than seems likely now. An option floated here, that councils should become mortgage providers again to fill the gap left by funding-constrained lenders, was pushed by local-authority leaders in a letter to The Times last week.

The government, though, also needs to show it is in control of its finances. Official figures showed public-sector net borrowing of £19.1 billion in the first four months of this fiscal year, up from £8.4 billion in the corresponding period of last year.

Economist John Hawksworth thinks the Treasury is on track for £50 billion of borrowing this year, even without any additional measures. In cash terms, the record £51 billion of 1993-94 is in sight.

Last week, Osborne opened up a new front, criticising Labour for burdening future generations with the consequences of its economic mistakes. The government was "willing to mortgage the country for its own short-term survival", he said. The Tories will attack any autumn giveaway on this basis.

They, to recall one of Margaret Thatcher's famous lines, are enjoying this. The question for them is when to lift the veil on the detail of their economic plans, without giving too many hostages to fortune or ideas for the government to pinch.

In the recent past, the Tories have suffered from providing too much detail, as did Labour in 1992. And so far the plans that Osborne has put up for the government to steal, notably his proposed tax clampdown on non-doms, turned out to be elephant traps for the Treasury.

The economic battle between the parties is about to enter its most intense phase. Labour have to put the errors and confusion of the past 12 months behind them. The Tories' aim has to be to not let them.

PS: All good things come to an end and, according to the Office for National Statistics, Britain's record expansion finished in the second quarter, growth being revised down from 0.2% to zero. So the record was 63 consecutive quarters of growth, not 64, and the economy will require Houdini-like properties to avoid a quarter or two of declining GDP, with most economists picking the current three-month period as being the one likely to show the first negative number.

I would make more of the end of the great expansion were it not for the fact that we are due a big so-called Blue Book revision of the national accounts figures on September 30. That may give us a different picture of the economy's recent performance, though it will not change the fact that we are in a sharp slowdown.

From The Sunday Times, August 24 2008

After the gloomy combination of soaring inflation, rising unemployment and a downbeat assessment from the Bank of England, there was nothing for it but to travel back in time to 1990.

The summer of 1990 marked the beginning of the last recession, a downturn that was to last until the spring of 1992, making it the longest, though not the deepest, in the post-war period.

What was the Bank saying 18 years ago, in the summer of 1990? Then, of course, it was a mere agent of the Treasury, and not the interest-rate-setting body it is today. But it had a view, and it expressed it in its August 1990 quarterly bulletin.

Then, as now, oil and other commodity prices had risen, pushing inflation sharply higher. There was talk of a credit crunch as the banks reined back lending.

But the Bank of 1990 was quite hardline and, as it turned out, quite wrong. So concerned was it about inflation and rising wages that it dismissed business worries about impending recession, saying that the gloomy surveys then being published "don't add up to a strong risk of recession".

We have all changed in 18 years. Before independence, it was almost the Bank's statutory duty to warn on wages and try to keep politicians, who took the economic decisions, on the straight and narrow.

Now that it has to take some of those decisions itself, things are slightly different, not least because the Bank has to take part of the responsibility for what Mervyn King, the governor, described as the "difficult and painful adjustment" the economy is undergoing.

Only time will tell if its assessment now of a "broadly flat" economy over the next 12 months, followed by an upturn, is accurate or, as 18 years ago, too upbeat. Many of the surveys now are also warning of grimmer times ahead than a merely flat economy.

Nor will we know for some time whether the Bank is right to put its faith in inflation coming back down sharply after it has hit a peak of 5% or so later this year.

Let me take growth and inflation in turn, accepting, of course, that the two are related. I wrote at the beginning of July that after 64 quarters of economic growth, avoiding at least a quarter of declining gross domestic product (GDP) over the next year will be an enormous challenge.

How big a challenge is revealed by looking at what is happening elsewhere. America's GDP, we now know, fell in the final quarter of last year, while both the eurozone and Japan experienced falling GDP in the second quarter of this year.

This was euroland's first GDP fall since the single currency began in 1999 and included declines in Germany, France and Italy. If Britain succumbs, it will have done so later than most competitor economies, which makes it slightly hard to see why the markets are so downbeat about sterling at the moment.

The other challenge is in the Bank's view of a "broadly flat" economy. Economies generally obey the bicycle theory — if they are not moving forward they are at risk of falling over. They can grow slowly but as a rule they cannot have no growth at all.

The problem is that stagnation generates its own downward momentum. Rising unemployment, already evident in the latest statistics, makes consumers cut back further. Weak sales make businesses retrench and cut jobs. Flat economies do not tend to stay that way for long. Either they snap out of it quickly or those downward forces have a habit of pushing them into outright recession.

Looking at the historical record, the last time the kind of scenario sketched out by the Bank happened was nearly half a century ago, in the days of "stop-go" economics. In the early 1960s, between the first quarters of 1961 and 1962 to be precise, the economy was flat, before it embarked on a vigorous upturn. The Bank is not necessarily wrong, but what it is predicting is unusual.

What about inflation? King was candid last week in admitting, not only that the Bank failed to predict the present rise in inflation but that, even if it had known, there was little it could have done. But for a body that needs to forecast inflation accurately, its recent record has been awful.

Two years ago it expected 2% inflation in 2008 and even its gloomiest prognosis did not foresee a rise much above 3%. That was also true a year ago. Granted, there was something highly illogical in commodity prices booming in the wake of the credit crunch, which no rational economic forecaster would have predicted. The Bank has also been taken by surprise by aggressive increases in the price of household gas and electricity by the utility firms.

To be fair, its latest forecast, of an inflation peak of 5% or slightly higher this year, followed by a sharp fall as past increases in energy and commodity prices (some of which are being reversed) drop out of the 12-month comparison, looks perfectly plausible. But then so did its prediction of a much lower peak made three months ago.

The current high for inflation severely tests not only the Bank's monetary-policy credibility but also its forecasting reputation. It has to endure its bed of nails for the next few months and so do the rest of us.

The big issue is not, it seems, wages, which are well-behaved and will remain so as long as the job market stays weak. Average earnings are rising by a modest 3.4%. The question is whether firms, while paying lip service to the national need to keep inflation low, try to force through as many price increases as they can. A flat economy and declining domestic demand should in theory constrain them. If not, life will get even more difficult.

The sunlit uplands that King and his colleagues see in a year's time rest on inflation dropping sharply, boosting the growth in real incomes and, while the Bank does not say so, giving room for lower interest rates. The risk is, long before we get there, that the economy will have been dragged down much further than is comfortable.

PS: After a couple of weeks in America, I have one or two observations. Americans are more concerned about the level of petrol prices than about house prices. And in general, for a country going through a more severe adjustment than here, there is far less economic gloom, including in the media. Maybe we enjoy wallowing in it while they don't.

Otherwise, ordinary Americans seem more engaged in the myriad local elections they get, for the offices of sheriff, judge, county commissioner and the rest, than in the presidential race. Poll fever may build, but it is not there yet.

From The Sunday Times, August 17 2008

Summer holidays are here, a good time to reflect on the past and on what is to come. After seven months of being battered by the twin shocks of a global credit crunch and surging oil and commodity prices, should we brace ourselves for an even grimmer autumn and winter?

The fall in the oil price from farcical to merely ridiculous levels, with other commodity prices easing in tandem, is good news, though it needs to drop a lot further to take one of those twin shocks away.

Evidence of an easing of the credit crunch is harder to find, despite slight reductions in mortgage rates, better news from some American banks and signs that predatory buyers are following Santander's example and circling some of Britain's troubled mortgage providers.

This may, however, be just clutching at straws. The record low for new mortgage approvals reported by the British Bankers' Association last month, two-thirds down on a year earlier, shows an unprecedented squeeze on credit availability.

Retailers, if you believe the official figures, have gone from boom to bust in a month, May's record 3.6% surge in sales volume being followed by June's unprecedented 3.9% plunge. The consumer trend, with sales up 0.6% in the second quarter, is plainly slowing. That is also true for the wider economy, which recorded its 64th consecutive quarter of growth in the second quarter, but of a mere 0.2%.

One good way of looking forward is with the National Institute's latest economic review. The National Institute of Economic and Social Research (NIESR) is the oldest of Britain's economic analysis and forecasting bodies, founded 70 years ago when John Maynard Keynes was still in his prime. At times during the Thatcher years, though not now, it was a kind of Treasury in exile.

Its latest forecast is interesting and not good news for retailers. Britain, it says, will have an outright consumer recession, with household spending dropping 0.8% next year after expected growth of 1.9% this year; 2010 will not be much better, with a spending rise of just 0.6%. Not for a long time have consumers been so squeezed.

Yet this predicted consumer recession will not result in a general recession, the institute says, despite the fact that household spending is roughly two-thirds of Britain's gross domestic product.

Over the 2008-10 period the economy will have its weakest run since the recession of the early 1990s, with growth rates of 1.5%, 1.4% and 1.9% respectively. But this will still be a slowdown rather than a recession. The NIESR's main forecast does not even have a quarter of declining GDP, so maintaining the record expansion that started as long ago as the spring of 1992.

Is it possible for the economy to grow while the consumer is in recession? NIESR acknowledges the risk of an outright recession — a fall in GDP next year — at just over one in 10. Sticking with its main forecast, however, where does growth come from?

One source is the government. While public spending is targeted to slow this year to 2% real-terms growth, from an average of 4% to 5% over the past few years, this is still enough to contribute half a percentage point to growth annually. Another contribution comes from investment and inventories, predicted to add at least half a percentage point in 2009 and 2010. The biggest effect, however, comes from trade.

NIESR is not forecasting an export boom. Growth in overseas sales over the next three years is below 1.5% annually, but it expects an import slump, because of falling consumer demand. This improvement in "net" trade, with a halving of the current-account deficit from £60 billion last year, 4.3% of GDP, to 1.9% in 2010, makes the biggest contribution to keeping the economy's head above water.

Other economists, I should say, see both a consumer recession and a wider recession, or at least a few quarters of GDP decline. NIESR's route is preferable, not least because a period in which the economy is driven by investment and net trade is overdue. It would still feel pretty grim to the man in the street, though unemployment is predicted to rise only modestly.

Perhaps the consumer squeeze won't be quite as intense as NIESR predicts, particularly if oil and food prices continue to ease. Still, that would deprive us of a useful experiment; the ability of the economy to grow even during a consumer recession.

One thing that would guarantee an even grimmer time for consumers, and the wider economy, would be if the Bank of England were to raise interest rates. The minutes of the meeting of the monetary policy committee (MPC) this month showed a split. Seven members were happy to leave Bank rate on hold at 5% but one, David "Danny" Blanchflower, wanted a quarter-point cut and another, Tim Besley, favoured a quarter-point hike.

Experts disagree but this left me troubled. Blanchflower and Besley are academics with high reputations but no business or financial-market experience, or background in monetary policy. You might say this means they are freed from the yoke of convention, and one of them may turn out to have blazed a trail for the rest.

But "feel" is vital for monetary policy, as is knowledge of the consequences for the financial markets of unexpected votes either way. I think this should be a condition of employment when it comes to future MPC appointments in what we are promised will become a more transparent process.

Faced with conflicting pressures from slowing activity and high inflation, the MPC was right to leave Bank rate at 5%. It remains the sensible course until there is decisive evidence of inflation easing, and this should come before the end of the year.

PS: When the economy turns down, you can bet the name of Nikolai Kondratiev will not be far away. He was the Russian economist who, before being executed in 1938 in Stalin's purges, advanced the theory that the global capitalist economy was subject to long cycles of 50 to 60 years. Long upswings are followed by long downswings, in which case we should prepare for decades of misery.

What about a Soros cycle? He is big enough to admit he cried wolf in 1987, in The Alchemy of Finance, and in 1998 in The Crisis of Global Capitalism. Is he crying wolf again? Probably. But we'll see.

From the Sunday Times, July 27 2008

On my bookshelf there is a tome I have been meaning to dip back into for some time. It is called Reforming Britain's Economic and Financial Policy.

Written by Ed Balls, then Treasury chief economic adviser, now in charge of what used to be the education department, and Gus O'Donnell, then head of the government's economic service, now head of the civil service, it was intended to be the bible of new Labour macroeconomic policy.

The foreword was by Gordon Brown, who was inspired by his own achievement. The reforms of 1997 ranked alongside those of the 1940s, he suggested, as he traced the "intellectual journey" to "an institutional framework that commanded market credibility and public trust".

The three pillars of this new framework were an independent Bank of England to deliver low inflation, "a fiscal policy framework which is delivering sound public finances" and a Financial Services Authority to ensure financial stability. The book was sold as suitable for students. Maybe it is now only appropriate for historians, particularly those interested in crumbling pillars.

What should we make of the fiscal policy pillar of which Brown was so proud when Treasury officials are busy working on a rewriting of his rules?

First, a little context. Two things happened on Friday. Stories appeared about an autumn rewriting of the fiscal rules hours ahead of figures showing a sharp deterioration in the public finances. I am assured the Treasury did not plant anything. Indeed, Alistair Darling, the chancellor, had to delay his trip to his Edinburgh constituency to deal with the fallout.

Why do the rules need rewriting? The two fiscal rules, to remind you, are the golden rule — only borrow to fund public investment over the cycle — and the sustainable investment rule: maintain government debt at a "stable and prudent" level, below 40% of gross domestic product.

The problem with the first is that it relies on a judgment, in practice the Treasury's, on where the economic cycle begins and ends. This not only allows the Treasury to time the cycle but it means fiscal policy is essentially backward-looking.

The issue has come to a head now because official statisticians will in the next few months produce a thorough revision of the national accounts. These estimates, in what is known as the Blue Book, are expected to give a definitive answer to when the economic cycle that began as long ago as 1997-98 came to an end. The golden rule, or something very close to it, will be preserved, but the Treasury is keen for the new version to have a credibility that the old one lost some time ago, by making it more forward-looking and transparent.

The bigger issue, however, is over the other rule. Until the credit crunch broke a year ago, the chancellor could claim not only that debt was below 40% of GDP, but that it would stay there, each and every year, into the indefinite future.

Now, while the Treasury is maintaining the stance that Northern Rock and Bank of England debt should not count towards the calculations, the game is up for this rule. Even before Darling announced a £2.7 billion tax giveaway to compensate for the 10p income-tax fiasco, and last week's decision to postpone the planned 2p increase in fuel duties, the Treasury had expected debt to rise to 39.8% of GDP.

Now debt, at 38.3% of GDP, is almost certain to rise above 40%. Adding in Northern Rock, it already has. At 44.2% of GDP, it is higher than the 43.5% level Kenneth Clarke bequeathed to Brown in 1997.

What the Treasury intends to do, it seems, is throw quite a few things more into the debt pot, including the government's liabilities under the private finance initiative (PFI), though probably not those huge public-sector pension liabilities.

What does it mean in practice? Had 40% remained a rigid rule, the government would have had to raise taxes or cut public spending over the next couple of years, which was probably not sensible.

In fact, those figures on Friday showed that the Treasury has the makings of a crisis in the public finances on its hands. Public-sector net borrowing in the first three months of this fiscal year, £28.2 billion, was well up on the £20.1 billion in the corresponding period of last year. Extrapolating that overshoot forward would give net borrowing for the full year of nearly £73 billion, points out Philip Shaw of Investec.

If the Treasury is right and the figures have been boosted by public-spending increases that will not be sustained, it may not be sensible to extrapolate. But tax revenues are weak. Stamp duty is down sharply, Vat and National Insurance contributions are down on a year ago and corporate tax revenues are flat.

I have pointed out before how in the last recession the government went from a balanced budget to a deficit of 7% of GDP. That was when the all-time cash record for government borrowing, £46 billion in 1993-94, was set. It will soon be broken.

How serious will this rewriting of the rules be for the government's credibility?

If the Treasury is smart and produces revisions to the rules that are sensible, forward-looking, transparent and all the other things beloved of independent experts, it is possible that fiscal policy will emerge stronger from this.

Unfortunately, there is rather a better chance that this will be seen as a politically expedient response to a crisis in the public finances.

Meanwhile, there are two pressing issues and both involve 2%. If the rewriting of the fiscal rules provided the government with an excuse to relax the 2% limit on public-sector pay rises then, as Peter Spencer of the Ernst & Young Item club points out, all would be lost. In the City, public-sector pay is the only thing standing between Labour and an inflationary deluge.

If a redrafting of the fiscal rules was followed by a softening of the Bank's 2% inflation target, that would also go down like a lead balloon. Some rules are definitely not meant to be broken.

PS: It is hard to recall what untroubled lives we led less than a year ago. In early August 2007, consumer price inflation was 1.8% and we had not heard of the credit crunch. Our biggest worry was that the Bank might nudge up interest rates a quarter-point. Happy days.

The Bank's next inflation report will show an even higher peak than last time. Central bankers as much as anybody would love a big oil-price fall.

From The Sunday Times, July 20 2008

Every day, it seems, brings a new announcement of job losses from housebuilders. Totting up the numbers for the past week or so gives a figure not far short of 10,000, and this is not counting the thousands of self-employed sub-contractors who were building and fitting out new homes until the sector hit the buffers.

The job market is turning, though in a quieter way than it used to. Readers with long memories will recall the News at Ten job maps of the 1980s, when it was possible to pinpoint how many jobs were being cut and where. In a service-based economy, that is harder. People are quietly let go.

Even in Britain’s factories, where employment has dropped by an average of nearly 12,000 a month over the past decade, the process has been much less visible than it used to be.

This week we will get the official labour-market statistics, which will almost certainly show another rise in unemployment, though probably a modest one. The question is whether we are on the brink of something bigger.

There is another question, which is whether migrant workers will make the job-market adjustment in a sharply slowing economy easier or harder.

Ahead of this week’s figures, the most recent official numbers showed a 38,000 rise to 1.64m in the wider Labour Force Survey measure of unemployment over the February-April period.

The claimant count, still the more widely followed measure, rose by 9,000 to 819,300 in May and is up by 24,400 since its low point in January. The unemployment rate on this measure is 2.5%, bang in line with what economists have traditionally thought of as full employment.

That is important. In the recession of the early 1990s unemployment started rising from a high base, just under 1.6m, double its recent lows. This downturn starts from a position of low unemployment.

It also starts from a position of record employment, more than 29.5m, driven by the private sector. In the past two years, private-sector employment has risen by 632,000, while the number of public-sector jobs has dropped by 74,000.

So where do we go from here? Two sectors, housebuilding and financial services, are in the eye of the storm, though other parts of the economy are being affected by the slowdown. The Home Builders Federation (HBF) estimates that 300,000 people are directly employed in new housebuilding, which coincidentally is roughly the same as the number employed in the City and Canary Wharf.

How many of these are vulnerable? Probably a greater number in housebuilding, where activity has halved, than in the City. There will be collateral damage across the wider housing market among estate agents, surveyors and mortgage brokers. But a wider slowdown affects most sectors. When economic growth slows below around 0.6% a quarter, unemployment can be expected to rise. Growth in the quarter just ended is unofficially estimated at 0.2% and will continue at best at this rate over the next two or three quarters.

John Philpott, chief economist at the Chartered Institute of Personnel and Development (CIPD), with his finger on the pulse of the job market, reckons the slowdown will push the claimant count up by 200,000 or so over the next 18 months.

There is an additional complication. Tougher rules are being introduced to get people off incapacity benefit and into work, and to keep them away from government employment programmes (which an OECD report last week said had not reduced youth unemployment below that in competitor countries). The effect will be to push up the claimant count.

Paul Bivand of the think tank Inclusion calculates the effect will be to raise the jobless total by 122,000 by autumn next year relative to what it would have been.

Adding these up implies that the claimant count will certainly go through 1m and could get to 1.2m, which sounds bad, though some of that would be due to procedural changes rather than the economy.

It would also be relatively mild in comparison with the recession of the early 1990s when the jobless total rose by more than 120,000 in a single month, March 1991, and increased by half a million over the winter and spring of 1990-91. In all, unemployment climbed by 1.4m in that recession. More recently, the claimant count rose by 130,000 in 2005-6.

One of the unknowns this time is whether migrant workers will be the economy’s flexible friends, having arrived in large numbers when the job market was strong but leaving again as things weaken.

This is a big issue for the next year or so, but it is also a big issue for the next 20-30 years. In the early 1990s the inflow of migrant workers dropped to zero, high unemployment acting as a powerful disincentive for foreigners to come to the UK.

This time, the sectors hardest hit, including building but also parts of the economy such as catering which rely on discretionary spending, are cutting their demand for labour. They have a high proportion of migrant workers.

At the same time, the outflow of people from Britain, 400,000 in the latest year, is likely to continue, partly because opportunities are better in the booming Middle East and Asia. Net inflows of people into Britain could turn negative.

That should help ease the unemployment problem but will raise longer-term questions. Official projections for population growth and housing assume net migration of 190,000 a year. We may be gearing up for a prolonged rise in Britain’s population that does not happen.

It may be that beyond the current downturn the flows of migrant workers will resume but it is also easy to see circumstances in which they will not. Last time it took until the late 1990s before the flow of migrant workers really picked up strongly. The character of the economy is changing in more ways than one.

PS Alistair Darling admits he runs the gauntlet of unpopular price rises when at his local Tesco. He could wear a baseball cap but the eyebrows would be a giveaway. However, John Hawksworth of Price Waterhouse Coopers might think about a disguise when shopping.

Perhaps the good news is that we all feel the pain of rising prices. That implies a determination not to let inflation take hold, which should offer some comfort to the Bank of England, stuck as it is between a rock and a hard place.

From The Sunday Times, July 13 2008

One of the most remarkable things about Britain's economy in recent years has been its ability to keep growing. Through thick and thin, even at times when the battery threatened to give up entirely, the long expansion has continued.

Millions of children have never known anything other than rising national income. Today's 16-year-olds were emerging blinking into the sunlight last time real gross domestic product showed a single quarterly fall.

Now, however, after 63 consecutive quarters of growth, is the party over? There have been close calls along the way — in the spring quarter of 2001 GDP rose a mere 0.1% in spite of a big public spending boost — but avoiding at least a quarter of falling GDP looks like an enormous challenge.

How much of a challenge has only just become clear. It started with the downward revision of first-quarter growth to 0.3%, half its rate in the final quarter of 2007 and a third of its rate a year earlier.

The quarterly numbers suggested a sharper slowdown than had been thought. They were followed by a series of very weak survey numbers and some high-profile corporate woe. With half the year gone, the gloom threatens to become all-enveloping. Will we even get to the end of the year with the growth record intact?

The question is, where will the growth come from? In a clutch of nasty numbers last week, some of the nastiest were the purchasing managers' surveys.
The survey for manufacturing reported that, with continuing price pressures, the index recorded its largest monthly decline since January 2000 and was at its weakest since December 2001, with output, new orders and employment all declining.

You may say we have become used to gloom from Britain's factories over the years. This year, though, it was supposed to be different, with the economy "rebalancing" towards Britain's factories, helped by sterling's fall against the euro.

Instead, manufacturing appears to be suffering from the credit crunch and soaring commodity prices along with the rest of the economy. The Engineering Employers' Federation said the survey may have overstated the gloom. However, hopes that industry would keep the rest of the economy afloat are fading.

If manufacturing is disappointing, construction is looking like a demolition site. The purchasing managers' index (PMI) for construction dropped to 38.8 last month. Last summer it was running at 64.8. The housebuilders' intense pain is being reflected in the numbers.

Bad news comes in threes, and the third was the PMI for services, the biggest contributor to economic activity. We know financial services are in trouble — you certainly would not want to be a mortgage broker these days — and the sector's woes are serious enough to push overall service activity down; to 47.1 from 49.8.

The service sector, of course, includes retailing and last week we had a 21-gun warning from Sir Stuart Rose, chairman of Marks & Spencer. We heard much the same from him in early January, since when consumer spending has surprised on the upside, including that spectacular, though disputed, 3.5% jump in retail sales in May. If you believe the official numbers, sales volume in May was up 8% on a year earlier. Even if you take them with a large pinch of salt, Rose's retailing recession must have started after May.

There is no doubt, however, that times should be getting much tougher for consumers and retailers and will do so over the second half. The squeeze is on.

The way the PMIs work is that levels below 50 indicate a sector is contracting. With manufacturing, construction and services all below the 50 level in June, that suggests the recession started last month. In practice, the read-across is not quite so neat and the survey levels for manufacturing and services are probably consistent with snail's pace growth rather than recession, but the warning signs are there.

Each month the Treasury asks independent economic forecasters to submit their predictions for the economy. The latest average, compiled a couple of weeks ago, was 1.7% growth for this year, 1.4% next.

Only one forecaster, Peter Warburton of the consultancy Economic Perspectives (and the shadow monetary policy committee, see item at end), predicts outright recession. In his view, growth this year will slow to 0.7% and the economy will contract by 1.9% next year.

He is, as I say, on his own but more economists are starting to talk about "technical" recession — two consecutive quarters of declining GDP. For most individuals, and people in business, all this is a decimal point too far. What matters is how weak it feels and the consensus among economists is that 2008 and 2009 will be the two weakest years since the last recession.

The question is whether "weak" captures it properly. If the credit crunch can bite so savagely in one area — housing — what will be its effect on the wider economy? If consumer confidence is plumbing new depths now, what will it be like if unemployment jumps and home repossessions soar?

The combination of the credit crunch and soaring oil prices is a horrible one, two big economic shocks in one. The crunch is biting harder, according to the latest credit-conditions survey from the Bank of England, while declining oil use in America is not enough to deter the oil bulls from pushing prices to new daily highs.

Last week the Basel-based Bank for International Settlements (BIS), the central bankers' bank, gave a pretty scary assessment of the outlook for all the advanced economies, including Britain. We could be on the brink of a "much greater and longer-lasting" downturn than people are assuming, it warned, so much so that the problem central banks could be facing in a few years could be deflation — falling prices — rather than inflation.

We know about deflation from Japan's experience over the past two decades and from the 1930s. The BIS says such an outcome is "unlikely" but "cannot be ruled out entirely". Let's hope it stays unlikely.

PS: What should the Bank of England do this week? The "shadow" monetary policy committee is clear; it should not raise rates. Eight members of the SMPC, which meets under the auspices of the Institute of Economic Affairs, think Bank rate should stay on hold. One, Patrick Minford, votes for a quarter-point cut.

The SMPC's verdict is probably quite helpful for the Bank. Certainly it suggests this is no time to be thinking about higher interest rates.

From The Sunday Times, July 6 2008

Something extraordinary is happening in the housing market. We are seeing an unprecedented collapse in mortgage lending and no sign of an official or private-sector response.

Housebuilders are hurting badly, as are others that rely on a thriving housing market for their livelihoods. Nobody, however, seems prepared to do much about it.

This week we will get figures from Nationwide and it will be a surprise if they do not show an eighth consecutive monthly fall in prices — and a big one. May's drop was a scary 2.5%.

I have been puzzling about why Nationwide and Halifax surveys have been showing such sharp price drops, at least as bad as at the corresponding stage of the early 1990s slump, when economic conditions are more favourable today.

Lenders are taking a more aggressive approach to cutting valuations on which they are prepared to lend. That, though, reflects only part of the weakness.

The real story is that the credit crunch is indiscriminate in its impact. In the early 1990s, peak-to-trough price falls on the lenders' national price measures were not that large, given how devastating the crash was. The Halifax index fell 13%, the Nationwide 20%.

Many people remember rather bigger falls than that and are right to do so. What we had was a "normal" price correction, beginning in London, southeast England and East Anglia and spreading to the rest of the country. The effect of this ripple pattern was to limit the drop in the national measures at any one time. In 1990, for example, the Halifax index showed no change. Prices fell 12% in East Anglia, though, while rising 13.6% in the north.

This time all regions are suffering together. So sudden is the downturn that few parts of the country are immune. The ripple pattern has been compressed.

We can see the sudden nature of the adjustment in figures for new mortgages. Last week the British Bankers' Association (BBA) reported real shockers, with new-mortgage approvals of only 27,968 last month, 20% down on April and 56% down on May 2007.

Again, this did not happen in the early 1990s. The kind of collapse in lending we have seen over the past 12 months took four years then; there was a 57% drop between 1988 and 1992.

It is important to recognise that the credit crunch is the driver of this downturn. This is not an implosion of the housing market under the weight of its own overvaluation. It is not a wave of forced selling by homeowners who got in over their heads. It is not a sudden and unanticipated collapse of demand. It is not a rush for the exits by buy-to-let landlords.

All these things may yet happen, but the cause is clear: a sudden and sharp drop in mortgage availability, combined with a rise in their price. Can anything be done? Should anything be done?

The extent of the crunch can be seen clearly in the numbers. The Council of Mortgage Lenders (CML) expects gross mortgage lending of £285 billion and net lending of £55 billion this year — half 2007's £108 billion.

About 40% of the stock of UK mortgages is funded not by customer deposits but by wholesale funding — senior debt, mortgage-backed securities and covered bonds. This time last year 60%-70% of new lending was funded in wholesale markets. When those markets closed last summer, lenders were stuck, Northern Rock particularly so. When they stayed closed, the result was a mortgage famine of a kind we have never seen before.

BBA numbers show how this is biting. Existing borrowers are not doing badly. Remortgages — moving the same amount to a new lender — totalled 63,303. Equity-withdrawal mortgages, when people change lender and borrow more, were 28,766, against fewer than 28,000 new mortgages. So there were more equity-withdrawal mortgages than new ones. First-time buyers are becoming extinct. Who is responding?

The Bank of England's special liquidity scheme, launched in April, may have played its part in keeping the banking system afloat, but has had zero impact on the mortgage market. Also in April, Alistair Darling announced that he had appointed Sir James Crosby, former chief executive of HBOS, to head a working group to report on possible remedies for the malfunctioning mortgage market.

I am not blaming Crosby, but Treasury wheels grind exceedingly slow. His interim report is not expected until late next month, nearly a year after the credit crisis broke, and his final report will not be until autumn. Caroline Flint, housing minister, told the Chartered Institute of Housing annual conference that officials were pulling out all stops in search of a solution, but evidence of that activity is hard to see.

The CML has been talking to the government about a plan to revive wholesale funding markets but is coy on the details. It says there is a solution that would not involve a transfer of risk to taxpayers. Part of it may be the Bank taking new mortgages, as opposed to pre-2008 loans, on to its books as collateral.

The New Local Government Network has called for something outlined here a few weeks ago — that the government, through local authorities, should get back into the mortgage market, as was the case until the early 1980s. Even with a big budget deficit, the government does not face serious funding constraints. When things improve, those mortgages could always be sold on to the lenders.

If there are fixes out there, somebody in government should be putting them into practice. As it is, there is an overwhelming sense of inaction.

Why, you might say, should the government do anything? Those who lived by the housing market should also die by it.

Nobody, however, benefits from a disorderly correction, or a malfunctioning mortgage market. First-time buyers are worse off than they were before. The housebuilding industry is suffering a downturn from which it could take years to recover. A government that prided itself on stability now risks presiding over extreme instability.

Steve Nickell, head of the government's National Housing and Planning Advice Unit, believes that current developments will exacerbate medium and long-term housing shortages. Prices may be falling now but the long-term trend is "relentlessly upwards", he said in introducing a new report last week. If the market overshoots down now, it will overshoot up again next time. It is hard to see that is in anybody's interest.

PS: Tough though it is for housebuilding, not all builders are struggling. Ian King, The Sun's business editor, tells me you can't move for scaffolding in his part of London. I can report my skip index is alive and well. This is not just anecdote. The Federation of Master Builders says some members have switched from new developments to loft conversions and other private work. A GE Money survey uncovered something similar.

The great debate was about whether the housing downturn would leave consumer spending unaffected or push it lower. What we didn't expect was weak housing associated with stronger spending elsewhere. It may not last — the Bank would be alarmed if it did — but for now we should treat tales of extreme woe from the high street with care.

From The Sunday Times, June 29 2008

Your starter for 10. Who said: "The rise in inflation that we are experiencing today is a worldwide phenomenon ... Indeed, on a genuinely comparable basis, inflation in this country has increased over the past six months by less than in the G7 as a whole."

It was Nigel (now Lord) Lawson, of whom we have seen quite a lot recently. He was speaking in June 1989 about the rise in inflation on his watch.

Chancellors have two lines of attack when confronted with unacceptably high inflation. One is to blame world events, and this is always used when the same party has been in power a long time. The other, for governments new to office, is to blame the opposition.

Alistair Darling cannot blame the Tories or his Treasury predecessor. So in his response last week to Bank of England governor Mervyn King's letter explaining why consumer price inflation had hit 3.3% he also emphasised "the global nature of inflation".

To be fair, the current situation is different from the late 1980s. When Lawson was blaming the world, Britain's inflation rate was more than 8%, nearly double the G7 average. Today, euroland inflation is 3.7%, while America's is 4.2%. But to the extent that no chancellor comes out and blames himself, nothing much changes.

What about central banks? The great thing about Bank of England independence is continuity. Governments may change but the Bank carries on. Does that mean it will never blame itself?

In the past week we have had soft cop (the letter to the chancellor) and hard cop (his Mansion House speech) from King.

His letter did indeed lay the blame squarely on international factors. Last December, consumer price inflation was 2.1%; now it is 3.3%. Of that 1.2 percentage point rise, 1.1 was caused by higher food, fuel, gas and electricity bills.

Without a 60% price rise in food commodities, an 80% increase in oil and a 160% surge in the wholesale price of gas, inflation would still be close to the 2% target and the City would still be looking for rate cuts, not rises.

But, as he also made clear at the Mansion House, this does not absolve the Bank of responsibility. "The rise in commodity prices cannot, by itself, generate sustained inflation in the United Kingdom unless we allow it to," he said. "We will not."

I believe it would be a mistake for the Bank to raise rates. It would make a very weak outlook look grimmer, without any real gains in lower inflation two years ahead.

Would raising rates help the pound? Not if seen by currency dealers as condemning Britain to even deeper misery. And, irrespective of what the Bank is doing, a market-driven tightening of monetary policy is taking place, through higher mortgage rates.

What matters, though, is not what I think but what MPC members think. Rate cuts are off the agenda for the foreseeable future. What would make the Bank turn its discussion earlier this month of the possibility of a rate rise into action?

Wages are important. Everybody knows inflation expectations are elevated, including on the Bank's own measure. Most of us do not, however, have a personal inflation calculator in our heads. What we do notice are big price increases for frequent purchases and those, according to an article in the Bank's latest quarterly bulletin, are instrumental in forming our judgments about future inflation.

The key for the Bank is whether heightened expectations get converted into higher pay increases. The Engineering Employers' Fed- eration says not, with settlements down to an 18-month low of 3%, and 7% of firms having frozen pay.

However, if there are many more "special cases" like the tanker drivers, the Bank will get worried, so this one bears watching. If Sainsbury's is right and its inflation rate is 3% rather than the much higher numbers doing the rounds for supermarket inflation, that would be good news. Even better would be if today's summit in Saudi Arabia has an effect on oil prices.

The Bank is also aware, however, that in today's less-unionised labour market, wages may not be the route through which a permanent increase in inflation shows itself.

This is where much-maligned "core" inflation comes in. Core inflation gets a bad press because it excludes energy, food, alcohol and tobacco; the things that are going up most sharply. Nobody could live a core-inflation life.

But what core inflation also tells us is the extent to which inflation is spreading into general price increases. Core inflation is now 1.5%, compared with 1.4% six months ago. Some members of the MPC will be content to see it stay there. The hawks want more. They would like to see core inflation heading lower, as the squeeze intensifies. So watch the horrible headline figures for inflation but keep a close eye on the core.

Those horrible figures are a reminder of one of the most difficult challenges for monetary policy. Even when forces are in train that will bring inflation down, there will be a period, possibly quite long, when it is going up. The Bank knows this is going to be pretty bloody, with the letters flying thick and fast between Whitehall and Threadneedle Street. JP Morgan expects October inflation of 5%.

Goldman Sachs points out that it is typically four to six quarters between growth slowing below trend and the output gap (spare capacity in the economy) increasing, and inflation heading lower. Only in the first three months of this year did growth drop below trend in Britain, so there is a long way to go.

It is also very important that growth does continue to slow. May's 3.5% jump in retail sales, the biggest for nearly three decades, went wildly against the grain of a slowing economy and will be taken with a pinch of salt. But from the point of view of holding rates down, a 3.5% drop would have been better.

Finally, it matters what other countries are doing. If you had a global MPC, it would be raising interest rates. But the bits of the world where it would be raising them would be where growth is booming. That is happening. India's reserve bank hiked earlier this month and China's central bank governor, Zhou Xiaochuan, said fighting inflation was his country's greatest concern. There are similar noises from Brazil.

The more action is taken in these global hotspots, the less the need for the Bank to do anything in our sharply slowing economy. I don't sense that the MPC wants to raise rates. It merely wants to show that it isn't complacent.

PS: Sir John Gieve, whom I have known for two decades, developed a knack for being in the wrong place at the wrong time. He was press secretary to John Major during his brief period as chancellor and permanent secretary at the Home Office in its "not fit for purpose" years. He was unlucky enough to join the Bank a year before the biggest financial crisis in decades.

Attention now switches to Spencer Dale, the Bank's new chief economist and newest MPC member. Great things are said about him at the Bank. As a "lifer" — he joined from university in 1989 — not that much is known about him outside, although he has spent the past two years advising the Fed. Will he be a hawk, dove, or some other bird? Watch this space.

From The Sunday Times, June 22 2008

The next few days will do much to determine whether prospects for Britain’s economy over the next 12 to 18 months are merely poor, or start to look dreadful.

On Tuesday the May inflation figures will be published and, while these things can never be predicted, are set to show the rate rising above 3%, triggering an open letter from Bank of England governor Mervyn King to Alistair Darling, the chancellor. Inflation on the target measure was 3% in April and should have been pushed above it now by rising food, petrol and utility bills.

The contents of that letter and of the minutes of the June meeting of the Bank’s monetary policy committee — published on Wednesday — will tell us much about whether the money markets are right to expect a series of interest-rate rises in the coming months — which could be the last straw for the economy.

Most economists, in contrast to the markets, have taken the view that the Bank cannot raise rates in the current circumstances. Yes, inflation is high, they concede, but this is due to global commodity and energy price developments. And yes, inflation expectations have risen, but there is no sign of any follow-through into higher wages. The Bank has to hold rates and grit its teeth.

So, if one were to preview the exchange of letters on that basis, King will cite the factors, mainly external, that have pushed inflation higher. He will say the Bank does not take any of this lightly, and is serious about getting inflation back to the 2% target, but it recognises that to try to do so quickly would hit the economy unnecessarily hard. A gradual return to target will be its strategy and, by implication, there will be no nasty upward lurches in interest rates.

Darling, in response, will say he understands the Bank’s difficulties and the factors behind them. He will say, in essence, that the government is happy for the Bank to take its time, which it plainly is. A Treasury research paper, “Global commodities: a long term vision for stable, secure and sustainable global markets”, sets out the factors that have pushed prices higher and will be used by the chancellor and Gordon Brown to try to influence other countries at this weekend’s G8 finance ministers’ meeting in Japan and other upcoming gatherings.

The risk, however, is that King’s tone and the minutes are more hawkish. The Bank’s own figures, released on Thursday, showed a jump in inflation expectations for the next 12 months from 3.3% to 4.3%. Official figures last week had industry’s raw material and fuel costs up by nearly 28% on a year ago, with factory gate prices rising by almost 9%.

The European Central Bank threw a sizeable spanner into the works with its warning 10 days ago that it was likely to raise rates next month, though subsequent guidance that this will be a one-off move calls into question why it chose to cause such a fuss for a quarter-point change in rates.

There is no doubt that central banks are becoming more hawkish. The Bank of Canada surprised the markets by not cutting rates last week. Amid a few green shoots for the American economy, the Federal Reserve seems to have reached the end of its rate-cutting cycle. I don’t expect the Bank to raise rates, but cuts that were expected a few weeks ago now look at best delayed. Until central banks can be confident that the price of oil will fall significantly, they will remain on alert.

There are wider issues to do with oil, some of which I will return to in the coming weeks. Jeff Rubin, chief economist at CIBC (Canadian Imperial Bank of Commerce) Markets, and his colleague Benjamin Tal, in a paper “Will Soaring Transport Costs Reverse Globalization?”, chart the rise in the cost of shipping goods from China to America, up from $3,000 for a container in 2000 to more than $8,000 now.

The initial impact of this is on consumers, raising the cost of goods from China, but long term the impact could be profound. Rubin and Tal describe higher energy prices as “the largest barrier to global trade today”.

Already there is anecdotal evidence that British firms looking at relocating operations to China change their minds when discovering the cost savings are modest and could be eroded by rising transport costs. Some work is even returning to Britain because of these factors. Such examples are rare but worth watching.

A second big issue is whether inflation targets were set at levels that were too ambitious. It is easy to forget how tough, relative to Britain’s past experience, a 2% consumer price inflation target (equivalent to about 2.75% retail price inflation) is.

Low inflation in the past, even in the so-called golden age of the 1950s and 1960s was 3% to 4%. You have to go back a long way, to the inter-war years and the 1870-1914 period, for a run of inflation as low as we have had over the past decade and a half.

This is not a time for abandoning or increasing the inflation target but it is an issue that will have to be addressed if global forces pushing prices higher persist, and achieving the target becomes possible only if the economy is subjected to a permanent squeeze.

The usual caveats about oil apply. The rise of the past few months is reminiscent of the last days of the dotcom boom, as investors scrambled to buy because they believed the world had changed. Everybody associated with the oil market has an axe to grind.

BP, which lent support to the high price last week with its new statistics on world energy, wants to get its hands on more oil. “While resources are not a constraint globally, the resources within reach of private investment by companies like BP are limited,” said chief executive Tony Hayward.

The International Energy Agency, which like most western governments refuses to blame the markets, wants Saudi Arabia and other Opec countries to raise output. Gazprom predicts $250 a barrel and sees oil as an instrument of Russian political power.

It is a paradise for speculators and oil producers. By the time the damaging effects of high prices on demand and economic activity are clear, the speculators will have moved on, like locusts, to cause mayhem elsewhere. If the Bank were to raise interest rates in response to high oil prices, they really would have caused mayhem.

PS: I don’t often return to something quite so quickly but numbers in last week’s column drew such a response I feel obliged to. I reported projections from Ross Walker of Royal Bank of Scotland that real household disposable incomes would grow by 2% this year and 2.2% next, preventing a consumer recession. How come, when average earnings are growing less than the retail prices index and food and energy bills surge ever higher?

Walker emphasises that his projection is not for very strong real income growth, which has averaged 2.8% over the past 20 years, nor for anything other than a modest rise in consumer spending. The statistics, so far, suggest we are not as squeezed as we feel. That could change, though, notably if the small rise in unemployment turns big and nasty.

From The Sunday Times, June 15 2008

All the news fit to print about the economy is very gloomy. In a matter of weeks the credit crunch's bite has got harder and evidence of a sharp slowdown tangible.

Add in blunt warnings from the Organisation for Economic Co-operation and Development, roughly suggesting Britain has been transformed from model economy into basket case, and it looks like the last rites.

So how bad is it, and are we looking down the barrel of recession? All good things come to an end, so is the record run of 63 consecutive quarters of growth to be consigned to the history books?

Not only have the housing- market data been terrible but survey data for services, manufacturing and construction show either significant growth slowdowns or declines.

Purchasing managers' surveys for the three sectors, published in recent days, tell a similar story. Manufacturing's purchasing managers' index dropped from 50.8 to 50; in services the fall was from 50.4 to 49.8; and construction slumped from 46.1 to 43.9.

Taken literally, given that index levels below 50 are supposed to indicate falling output, the surveys suggest manufacturing has stopped growing and services and construction are shrinking. In practice, the read-across is not perfect but the slowdown message unmistakable. Anecdotally, I have come across few business people recently who would disagree.

We know why this is. The credit crunch's ugly sister, high energy and commodity prices, means the economy is being hit by two big shocks at the same time. All the advanced economies, Britain's main markets, are slowing. The only thing that prevents a global recession is the strength of emerging economies.

If you believe the OECD, Britain is peculiarly vulnerable. Our former strength, a comparative advantage in financial services (remember those boasts about London overtaking New York?) is now a disadvantage. Housing is becoming an enormous millstone round the economy's neck.

The OECD's warnings should be put in perspective. Its record on forecasting UK growth is not as good as the Treasury's. The research it has done on links between the UK housing market and the wider economy scratch the surface compared with the detailed work done by the Bank of England. Its forecast for UK growth this year is above America, euroland and Japan, and next year is faster than America and in line with euroland. This does not suggest an economy uniquely suffering from the credit crunch and housing gloom.

However, some of the OECD's points were well made, and bold for a body that used to be very wary of upsetting member governments. It is indeed the case that under Gordon Brown the government spent far too much in the good times, leaving the public finances vulnerable in a slowdown.

It is a sobering fact that in the recession of the early 1990s the budget deficit (public sector net borrowing) went from a surplus of 0.2% of GDP in 1989-90 to a deficit of 7.8% by 1993-94.

What about housing? The numbers, as I say, look dreadful. New mortgage approvals fell to an all-time low of 58,000 in April. The Halifax house price index, having risen 1% in the three months to February, plunged more than 6% in the three months to May. This is an annual rate of decline of 25%, making even the gloomiest forecasts look optimistic.

House-price falls like this happen in two circumstances. One is when the economy is in recession and unemployment rising sharply. That is not happening, not yet at least. The other is when the authorities lose control of monetary policy. Typically, a loss of control of monetary policy happened in a sterling crisis. This time the loss of control is the result of the credit crunch, which has deprived the Bank of its ability to influence the price and availability of credit.

There are issues about whether the Halifax and Nationwide house price measures exaggerate the slide, though I applaud Halifax's honesty in releasing exceptionally gloomy data when it is trying to get a rights issue away. It will be interesting to see if these falls are reflected in broader price measures such as the Land Registry.

The broad picture is clear, though. Mortgage rationing has cut out a swathe of potential buyers and created a thin market. Price changes are more dramatic in thin markets, exacerbated by cuts in valuations by the lenders.

Do house-price falls in thin markets make it more likely that there will be a serious knock-on effect to the rest of the economy? The slump in housing activity is seriously affecting housebuilders, estate agents and anybody else directly connected to the industry but, without ignoring their pain, the big question is the impact on consumer spending.

So far, the spending slowdown has been modest. The other big-ticket item most people buy is a car — and there are plenty of reasons not to buy a new car — but registrations in the first five months were down a modest 0.6% on last year, with sales to private buyers down only 3.5%.

An analysis by Ross Walker of Royal Bank of Scotland suggests consumer spending is not heading for a fall as it did in the recessions of the early 1980s and 1990s. While consumer confidence is weak, its relationship with actual spending has been poor in the past.

Of more relevance, according to Walker, are rising real household disposable incomes, set to increase by 2% this year and 2.2% next, supporting consumer spending increases of 2.4% and 1.4% respectively. When consumer spending grows, recession is unlikely. Should the Bank help things along by resolving that other policy dilemma, on interest rates? Economists at UBS, in a presentation last week, argued strongly that in advanced economies the downward risks to growth from the credit crunch far outweighed the upward dangers for inflation from rising food and commodity prices.

That is not the view of the European Central Bank, whose president, Jean-Claude Trichet, warned on Thursday that the ECB could be raising interest rates by a quarter-point to 4.25% next month. If that seems strange, perhaps we should be grateful for the fact that the Bank is merely content to keep its rate on hold at 5%, as it did last week.

Normally I would argue for a cut, but these are not normal times. A rate cut now would be wasted ammunition, costing credibility for little gain, particularly when set against the ECB's hawkishness. Until the usual transmission mechanism for monetary policy is restored there is no point in the Bank doing anything.

PS The job of deputy governor of the Bank looks attractive. The salary is £235,000, there is prestige attached and, as with US vice-presidents, you are a heartbeat away from the top job. Except the Bank is not such a fun place to be, there are two deputies and the battle to succeed Rachel Lomax in one of those jobs has become a public one.

Both the Bank and Treasury deny tensions over the post, though Alistair Darling is determined to beef up the Bank's financial stability expertise by appointing a committee of outside experts to advise the governor. Having met the banks, he has taken their criticism of the Bank in recent months on board.

From The Sunday Times, June 8 2008

Sombre — there is no other word for it. One good measure of the seriousness of the economic situation is that the Bank of England governor has stopped making jokes. Gone are the quips about disco dancing or the true meaning of Christmas not being clear until Easter (as far as retail sales statistics are concerned).

As he moves into his second term, King confesses to waking up each morning worrying about the banking system. He is aware the last thing a miserable, put-upon public wants at this stage is a laugh-a-minute central banker. Long faces are this season's look at Threadneedle Street.

Mind you, there must have been one or two smiles behind closed doors after more than one daily paper chose to lead last week on the governor's declaration that the "nice" decade was over.

Mine and the Bank's recollection is that he first declared the nice decade over in October 2004, did so again in October 2006 and has been doing so at regular intervals since. You might ask how nasty it has to get before people decide things are no longer nice.

As some readers will be aware, "nice" has a special meaning for the governor. To economists, nice stands for "non-inflationary, consistently expansionary". It describes, in other words, the period we have been through of very low inflation and continuous economic growth.

Unlike many in financial markets who are convinced that we are seeing the return of inflation in a big way, I am not persuaded we have broken out of the long run of low inflation. A 3% inflation rate on the consumer prices index (CPI) is not high in the context of a doubling of oil prices in a year and a surge in other commodity prices. Retail price inflation of 4.2% is remark- ably low in these circumstances.

Even if both rise by a percentage point or so, we will have escaped a potentially damaging inflationary shock very lightly. The Bank's remit allows for larger deviations than this from the 2% CPI target because of "external events and temporary difficulties", which is why 1% to 3% is not a target range, though falling outside it calls for the governor to write a letter of explanation.

The trouble is we have got used to extremely low and very stable inflation; the longest run of low and stable inflation in the post-war period. And this, of course, is what the Bank is judged on. The letters the governor expects to write in the coming months (he has to write one every three months if CPI inflation stays above 3%) will be seen as a failure.

There is another reason why the mood is sombre. After more than a decade in which the Bank and its monetary policy committee (MPC) have come to be seen as the masters of the economic universe, we now see its powers are limited to the point of impotence.

The first area of impotence is interest rates. What we are seeing is not, in the main, an interest-rate shock, but the fact is that three- month Libor (the London interbank offered rate), the most important rate in the economy, is about 5.8%, while Bank rate is 5%. Libor is closer to where it should be if Bank rate was 5.75%, the level reached before the MPC started cutting last year.

The picture on mortgage rates is more varied. A two-year fixed rate, 95% loan-to-value, is up from 6.33% to 6.94% since July last year, while a similar 75% loan-to- value mortgage is almost unchanged at 6.08%. The average standard variable rate is down from 7.44% to 7.24%, the average tracker from 6.22% to 5.97%.

But the normal pass-through from rate cuts is not happening, and in many cases official rate cuts have been meaningless for borrowers; the opposite has occurred for them. The Bank has also been powerless to prevent a sharp drop in credit availability at all rates, even if it had wanted to.

The second area of impotence relates to global commodity and energy prices. "Core" inflation in Britain, excluding food and energy, is running at 1.4%. Without the impact of higher global food and energy prices the Bank would be in danger of writing a letter explaining why inflation had dropped below 1%.

To be fair to King, he takes this one on the chin. He knows that for much of the "nice" decade the international inflation backdrop was favourable but the Bank got the credit for delivering low inflation. He knows he cannot lay the blame for everything on international events, as Gordon Brown does. King insists the Bank's job is to deliver low inflation whatever the global circumstances, though to try to do so immediately at present would inflict unnecessary pain.

But the influence of global events means things can change quickly. The inflation picture changed substantially over the past three months and can do so again over the next three or six, in either direction. Headlines about "no rate cuts until 2010" are not sensible.

The final area of impotence concerns sterling. The pound's 14% average fall since January last year — more against the euro — broke the long run of strength that had accompanied the entire independence era since May 1997.

You can argue that the Bank has brought about sterling's fall by cutting interest rates while the European Central Bank held steady, though calculations in the Bank's inflation report last week suggest this does not explain much of the fall.

You can argue that the Bank is also culpable for its part in the Northern Rock fiasco, which undermined international confi- dence in the British economy and sterling. Some currency dealers have been looking for an excuse to sell the pound for some time and the prospect of Britain catching a cold from America offered it.

There are other explanations. Sterling was a big beneficiary of M&A (merger and acquisition) flows in the first half of last year. When these stopped abruptly, the pound lost one of its means of support.

The truth is nobody knows, and the Bank can't do much about it. Raising interest rates might send sterling lower still. Sterling's fall helps to rebalance the economy but fuels inflation through higher import prices. The Bank is powerless. No wonder the mood is sombre.

PS: Now I have reminded you of the meaning of "nice", let me offer clarification on a more esoteric matter, the fiscal rules. Alistair Darling's £2.7 billion tax giveaway last week would have been astonishing in any circumstances; the biggest tax cut since the pre-election budget of 2001. If the weakened Brown government is prepared to give this much away before a by-election, think what might happen before a general election.

Perhaps not. Robert Chote, IFS director, points out that the Office for National Statistics is in the process of revising the GDP figures, partly to better account for financial services ("financial intermediation services indirectly measured" in the jargon). An upward revision of GDP might allow debt to stay below the 40% ceiling. But we would all know the rules had been bent again.

From The Sunday Times, May 18 2008

It is hard to keep up with the price of oil. No sooner have we got used to $100 a barrel than it is in the $120s. Will the price rise to $150, $200 or even $300 a barrel? How far can it rise without doing severe damage to the world economy?

A few days ago Arjun Murti, the analyst at Goldman Sachs who predicted three years ago the price could top $100 a barrel, said the "superspike" could take it to $150 or $200. His prediction had more impact than a similar forecast days earlier from the president of Opec (the Organisation of Petroleum Exporting Countries).

Neither Murti nor Chakib Khelil, Opec president, are disinterested observers. Goldman is one of the world's biggest traders in energy derivatives and Opec has a vested interest in a high oil price. But Daniel Yergin, president of Cambridge Energy Research Associates, has previously predicted a fall in prices and also thinks $150 is likely.

That would be enough to push petrol up to about £1.25 a litre and diesel to £1.40, well over £6 a gallon. It