A few days ago, something odd happened. A bad set of trade figures came out and they resulted in sterling coming under pressure. Why odd? Because it is a long time since the markets took any notice of the monthly trade figures.

In the distant past, they were regarded as the single most important barometer of the country's health. We will never know for sure whether a bad set of trade figures cost Harold Wilson the June 1970 election, but they certainly did not help.

Later, capital flows took over from trade as the driver of currency movements. Sterling was strong from 1996 to 2007 because of this, despite a deteriorating trade picture that nobody took much notice of. Now, it seems, trade is important again.

So are the markets right to focus on the trade figures again? No and yes. No, because there are certain figures some analysts should not get their hands on.

The trade deficit on goods and services in January, £3.8 billion, looked dreadful compared with the December figure of £2.6 billion. But a month ago the December figure was £3.3 billion. Without wanting to sound like a broken record, these figures are prone to revision, even leaving aside January weather effects, and the markets should have been more aware of that.

Part of the problem for sterling at the moment is the political uncertainty discussed last week. The other is the London effect. London is the world's biggest foreign-exchange centre, turning over a scarcely believable $1.7 trillion (£1.1 trillion) a day, and traders always have some data to latch on to, in a way that does not happen for other European countries. There are plenty of rent-a-quote currency analysts ready to talk down the pound.

But yes, markets are right to regard trade as more important now. One reason sterling was strong before the crisis was flows into the UK banking system from abroad to meet the banks' funding gap. Those flows have been greatly reduced and will remain so, which helps to explain sterling's fall.

Britain's trade has improved somewhat. The trade deficit in goods and services narrowed from £45 billion in 2007 to £38 billion in 2008 and £33 billion last year. The current account deficit seems to have been only about 1% of gross domestic product last year, from nearly 4% in late 2006.

That said, there are two problems for Britain when it comes to exporting, despite the huge advantage of a competitive exchange rate. We don't make enough of the right things and we don't sell them to the right places. That is particularly true of goods, in which UK exports last year, £228 billion, were less than three-quarters of the value of imports, £309 billion.

On the first, a report last week, Ingenious Britain: Making the UK the leading high-tech exporter, offered some useful pointers. It was commissioned by the Conservatives and written by Sir James Dyson, the entrepreneur. Britain does a lot better in high-tech exports than is usually thought. The Engineering Employers' Federation reports a strong revival for high-tech sectors, particularly electronics.

There is a lot more that can be done. In 2007, before the financial crisis, Britain registered 17,000 international patents, according to the World Intellectual Property Organisation, compared with 240,000 by America and 330,000 by Japan.

Dyson argues that the problem starts in schools, where only 4% of teenage girls want to be engineers compared with 32% who want to be models, and he blames the bias against science and technology in education. Paying science, maths and technology teachers a lot more might help. Universities are too constrained, especially by the drive to produce peer-reviewed academic research, which limits their ability to collaborate with business.

Financing high-tech start-ups is risky and should be rewarded with more generous tax relief. Government support, particularly the research and development tax credit, should be refocused on small, high-tech businesses. By their nature, however, these changes will take time.

What about shifting the geographical bias of our exports? That well-known economist Gordon Brown put his finger on the problem a few days ago. "It's pretty obvious what's happening," he said. "The European economy, which is our major source of growth, is not growing fast enough."

He is right. Retail sales in the EU are doggedly failing to recover. In January they were 1.6% lower than a year earlier. Without demand on the Continent, sterling's undervaluation against the euro is wasted.

Last year nearly 55% of Britain's goods exports went to the rest of the EU. There is little evidence that patterns of trade are shifting. Indeed, because many foreign firms use Britain as a base to export to the Continent, that is easier said than done.

The good news is that exports to China are rising. In the latest three months, despite those disappointing January numbers, UK exports to China were up by an impressive 48.4% compared with a year earlier. Exports to South Korea rose by 22%.

The bad news is that we start from a very low base. Though the share is rising, only just over 2% of UK exports of goods go to China. Exports to the four Bric countries (Brazil, Russia, India and China) added up to 5.2% of UK exports of goods last year.

The picture for trade in services is different, though not hugely so. International Financial Services London, which produces data on the sector, said 33% of the UK's trade in financial services in 2008 was with the EU, followed by America, 26%, and Japan and Switzerland, 4% each. China and India combined accounted for less than 1%.

Building new export markets is hard work. It will take time to shift the bias of Britain's trade away from Europe. Sooner or later, however, it has to happen. Otherwise Britain will be left in the slow lane.

PS: March 24 may or may not be Alistair Darling's last budget outing but he can do the country a huge favour by clearing up some of the mess he has created for Britain's pensions system. Last week I attended the National Association of Pension Funds (NAPF) investment conference, where I discovered two things.

This is the thin end of a nasty wedge, which could kill company pensions. Once senior people lose the incentive to participate, schemes risk falling by the wayside. Far better, if the concern is avoidance, to slash the absurdly generous £245,000 annual allowance for contributions. This government started damaging pensions in 1997 with Gordon Brown's £5 billion annual tax raid. It is not too late for the chancellor to make sure it does not end by wrecking them entirely.

From The Sunday Times, March 14 2010

The storm has subsided, for now at least, but nobody believes it is over. If it were still raging as hard as a few days ago I would have to acknowledge our part in the pound's downfall. Last Sunday's poll in this newspaper showing a lead of just two points for the Tories, the narrowest on a comparable basis since October 2007, produced a good old-fashioned sterling slide on Monday. It was almost nostalgic.

We can expect a few more weeks of this. Markets hate uncertainty, and there is plenty of it. We do not even know the date of the budget, though that is likely to be announced as March 24 this week, let alone the election date, though it will be a surprise if it is not May 6.

Political uncertainty somewhere is the norm. Other countries' elections produce inconclusive outcomes. Hung parliaments, and coalition governments, are commonplace elsewhere in Europe.

So why do the markets have such a downer on Britain? The simple explanation is that, along with America, the UK suffered a sharper deterioration in public finances than other big advanced economies. A budget deficit of an eighth of gross domestic product is enormous in anybody's book.

That, however, has been in the market for some time. It was as long ago as April 2009 that Alistair Darling told the world that the government would borrow £175 billion this year (a figure nudged up to £178 billion in the December pre-budget report). The only news there has been on this in recent weeks has been to suggest that this figure will be undershot slightly.

Britain's economy is doing better. It may be too soon to declare outright victory over recession but normal service is being restored in one respect: Britain is growing faster than the eurozone. That began in the final quarter of last year, when UK growth of 0.3% exceeded the eurozone's 0.1%. It has continued this year, according to surveys. Britain's services sector surged ahead last month on the purchasing managers' survey, while growth in the eurozone slipped back. Britain's manufacturers are outperforming their European counterparts.

Of course it is easy to exaggerate the extent of the "crisis" for sterling and financial markets. The pound has been lower against the dollar and euro than it is now, though sterling will be clouded by uncertainty for at least the next few weeks.

In fundamental terms, sterling is undervalued against both the dollar — where the long-run rate is $1.68 — and the euro. Simon Derrick, currency economist at Bank of New York Mellon, thinks fair value for the euro is 70p, which translates to roughly 1.40 to the pound. I would put it a bit lower than that, but well above current levels. Capital Economics predicts that, once the current uncertainty is over, sterling will rise to 1.25, by the end of the year.

Even the widening of the gilt-bund spread — the extra cost of funding Britain's debt compared with that of Germany — is not what it seems. Philip Shaw, economist at Investec Securities, describes as "hopelessly simplistic" the idea that this in any way measures the likelihood of a British debt default.

The spread, roughly 90 basis points (0.9 percentage points) for 10-year gilts-bunds, was higher in the months leading up to the global financial crisis in 2007 and in 2004-5, when borrowing was a fraction of today's levels. The recent widening reflects a number of factors, most obviously the pause in gilt purchases under the Bank of England's £200 billion quantitative easing programme.

Some facts get lodged in the minds of the markets. One comes from a report by McKinsey, the consultants, pointing out that in 2008 Britain's total debt, at 469% of GDP, exceeded that of Japan, at 459%. Go beyond the executive summary, however, and McKinsey points out that a chunk of that debt reflects Britain's position as a global financial hub. Adjust for that, and total UK debt is higher than France, Germany and Switzerland but not enormously so. Without the benefit of a global financial centre, Iceland's debts rose to 1,200% of GDP and Ireland's 700%, according to McKinsey.

A significantly bigger proportion of UK debt is domestically held than in any other leading European country. The average maturity of UK government debt, 12.7 years, is twice the OECD average and well ahead of other countries. Britain could still suffer a funding crisis but debt maturity and the low starting point for UK public-sector debt are significant counterweights.

So it must come down to where we started: political risk. Hung parliaments are rare. The last was in February 1974, followed eight months later by another election that gave Labour a majority of three.

We may not get a hung parliament this time, though that is where the polls are pointing. The obvious riposte is that all three parties are committed to cutting the budget deficit, that the differences between them are small, and that threatened with a fiscal crisis they would find ways of working together to ensure a rapid drop in borrowing to keep the markets sweet.

That is where the problem lies. A 1974 scenario could mean the comprehensive spending review planned to start soon after the forthcoming election would be delayed, possibly for a year. If parties have been coy about precise plans now, that coyness will last beyond the election if another is looming.

The particular problem here is Gordon Brown. I believe the chancellor when he says he wants to cut the deficit. I believe George Osborne and Vince Cable, the shadow chancellors. The prime minister, however, does not seem to believe it, even if he is occasionally persuaded to say it. He cannot believe what he saw as a transformation of Britain's public services during his chancellorship, "prudence for a purpose", has to be followed by more savage cuts than anything Margaret Thatcher tried.

Until he believes it, and can convince everybody he does, the markets will continue to harbour extreme doubts. And they will continue to believe a Labour victory, particularly a minority Labour government, would be very bad for Britain.

PS: Everybody hates paying tax, not least Britain's biggest companies. But are they really paying 57% of profits in tax, as reports last week suggested? The Hundred Group of FTSE 100 finance directors, on whose calculations the 57% figure was based, did not even claim that for itself.

Because of this, it is not impossible a big employer would have a total tax burden close to 100% of its profits. Would that mean the Treasury was taking all the profits in taxes? No. The NI contributions would be part of the cost of doing business. We would all like it, of course, if those costs were lower.

From The Sunday Times, March 7 2010

At some stage those who run economic policy will shift from managing this crisis to ensuring they are doing enough to prevent the next one. Before the crisis, it all seemed so simple. Most countries adopted inflation targets — implicitly or explicitly — and nudged a single instrument, the interest rate, to ensure it was met.

I often had to explain to younger readers that monetary policy in Britain had not always been about nine people sitting round a table at the Bank of England each month and deciding whether to change interest rates by a quarter of a point.

Britain was not the first to adopt such a target but it, and an independent central bank, were the cornerstones of UK economic stability and success. Were we deluded? An International Monetary Fund paper published this month suggests, in part at least, that we were.

Written by IMF chief economist Olivier Blanchard and two colleagues, its essential point — which will not surprise non-economists — is that we were not as good as we thought. The period before the crisis, the "great moderation", or "great stability" was not, after all, proof that policymakers had cracked it and, as Tony Blair and Gordon Brown kept telling us, eliminated boom and bust.

"As the crisis slowly recedes, it's time for a reassessment of what we know about how to conduct macroeconomic policy," said Blanchard, launching the paper, Rethinking Macroeconomic Policy, available on imf.org.

"We now realise that economists and policymakers alike were lulled into a false sense of security by the apparent success of economic policy ahead of the crisis."

Inflation-targeting, some believe, was the source of many of the problems of excess we are suffering from. Low and stable inflation, and the absence of nasty surprises on interest rates, encouraged lenders and borrowers to take more risks than they should have done. Stability on the surface concealed huge instability. If inflation and interest rates had been more volatile, things would not have got so out of hand.

So should the lesson of the crisis mean we should no longer target inflation and build in a bit more volatility? No. Aim for volatility and you will get more of it than you can handle. Inflation-targeting, while far from flawless, has been the most effective model for UK monetary policy in modern times, and for many other countries.

The mistake, as the IMF paper points out, was that low and stable inflation was assumed to be both necessary and sufficient for wider stability. Those at the top at the Bank of England ignored the concerns about financial stability raised by their own experts and were not alone.

All this must change. We should keep inflation targets but they have to be augmented. Central banks were guilty of ignoring something that should have been near the top of their agendas: what was happening in the banking and shadow banking system. Money and credit were seen as only important for inflation, not whether they were creating dangerous market bubbles. We will not see a return to old-style credit controls but new so-called macro-prudential tools, to constrain the banks' ability to bankrupt the economy. That has to happen.

Where the IMF paper has got it badly wrong, I think, is in its suggestion that it would be sensible to raise the inflation target in Britain and elsewhere from 2% to 4%. Its argument is that, just as a 2% inflation target was associated with a normal interest rate of 5%, so a 4% target would be associated with a rate of, say, 7%.

When crisis strikes, there is more room for cutting rates from 7% than from 5%. The "zero bound" — interest rates cannot normally go negative — is a lot further down.

Why is this idea wrong? After all, 4% is not much higher than 2% and might not make an enormous amount of difference, particularly if adopted by all countries.

It is wrong because, while I am no inflation nutter, adopting a target that doubles the price level every 15 years seems to me irresponsible. It is wrong because it would endorse every suspicion in the bond market that governments will seek to inflate their debt away, rather than go through the hard job of raising taxes and reining back spending. It would be a surefire way of igniting a huge sell-off in government bond markets.

Most of all, I think it is technically wrong. Imagine if, over the past 10 years, Britain had had a 4% inflation target. Most of that period, inflation was below 2%. To inflate up to the higher target, interest rates would have needed to have been lower rather than higher. A 4% inflation target might have been associated with a typical Bank rate of 2% or 3%, rather than 7%. The future will be different from the past but perhaps not that much. A higher inflation target would have meant an even bigger boom is asset prices.

Indeed, I would draw the opposite conclusion from the IMF. For Britain at least, the Bank should have aimed lower on inflation. I say this not for the usual trite arguments about the inclusion, or not, of house prices in the consumer prices index (CPI).

The old pre-December 2003 inflation target, the retail prices index excluding mortgage interest payments, included a house-price element but did not signal inflationary problems any sooner than the CPI, even as late as 2006 and 2007.

No, the argument is a different one. From the adoption of inflation-targeting in late 1992, it had always been a tale of two inflations in the UK. On one side was domestically generated, mainly service-sector inflation, which stayed closer to 4%. On the other was goods-price inflation, much of it reflecting import prices, which was zero or negative.

The Bank took the benefit of favourable goods-price inflation to achieve, or better, the target it was set. The Bank was too easily satisfied. It should have got domestically generated inflation down to 2%. That would have meant higher interest rates and, perhaps, rather less credit-generated exuberance.

However, some of those favourable goods-price developments, the "China effect", have faded. Though the Vat increase complicates it, goods-price inflation is now at 3.9% versus 3% for services.

When the dust has settled, 2% is still a pretty good target. The Bank's medium-term aim, when the economy is strong enough to take higher rates, has to be to get domestically generated inflation down to that. But don't mess about with the target.

PS: It may be seasonal but a certain bleakness has descended, notwithstanding Friday's welcome upward revision to growth in the fourth quarter from 0.1% to 0.3%. Revisions to earlier data made this the deepest recession (6.2% peak to trough) in the post-war period, while the details raised doubts about whether the upturn can be maintained. It is not sensible to get too hung up on this, given that further data revisions are inevitable but, as I say, the mood has darkened.

Their mood does tell us they will be slow to raise rates. Three members of the shadow monetary policy committee, which meets under the auspices of the Institute of Economic Affairs, think the Bank should raise rates to 1% this week. Much as I love the shadow MPC, I don't think that will happen.

From The Sunday Times, February 28 2010

What does an economic wrecking ball look like? If you know, and can put a number on it, the Bank of England would love to hear from you.

The last time large parts of Britain’s economy were physically flattened was the second world war. When the wreckage of the Blitz was surveyed, it was clear how much had been lost and what needed to be done.

The nearest peacetime equivalent was the recession of the early 1980s. Then, enormous damage was done to swathes of British manufacturing and the lost capacity was plain to see in permanently padlocked or demolished factories.

This has been an invisible recession — large in scale but harder to see. The great office towers in the City and Canary Wharf, monuments to Mammon, are still standing, though not as fully occupied as they were. So are blocks of city centre flats, products of an over-exuberant buy-to-let boom.

If you wanted to find physical evidence it would be in boarded-up shops. One in eight are empty, including many former Woolworths’ stores. High streets tell us something, though the changing nature of retailing means there were boarded-up stores even during the boom years.

So the question of how much we lost, and how long it will take to rebuild, is not straightforward. It is, however, a key one. Even with uncertainty swirling around financial markets, Mervyn King, the Bank of England’s governor, last week identified the “magnitude and persistence” of the recession’s impact on the economy’s supply capacity as one of the biggest uncertainties in the outlook.

Why does it matter? Put simply, if there is plenty of spare capacity then, as long as demand picks up, the economy should be able to grow for years without running into bottlenecks and higher inflation.

At the other extreme, if enough has been lost and cannot be quickly rebuilt, even a modest recovery could run into the buffers.

So which is it? Official figures show the economy shrank 6% from peak to trough from the spring of 2008 to the autumn of last year. In normal times it might have grown 4% over that period, so if it were operating at capacity before the recession, other things being equal, a 10% “output gap” has opened up.

The Bank expects official figures to be revised up, at the peak and the trough, so I judge its estimate of the recession’s GDP fall is about 5%, which would still leave spare capacity equivalent to 9% of GDP.

How much of that was lost in the crisis? The Treasury thinks there was a permanent loss to the economy of 5% of GDP from 2007 to 2010. Because that loss was spread over three years rather than disappearing in one fell swoop, it thinks the output gap was 6% at the trough of the recession last year. That is a lot of spare capacity. Jobmarket and survey data also suggest a significant gap, though not quite as much.

How quickly it is used up depends on how fast the economy grows in relation to its long-term trend. As discussed last week, some economists think trend growth — the economy’s sustainable path — has been knocked as low as 1.75% a year by the crisis, while the Treasury is sticking to its pre-crisis assumption of 2.75%.

This year, even on gloomier trend estimates, will see spare capacity increasing further with a below-trend recovery. Next year and beyond is where it gets interesting. Despite stressing the uncertainty, the Bank comes down pretty firmly on the side of those who think there is plenty of slack for the economy to grow without restraint, if it can lift itself up from the floor.

Its inflation report attracted headlines last week for conceding that a double-dip recession could not be ruled out (though neither could a rip-roaring recovery) and for King’s phrase that the economy “has continued to bump along the bottom”.

In fact its forecast — slightly weaker growth but greater confidence that some downside risks have faded — is one any sensible person would give his right arm for.

Though the Bank does not do normal forecasts, preferring its fan charts, medians, modes, uncertainties and “skewnesses” (don’t ask), it appears to be projecting growth of about 1.5% for this year, followed by 3.5% in both 2011 and 2012. It remains more optimistic than other forecasters.

At the same time, and this is what raised most eyebrows, the Bank was able to present an aggressively optimistic inflation forecast. After a long period in which its projections have been too low, it expects a dive in inflation from over 3% this week (some say it will be more than 4%) to below 1% during the next few months.

We will know this week if there was a split in the monetary policy committee on the decision to pause its £200 billion programme of quantitative easing. There was clearly a split, a “range of views”, on inflation, with some worried it will stay higher for longer because of the lower pound and rising commodity prices.

What happens to inflation in coming months will not reflect spare capacity but gas prices, post-election tax changes, the effect of the weather on crops, and those other short-term inputs into the consumer prices index.

Further out, I suspect, notions of capacity are more flexible than they used to be. Adding to capacity is no longer about building a new factory or an additional production line. These days it may be as simple as taking a few more people on and letting them work from their computer at home.

So, while I do not think inflation will drop as fast as the Bank expects over the next few months, I do think low inflation will be a medium-term legacy of the recession because of spare capacity. It usually is.

I have got this far without mentioning bank lending. Surely the big constraint on the economy’s ability to grow will be constraints on credit as the banks restructure their balance sheets and boost capital?

The Bank thinks not. It thinks a phenomenon I have written about here, the “creditless recovery” is likely. While credit conditions will improve — loans becoming more freely available — the Bank thinks “access to the capital markets and recourse to internal finances [by companies] should enable output to grow at healthy rates without requiring a significant pick-up in net bank lending to UK households and companies.”

As a prediction, that is almost as bold as the Bank’s inflation forecast for this year.

PS: It seems certain Alistair Darling’s March budget, his third, which may be on March 17 or 24, will be the last formal political event before the election campaign. Comparisons are being drawn with Roy Jenkins’s budget, also his third, just before the 1970 election.

So is there a risk for Labour that Darling will present a Jenkins-style budget? Apart from that tax rate the answer has to be: if only. Budget and balance-ofpayments surpluses, 3% growth and a decent tax cut. The chancellor would be the hero of the hour.

From The Sunday Times, February 14 2010

Imagine. The budget goes down badly in the markets, producing a big bond market sell-off and the threat of a downgrade from rating agencies.

A sombre prime minister broadcasts to the nation, explaining the need for austerity. Public-sector workers and students take to the streets. It does not reassure investors or head off a downgrade. The country is gripped by a fiscal crisis.

That is the kind of thing that has been happening in Greece in recent weeks and spreading to Portugal and Spain. Is it in store for the next British government?

The Greek question is important in its own right but also for other countries that have large deficits. "Nobody is suggesting we are going to follow Greece," Philip Hammond, the shadow Treasury chief secretary, said last week, only to be contradicted by George Osborne, the shadow chancellor, who said Britain was "facing a Greek-style crisis if we do not deal with this problem".

The Tories are having a bit of a wobble. Last week the Institute for Fiscal Studies (IFS), in its annual green budget, advocated more ambitious plans to cut the deficit but said it would be risky to start squeezing too soon. The Tories may have got wind of that, and got wind of voter concerns about the party's austerity message, with a narrowing poll lead. What looked like a firm commitment to begin cutting as soon as David Cameron was in Downing Street appears to have been softened. There would be no "swingeing cuts" in the first year, he said.

It looked like a u-turn, and that is how it will probably be seen, but to be fair to the Tory leadership, deep cuts in the first year were always a bit of a red herring.

Their Treasury team knew the difficulty of "in-year" cuts — reductions after the fiscal year has started. Assuming a May 6 election, and a Tory budget within 50 days (if the party wins) we would be three months into the fiscal year before anything was announced, let alone implemented. Cameron and Osborne, particularly Osborne, always sounded more gung-ho about early cuts than these constraints implied, however. It is a change of tone.

This was always a bit of a phoney war. As the IFS pointed out, Labour is planning a fiscal tightening in 2010-11, 1.6% of gross domestic product, by reversing some temporary measures such as lower Vat, tax increases such as the 50% income-tax rate and reductions in public capital spending.

It was politically convenient for Labour to present itself as the guardian of recovery and the Tories to strike a pose as custodian of the public finances, even if the actual differences between them were small. The Tories have, however, blinked first.

Does this make Britain more likely to be the next Greece? This is a jumpy time, with markets nervous about a hung parliament as polls have narrowed. But the lack of market reaction to the Tory change of tone shows it is the need for a clear deficit plan, which has to be set out in the first few weeks, that matters. When the deficit is clearly on the way down, pressure will ease.

The IFS and National Institute of Economic and Social Research think more will be needed to halve the deficit (which may undershoot the Treasury's £178 billion projection this year) than we yet know about.

The IFS reckons the Treasury has detailed £57 billion of the £70 billion of spending cuts and tax increases needed, leaving £13 billion to announce. That sounds fairly small beer, like the "black holes" we used to worry about in pre-crisis days. Don't forget, however, that the £13 billion is on top of a yet-to-be-implemented £57 billion of spending cuts and tax hikes.

Though it would be desirable to achieve this £13 billion on spending, that may be hard even for a determined government. Treasury figures imply real cuts in spending on services of 2.9% a year from 2011 to 2015. Protect areas like schools, and real cuts elsewhere rise to 6.7% for at least two years. Even the Treasury's biggest squeeze for decades will be hard to achieve.

So there will have to be some tax increases and the IFS has performed a service by coming up with a menu. Instead of merely raising Vat, it suggests widening the Vat base — bringing in zero-rated items such a food, children's clothing and books — would be more effective. Accompanied by extra help for the lower paid, this would raise a decent £15 billion a year and be a tax on spending rather than income. Vat could be imposed on financial services.

A comprehensive carbon tax would appeal to an incoming government and could bring in £13 billion, though it would hit large energy users. The IFS thinks there is scope for significant savings — £10 billion a year or more — from means-testing or taxing "middle class" welfare benefits.

Though imaginative, it sounds a bit grim. If you wanted to find optimism last week, look at the National Institute's new medium-term projections. Partly because of Britain's slower start but also demographic factors, our growth rate between 2012 and 2016 is put at 2.7%, above America (2.6%), the eurozone (2.2%) and Japan (1.2%).

One of the big debates is about how much the crisis has subtracted from the ability of economies like Britain's to grow over the medium term. Clearly there is scope for disagreement on this.

Michael Dicks of Barclays Wealth, in his chapter in the IFS green budget (which Barclays now sponsors), concludes that Britain's "trend" growth rate has been knocked down to 1.75% by the crisis. The Treasury still thinks Britain can grow at a 2.75% rate.

The National Institute is somewhere between the two on trend growth but thinks the process of catch-up after the recession will allow 2.7% growth (as in the first half of the 2000s) for some years.

If it is right, tackling the deficit will be easier. Barclays' projections, on the other hand, point to two austerity parliaments, with £50 billion of additional cuts or tax increases on top of the IFS's £13 billion.

Slow growth looks plausible seen from the perspective of an economy emerging slowly from recession, though these things can change. Tackling the deficit is one political priority. Getting growth going is another. Balancing the two will be tricky.

PS: The markets were right to expect a pause in the Bank of England's quantitative easing programme at £200 billion, though the monetary policy committee (MPC) was careful to retain the option of doing more if conditions warrant it. But I think this is the beginning of a process in which, very slowly, monetary policy is "normalised" in the UK.

The Bank, indeed, would have power coming out of its ears. The pace of spending cuts and tax rises would be set by the Tories in co-ordination with the Bank.

From The Sunday Times, February 7 2010

Sometimes I wish I wrote about sport. There is plenty of debate before and after the match but, except in extremely rare circumstances, the score stands. Whether or not the Russian linesman was right to say the ball crossed the line in the 1966 World Cup final, England won.

In economics, on the other hand, the score rarely stands. Data revisions are as much a part of the game as groin strains in football or tendonitis in tennis.

Thousands of column inches were devoted last week to three things. One was that the economy grew by a mere 0.1% in the final quarter of last year, the second was that this is the deepest post-war recession and the third was that it is the longest.

One is definitely untrue. Even on figures we have, this is not the deepest post-war recession. It shares a 6% peak-to-trough fall with the slump of the early 1980s.

The 0.1% figure will not be true for long, and probably not survive the next couple of months, when the Office for National Statistics (ONS) gets more data in. The bigger revisions, which should show that recovery started in the middle of 2009, and that the peak-to-trough gross domestic product (GDP) decline was 4% rather than 6%, will not come until the middle of the next parliament. I will care, as will economists at Goldman Sachs, who have charted past data revisions, but I am not sure many will.

That is one reason why it is at best premature to describe this as the longest post-war recession. On preliminary data, likely to be revised, it is the longest continual period of falling GDP, six quarters. But the recession of the mid-1970s dragged on for the best part of three years and that of the early 1990s for two, even though GDP did not fall continuously.

The GDP numbers have brought to wider attention some deep underlying problems in UK official economic statistics. Those who labour on full-scale macroeconomic models, including my near-namesake David B Smith of Beacon Economic Forecasting and the University of Derby, have been exasperated for years by national accounts data, and the huge discontinuities and inconsistencies they throw up. The Bank of England, aware of the ONS's record, took to "backcasting" the official figures.

But, to go back to my yearning to write about sport, it gets a bit tiresome always shouting at the referee, and attacking what looks like the ONS's pessimistic bias. Economists at Fathom Financial Consulting got the 0.1% figure right and not just because they thought it was sensible to aim low.

The fact is that if we were bounding out of recession, even the ONS could not disguise it. Given the pace at which we plunged into a recession — with a drop in GDP of more than 4% in the space of six months a year ago — there was a hope that when the economy turned, it would do so dramatically.

The "Zarnowitz rule", after the late, eminent American business-cycle economist Victor Zarnowitz, said that the steeper the descent, the more rapid the bounce-back into recovery. This, what you might call the trampoline theory of recessions, had some sound thinking behind it.

Most recessions are driven by destocking, a run-down of inventories, and this contributed to the steepness of Britain's decline last year, at least according to the figures. You might expect that once there were signs of stability, this process would go into sharp reverse, which could easily have produced quarterly growth rates of 1% or more, not a feeble 0.1%.

That has not happened, either because firms have learnt to get by on permanently lower stocks or are not sufficiently confident to rebuild to normal levels.

Why is the recovery not stronger, given the stimulus the economy has had? Some people say it is due to Britain's large financial sector but financial services are only 8% of GDP and appear to be growing as fast (or slowly) as the rest of the economy.

Another "sectoral" explanation is that Britain has too small a manufacturing sector, and exporters too focused on the rest of the EU, to benefit from growth in the emerging economies, in contrast to, say, Germany. There is something in this.

The truth, however, is probably more straightforward. UK households and businesses were more dependent on credit than their counterparts in many other countries. When credit crunched, and its supply was abruptly cut off, the effects of that were severe. Now, while things have picked up from their low point, the economy is still hugely credit-constrained.

Another widely reported statistical story a few weeks ago, following the ONS's revelation that the saving ratio jumped to an 11-year high of 8.6% (of income) in the third quarter, was that Britain had rediscovered the virtues of thrift.

That is not the case, as a new paper from Mark Cliffe and James Knightley of ING points out. The amount households set aside in savings actually fell dramatically during the recession. But borrowing fell even more sharply. Netting these out gave the rise in the saving ratio, driven by the fall in borrowing, and some repayment of debt, rather than an urge to save.

"There is no sign of a convincing increase in saving in bank accounts or other assets," they write. "If we are right in expecting income growth to slow sharply in 2010, savings are likely to fall afresh."

It is a good point and one that is relevant to the weakness of the recovery. It may be that even if households did not discover the urge to save, they suddenly became debt-averse. I think, however, the main reason borrowing fell was because credit was not available. That applies to small and medium-sized firms as well as households. Bank of England figures show that the growth of so-called M4 lending, adjusted for financial-sector transactions, is at its weakest since 1994.

Andrew Haldane, the Bank's executive director for financial stability, has hit out at bank behaviour that is "unlikely to support banking stability", notably paying out too much in bonuses and dividends. The banks have their own debt hangover to deal with. One way they are doing so is by not lending enough into the economy.

PS: Will they or won't they? Inflation figures 12 days ago argued against extending the Bank of England's £200 billion quantitative easing programme but the weak GDP numbers brought it back into play as far as the markets are concerned. I would not do any more. What will the monetary policy committee (MPC) do?

Broad money, adjusted for distortions, so-called M4x, is weak, and that would argue for extending easing at this week's meeting. So it could be close, and a split vote. The City, on balance, expects the Bank to stop. The announcement at noon on Thursday will be interesting.

From The Sunday Times, January 31 2010

When one door opens, another slams in your face. Just as the news on unemployment is getting better, inflation takes a turn for the worse.

There is a long tradition in economics that says these two things are directly related but I do not think this is what is happening here. There is also the tradition of the "misery index" — the sum of the unemployment and inflation rates — and that rose sharply, by the full percentage point of the jump in inflation from 1.9% to 2.9% (unemployment was steady at 7.8%).

I will come back to inflation. Unemployment has now fallen for two successive months on the claimant count and recorded its first fall on the Labour Force Survey measure since May 2008. Having been widely predicted to reach 3m by now, it is 2.46m, and has so far failed to breach the 2.5m level. Vacancies are rising again.

This is good news, and not just for those who might have become unemployed, between 450,000 and 500,000 on government estimates. Following tentative evidence the public finances may not be quite as disastrous as feared, official calculations suggest lower-than-expected unemployment could cut public spending by a cumulative £17 billion over the next five years.

I have focused on labour-market flexibility, particularly wages and working hours, which has been very important. The Department for Work and Pensions also emphasises the role of labour-market policies in improving the outcome.

Jobcentres are doing well and the department extracted money from the Treasury for labour-market support during the crisis. Unlike in previous recessions, people have not been shifted off the claimant count into other benefits; there has been a net flow into jobseekers' allowance from lone-parent and incapacity benefits.

Inflows into unemployment have been lower than in the last recession and people are leaving the register faster; 70% leave unemployment within six months, compared with 63% in the 1990s and 60% in the 1980s. Employers, having once written off the official employment service, now express more than 90% satisfaction with it.

The government is also targeting help at the young. The latest figures showed a drop of 16,000 to 927,000 in the number of young people unemployed, and 29% of them are full-time students wanting part-time work. But this total is still too high and the job market is still a long way from normal.

As Nigel Meager, director of the Institute for Employment Studies, points out: "The number of working-age people out of the labour market has breached 8m for the first time. A growing number of these would like to work and many are underemployed, with more than 1m part-time workers unable to find full-time positions."

So despite the good news, the job-market misery has not gone away, though it has been less than feared. It will be a miracle if we get through January-March without some renewed rise in unemployment.

Mervyn King offered his own bit of misery last week. The Bank governor gives four big speeches a year. This one, as always, was elegant and well-argued. But King sounded like a dispassionate commentator on the economic scene, rather than somebody with his hands on the levers.

"The patience of UK households is likely to be sorely tried over the next couple of years," he said. "There is little scope for growth in real take-home pay, which may remain weak even as output recovers. It is clear that inflation is likely to pick up markedly in the first half of this year." Any sense the Bank had anything to do with this was hard to find.

Perhaps this was what provoked Danny Blanchflower, a former member of the Bank's monetary policy committee (MPC), to call last week for a fundamental shake-up of the MPC. His mildest reform would be to revert to a measure of inflation that included house prices, the old RPIX (the retail prices index excluding mortgage interest payments). His biggest reform would be disbanding the MPC entirely and replacing it with a new committee focused more on unemployment than inflation.

I like Blanchflower a lot but he is technically wrong to say that a shift back to the old RPIX target "would make it clearer that we are in a deflationary period". RPIX inflation was 3.8% last month, well above its old 2.5% target. King will have to write a letter next month explaining why consumer price inflation has risen above target. He would have had to write one this month on the basis of the old target.

As for having a different kind of MPC, not focused solely on inflation, that is a much bigger question. The MPC can and will have to take more account of what is happening in the financial system.

It will need new tools to try to prevent the collective behaviour of the banks from risking the entire system. That will affect its use of the interest-rate weapon. But this is no time to talk about an MPC focused on unemployment rather than inflation. With the fiscal rules no more, getting rid of the inflation target would be seen as an act of financial suicide by the markets. At a time when some are already ready to conclude that the Bank has taken too many risks with inflation, this would be the final nail in the coffin.

Why is the Bank, from the governor downwards, so useless at responding to fundamental criticisms like this? They appear to regard Blanchflower as a disgruntled former employee who will eventually go away. He will not, and neither should he. But the argument for an independent central bank and inflation target should be incontrovertible. Few questioned that low inflation delivered benefits in growth and employment, particularly in a country like Britain with a history of price instability.

The Bank needs to make that case again, and in a way that reaches ordinary people and businesses. Otherwise the MPC could see its rationale eroded away.

Which brings me neatly back to the latest inflation figures. With the money supply subdued — Bank of England figures suggest M4 fell last month — average earnings growth weak and oodles of spare capacity after the recession, there are only two genuine routes to higher inflation: the weak pound and higher commodity prices.

The pass-through from sterling is a one-off, and rises in commodity prices will be offset by weak domestic inflationary pressures. The Bank knew an inflation spike was coming, and must grin and bear it.

What it should not do, in my view, is announce any more quantitative easing next month beyond the existing £200 billion. Despite strong arguments for this being a temporary blip, to do so would risk looking like the Bank did not care about inflation. It should pause.

PS: Lord Richardson, who has died at the age of 94, ran the Bank of England in an era when a gentle raising of the governor's eyebrows was enough to make the City sit up and take notice. Mervyn King paid tribute to him as "a man of dignity who served the Bank and the country with distinction. He was held in great affection by all who knew him."

Lord Burns, chief economic adviser to the government at the time, recalls that Richardson found that period difficult but that some of the accounts of the amount of blood on the carpet were exaggerated. Burns and Richardson remained friends after he stepped down as governor in 1983.

From The Sunday Times, January 24 2010

It is the big question after any recession. Where will the growth come from? A big part of the answer, this time at least, has to be from exports.

Consider the evidence. For more than a decade, from late 1996 to the autumn of 2007 (the fall of Northern Rock), sterling was overvalued on average and especially against the euro. Then it came down to earth, to the point where it is clearly undervalued against the euro and competitive against other currencies.

This was not a deliberate policy aim of the Bank of England or Treasury (if it had been, the pound would probably have gone up) but a happy accident — an essential ingredient in rebalancing the economy.

Exhibit two is the fact that, after a dreadful 2009, when world trade slumped more than 12%, a post-war record, it is now recovering. That recovery will gain momentum this year and next. Though many people are sniffy about Britain's exporting abilities, mainly because of our appetite for imports, one thing we know is that when world trade grows, UK exports do well.

The recovery in world trade, at a time when demand in Britain can be expected to be more constrained than in the recent past — for a variety of reasons — is another happy accident, though skewing growth away from the consumer has been an ambition of policymakers for years.

So the conditions are in place: there has been no acceleration in wage inflation to undo the competitive advantage of a lower exchange rate (the opposite, in fact). Will it be an export-led recovery?

Yes, according to the Ernst & Young Item club, which has a new forecast out tomorrow. "Growth is almost totally dependent on a sustained upturn in the world economy and upon the energy and enterprise of UK exporters of our prized goods and services, from whisky to water pumps, and education to entertainment, to cash in on a rebound in world trade," said Peter Spencer, its economic adviser. "But let's not be under any illusion — this high-wire rebalancing act is going to be very challenging."

Item's numbers suggest, however, that it will happen. This year will not be much to write home about, even for the most
far-flung exporter. Item predicts that exports will rise by 5.7% but imports by 6.6%, within the context of just 1% overall growth in the economy.

If Item is right, however, the three years from 2011 will be a golden age for exporters, with growth of 9%, 9.5% and 8% respectively, easily outstripping imports and propelling the economy as a whole along at a decent pace of about 3%.

History is on the side of a decent export-led recovery. Three things we learnt from the upturn after the recession of the early 1990s were that first, the budget deficit comes down faster than you expect; second, that inflation as a result of a big fall in the exchange rate does not last in an economy with plenty of spare capacity; and third, that it is indeed possible for the UK to have export-led growth.

The big current-account deficit of the Lawson boom of the late 1980s, nearly 5% of GDP, was all but eliminated by 1997.

The issue of export-led growth came up, too, at a joint monetary policy seminar with the Centre for Economic Policy Research (CEPR) last month at the Bank of England. In Bank-speak, the verdict was that exports should do the trick, though with caveats. "It was thought that the significant exchange-rate depreciation since the summer of 2007 should boost exports and reduce imports in the coming quarters," it concluded.

The caveats were mainly about the squeeze on credit available to exporters, depriving them of the opportunity to take advantage of the situation and the fact that firms are often very slow to compete on price. Many exporters have left their local-currency prices where they were, preferring to take the benefits of sterling's lower level in higher margins.

The economists at the Bank-CEPR seminar were right to add caveats, though credit constraints should ease over time and it is normal for exporters to respond initially by widening margins, only later exploiting the advantage of a competitive exchange rate to increase market share. Do not forget, too, that rising exports are only part of the story — the other being slower growth in imports. As far as GDP is concerned, it is "net" exports that matter.

How do we square the idea of an export-led recovery with the fact that manufacturing is so clearly still in the doldrums? Official figures last week showed that manufacturing output in November was flat for the second month in a row, marginally down on the start of 2009, and 14% down on its pre-recession level in 2007.

Even a manufacturing optimist would concede that it will take four to five years to get back to where industry was before the recession. A competitive pound has not stopped the closure of the Bosch factory in Cardiff, with the loss of 900 jobs.

The Engineering Employers' Federation last week predicted "a long slow haul to recovery" for manufacturing, with growth of only 1.2% this year, though admittedly followed by 3.4% in 2011 on the back of stronger exports.

We would all like to see a bigger and faster revival of manufacturing, and for rebalancing to achieve something that is as rare as hen's teeth in economic history: industry increasing its share of the economy after a prolonged decline.

It is important to also bear in mind, however, that not all of Britain's exports are screwed together in factories. More than two-fifths of UK exports are in services. Some of the brightest prospects are in those services where Britain was competitive anyway, and which will receive a further boost.

This includes, as well as much-maligned financial services, Britain's strong business services sector. It includes the law, the creative and media industries, healthcare, education and civil engineering. It takes in biotechnology, where Britain is second only to America, as well as software, where there are more than 100,000 independent UK firms.

So it can happen, and indeed it probably has to. Britain's exporters have taken too much of a back seat in recent years. Now their time has come.

PS: Only eight days to go until the release by the Office for National Statistics (ONS) of GDP figures for the fourth quarter and the excitement is almost unbearable. With it, however, goes a bit of nervousness. This is the quarter, of course, which should show the emergence of the economy from recession. If it doesn't, many economists will be inclined to hang up their abacuses. From all the evidence we have, it should happen. Even the double-dippers need a quarter of growth to dip from.

I don't blame NIESR for this. In time, I suspect, its recovery profile will have been shown to be right, though data revisions will also eventually change its verdict that last year was the worst for the economy since 1921.

From The Sunday Times, January 17 2010

Though it was given a bit of excitement by the coup that never was (and maybe never will be) against Gordon Brown, this election campaign already has a depressing feel to it. We feared the debate would be reduced to the lowest common denominator and that is what we are getting.

Alistair Darling should have known better than to wheel out a dossier he described as "the Conservatives' £34 billion credibility gap", detailing what he claimed were the opposition's uncosted tax and spending commitments.

I am always inclined to think kindly of the chancellor, perhaps naively, so I suspect he knew better but that his hand was forced by a higher authority. Heaven knows what tricks he will be required to perform as polling day approaches. Just say no, Alistair.

What you will also know is that David Cameron got himself into a bit of a tangle over whether a Tory government will definitely introduce some kind of tax break for married couples.

He will, though I suspect he was trying to give himself a bit of extra room for manoeuvre. We can also assume, barring a political earthquake, that the Tories will stick to their pledge to raise the inheritance tax threshold to £1m per individual.

This pledge is a good example of how policies that were right for their time can end up being huge millstones around a party's neck. When the inheritance-tax pledge was unveiled in October 2007 it gave George Osborne his greatest political triumph and did more than anything to persuade Brown to delay an early election that he probably would have won.

Now it looks badly out of place. It should have been buried when it became clear that the state of the public finances did for the Cameron-Osborne strategy of "sharing the proceeds of growth" between public spending and tax cuts.

If not then, it should have gone when the government announced tax hikes for all, most notably the planned rise in National Insurance in 2011. The Tories regard the inheritance-tax pledge as a matter of trust but it is something they will live to regret.

I regret it because it means that nobody is standing up against what will be a very damaging change to our tax system, due to take effect in less than three months.

In April Britain's top rate of tax will rise to 50%, reversing the cut to 40% 22 years ago. Britain will have one of the highest rates of income tax among the advanced economies, as part of a very messy system.

As many will know but others are yet to discover, the effective marginal income-tax rate on incomes between £100,000 and £112,950 will be 60%, because of the progessive withdrawal of the personal tax allowance. Then there is a lull, before the new top marginal rate comes in at £150,000.

Some who read this will be directly affected by this change. Others will wonder what the fuss is all about. After all, what is wrong with rich people paying more? And did we not have a 60% top tax rate for nine years under Margaret Thatcher?

It matters for three reasons. It sends out the wrong signal to people wanting to set up and succeed in Britain — risking killing the golden goose. It will also mean that even more effort is spent on trying to keep income out of the taxman's grasp. And, most importantly, it is likely to result in less revenue for the exchequer over time.

If there was such a thing as a political consensus in Britain in the 1990s and most of the 2000s, it was over the top rate of tax. Tony Blair persuaded a reluctant Brown that a sure way to extend the party's appeal to aspirational Britain was to commit to not raising the top rate of tax above 40%.

He could not prevent him finding ever more inventive and stealthy ways of raising tax in other areas but the 40% top rate was sacrosanct. It was a Labour manifesto commitment in 1997, 2001 and 2005, which means that in April it will be broken.

True, the Liberal Democrats always favoured increasing the higher rate to 50%. But as far as the Tories and Labour were concerned, this was not a matter of debate. However much Labour ministers would have liked to squeeze the rich much harder, they were persuaded by the evidence that this would be counterproductive.

What we know from that evidence from HM Revenue & Customs (HMRC) is that even as the top rate of income tax came down the proportion of tax contributed by the highest paid went up. Whether this was the Laffer curve — above a certain level higher tax rates act as a powerful disincentive and reduce revenues — or simply the fact that lower tax rates reduce the need for complex avoidance activity, something important has happened.

In 1978-79, when the top rate of income tax was 83% (98% on earned and unearned income combined) the highest-earning 1% of the population paid 11% of income tax revenues. By 1986-87, after the top rate was cut to 60%, the highest-earning 1% accounted for 14% of revenues. By 1990-91, following the top rate reduction to 40%, the top 1% contributed 15% of revenues, since which time their share has increased considerably, to an estimated 24.1% this year.

Nor is this confined to the very top tier. In the late 1970s, the top 5% paid 24% of all income tax; this year it is 43.1%. The top 10% accounted for 35% of the tax take when Denis Healey was chancellor in 1978 but now the figure is 53.3%.

It is the case that over the past three decades the richest have become, relatively speaking, much richer. Their share of the tax take has, however, grown much more rapidly than their share of income. There is another change, which is that until 1990-91 married couples were treated as a single tax unit but the effect of this is small.

Now we are going back to new higher rates of income tax, and nobody is speaking out against it.

My hopes were raised by a speech last week by Lord Mandelson, perhaps the last true standard bearer for New Labour now that Blair has put it behind him. But, while saying "there is never a case for punitive taxation" and that the government would guard against imposing tax rates that would act as a disincentive, the new top rate was "justified in the quite exceptional circumstances we face".

So not much of a fight from the business secretary and none from the Tories, who think opposing the new top rate would mean a plunge into the elephant trap dug by Labour. They may be right, though I would have thought that a principled and philosophical opposition to Labour's top rate tax hike was politically more astute than the pledge on inheritance tax.

So the battle has been lost without a fight. I always thought having a low top rate of tax was very important for Britain, not least because it compensated for some of our shortcomings in the eyes of footloose international businesses. Now that advantage is going, possibly for ever.

PS: The forecasting competition is now closed, and thanks for all your entries. The file will be opened in 12 months, by which time the snow will have gone but probably come back again. Most readers who submitted forecasts are more optimistic about the recovery than the professionals. Let us hope they are right.

As for forecasting more generally, it is undergoing a bit of soul-searching, particularly because model-based forecasts failed to pick up that much was amiss before the crisis. There is a lesson from history here. Economic forecasting, fashionable in America in the 1920s, fell into disrepute for a couple of decades after the Great Depression. So far, this time it is hanging on.

From The Sunday Times, January 10 2010

A new year, a new decade, but what kind of economy? Let me start big and gradually bring it down to size.

The big picture is that the world economy is recovering. That recovery is, however, heavily skewed towards emerging economies such as China, India and Brazil. The International Monetary Fund’s numbers tell the story as well as anybody’s. In 2009 the world economy contracted by 1.1%, the worst performance since the second world war. That was split between a 3.4% drop for advanced economies and a 1.7% rise for the emerging ones.

That gap will be preserved, more or less, during the upturn, so the IMF expects global growth of 3.1% this year, split between a modest 1.3% expansion in advanced countries and 5.1% growth in the emerging world.

Just as advanced economies were hit harder by the financial crisis, so they will be slower to recover. Emerging economies are much better placed. Gerard Lyons of Standard Chartered describes “an arc of growth from China to India and then on to Africa”. Stephen King of HSBC sees the crisis as the “tipping point”, which has made the shift of economic power from west to east irreversible.

One way of looking at this is by comparing the performance of the “E7” — China, India, Brazil, Russia, Mexico, Indonesia and Turkey — with that of the more familiar G7 (America, Japan, Germany, Britain, France, Italy and Canada).

We start this decade with the combined gross domestic product of the G7 comfortably ahead of that of the E7. By the end of it, according to John Hawksworth of Price Waterhouse Coopers, the E7 will be in the ascendancy.

“The shift in global economic power is not just reflected in GDP,” he points out. “The G7 has already given way to the G20 as the key forum for global economic decision-making, while it was the G2 [America and China] that took the lead in the Copenhagen climate-change talks.”

That is the big story, for this year and many years to come. We should not, however, confuse the relative and the absolute. Britain was displaced by America as the world’s leading economy long ago but that did not stop our living standards continuing to rise, and at an accelerating pace.

What about the shorter term? There are several questions. Will there be a recovery? Will Britain be flung into crisis by record levels of public borrowing? And, related to this, will those problems be compounded by an indecisive general election outcome? Where will interest rates end the year?

The latest GDP figures did not quite show it, but most of the components were consistent with recovery having started some months ago, as are the unemployment figures. Forecasters usually make the mistake of erring on the side of caution in the early stages of recovery.

Even so, taking the official figures at face value, they make it hard to have a strong number for growth in 2010. If GDP has risen by 0.4% in the final quarter of 2009, and then increases at the same rate in the first two quarters of this year, that is consistent with 2010 growth of about 1%.

Could we get no growth at all? After all, the talk is of at least as many pay freezes this year as last, Vat has just gone back up and higher taxes are on the horizon. The answer is yes, though the latest figures suggested Britain’s households have done a lot of the rebalancing they need to do and incomes have been rising quite strongly.

Darren Winder of Cazenove estimates that for a typical household the income available for discretionary spending rose by 21% during 2009, most of which was used to boost saving, and will rise by a further 4% in 2010.

Businesses seem to be in an even better position, suggesting investment should play its part in the recovery, as should exports if the IMF is right about the global upturn. I would expect a further narrowing of the current account deficit, and a quarter or two of balance or surplus, with the red ink for the full year no more than £10 billion.

The combination of £178 billion of government borrowing, an upcoming election and the critical judgments of the rating agencies and the markets mean we are in for a nervous few months.

The Treasury is keen to point out that not only did Britain start the crisis with lower levels of public debt than elsewhere but that most official borrowing is in long-dated gilts. Britain’s vulnerability to a sudden loss of confidence is overstated, according to officials.

I cannot pretend to see into the minds of the rating agencies but my hunch is that Britain will not lose its AAA rating. The only caveat is that the agencies are not averse to publicity. So, while they appear to have settled on doing nothing until after the election, an earlier move is not out of the question.

One trigger could be if the polls start to point towards a hung parliament. There are, however, a couple of things to bear in mind. One is that, whatever the national polls are saying, UK elections are decided by a tiny number of voters in marginal constituencies. They appear to have swung even more to the Tories than national polling suggests. Only if there is evidence that this has been reversed should people get too worried.

The other point is that, while the parties are keen to emphasise their differences, they all know the numbers. Since the pre-budget report, Alistair Darling has made it clear that the quicker growth comes through, the more aggressive the Treasury will be in taking action to cut the budget deficit. The official briefing papers setting out this strategy will be available to all three would-be chancellors after the election.

Can unemployment continue its recent better-than-expected run? It would be a minor miracle for it to go through this winter without increasing somewhat. The claimant count is now 1.63m. I would look for 1.75m by the end of the year.

Inflation will fall back after its impending rise, though it may not fall too far. For years it was reasonable to assume the Bank would hit its target. That is reasonable again, so 2% is a plausible number for the end of the year.

As for Bank rate, the choice is between the Monetary Policy Committee sticking at 0.5% and nudging it higher in the second half. Though savers would love more, I will go for a gentle nudge only, to 1%.

PS: Two questions have arisen from last week’s forecasting league table. One is why the Bank of England is not included. The answer to that has nothing to do with the fact that I use the Treasury’s compilation of independent forecasts to create the table. Rather, it is because the Bank’s forecasts are presented in a way, with fan charts and probability distributions, that does not lend itself to this kind of comparison.

Anyway, such things do not concern readers, who have already sent in a good selection of 2010 forecasts. There may not be a lucrative television programme in it but Britain clearly has a lot of hidden forecasting talent.

From The Sunday Times, January 3 2010

One of the effects of the credit crunch and recession has been to make us even more sceptical of economic forecasts. Model-based forecasts, or even those based on hunch and guesswork, suffer from a fundamental flaw. Humans are not blessed with the gift of being able to foretell the future. The human element even in model-based forecasting is very important.

What forecasters should be blessed with, and one hopes they will be when the lessons of the past year or two have been absorbed, is better ways of telling which way the wind is blowing.

Until the credit crunch, most economists would have struggled to explain what a subprime mortgage-backed security was, let alone its significance. The shadow banking system, which turned out to be enormously important, was kept firmly in the shadows.

In future, economists will be looking harder for clues in the credit markets and will no longer take the banking system for granted. Whether any of that will make them better forecasters remains to be seen.

That said, this recession could have taken several paths. A year ago the debate was over whether the financial hurricane unleashed by the collapse of Lehman Brothers the previous September had blown itself out.

The final three months of 2008 were terrible. Could it get any worse? The answer was yes, and by enough to push most forecasts badly off course.

Britain's gross domestic product (GDP) had been expected to fall by progressively smaller quarterly amounts. As it was, the GDP fall in the first quarter alone, 2.5%, not only equalled or exceeded most people's forecasts for the full year but was bigger than any previous annual fall in the post-war period. This, as I noted last week, was the "falling off a cliff" moment for the economy.

Things did get progressively better as the year progressed, with declines of 0.7% in the second quarter and 0.2% in the third. But the first quarter did it, scuppering pretty well everybody's forecast.

At the start of the year, no forecaster predicted a bigger GDP decline than 3.2%. The outturn, according to the Treasury, was a decline of 4.75%.

I have therefore had to be a little more generous with my scoring system — widening the bands as the Bank of England has done for its famous fan charts — in assessing the record of economists on growth.

Inflation and interest rates were less tricky. It was clear a year ago that the Bank of England was heading into a period of very low interest rates, even though we had never before seen a Bank rate below 2%. It was also evident that inflation would be low. Those who got this one wrong thought low inflation would tip into outright deflation. That happened, briefly, for the retail prices index, but not more generally.

One interesting development, right at the death, has been the improvement in Britain's balance of payments which, taken together with the announcement of a saving ratio of 8.6% in the third quarter, suggests the economy is starting to rebalance.

Last week's downward revisions to the current account deficit, however, took the Treasury by surprise. In the pre-budget report only a couple of weeks ago it estimated that the 2009 current account deficit would be £31 billion. Now with the deficit for the first three quarters revised down to only £11.1 billion, it looks like ending up at only half that. I still think we are heading back towards a current account surplus before too long.

The smaller than expected rise in unemployment has been covered here on a number of occasions. Forecasters were not that gloomy a year ago, expecting an end-year claimant count of just above 1.8m on average. They became extremely gloomy around March, however, after a couple of huge monthly increases. As it was, the year ended with the count edging lower.

So who got it most right? As I say, I have had to widen the bands greatly for GDP because nobody came close to getting it right. But on the basis of my scoring system, congratulations are due to Peter Warburton of Economic Perspectives and the team at Hermes, the fund manager.

Warburton, whose forecasts were too pessimistic during the good times, has fared much better during the past two difficult years. Hermes, one hopes, has been making a lot of money in the markets on the back of its forecasts.

Also worth noting is that the Ernst & Young Item Club, which uses the Treasury's model, did better than the Treasury itself, though the Treasury, like other official organisations, handicaps itself by not making predictions for all the items that are in my table. In 2010 we will at least have a Treasury unemployment prediction to include.

My forecasts were for a 2.5% GDP decline, 1% inflation and Bank rate, 1.75m unemployment and a current account deficit of under £20 billion. That was worth seven points, the same as the winners but, as I always say, on the basis of my own scoring system.

A year ago, after being constantly told by readers that they could do better than the so-called professionals (and much better than me), I launched an experiment by inviting people to submit their own forecasts.

Many readers did so, so much so that in recent days I have felt a bit like an exam marker. So how did the Class of 2009 do?

One immediate observation is that amateurs, if that is what they were, were much less constrained than the pros. Not for them any clustering around the consensus. So we had plenty of predictions of GDP falls of 5% or much more.

The trouble was, and this was reflected in the scoring, if people were gloomy about one thing they tended to be gloomy about everything. So predictions of enormous falls in GDP tended to go alongside forecasts of 10% inflation and interest rates, unemployment running into many millions and current account deficits of a couple of hundred billion.

One useful thing about economic models, which may be their only useful thing, is that they pull forecasts back towards some kind of consistency. So, except in very rare circumstances, the deeper the recession, the lower are inflation and interest rates.

Despite this, many readers did well and there were plenty of threes, fours and fives, as well as zeroes, among the scores. As I was approaching the end of my marking, however, I was ready to conclude that the best amateurs were not quite good enough to beat the best professionals. Three excellent scores of six were achieved by Edward Reeve, Barry Thomas and Andy Turney but nobody was able to top seven.

Then I came across Clive Watkin's entry. He predicted a 4% drop in GDP, 1.5% inflation, a £30 billion current account deficit, unemployment of 1.4m and a 1% Bank rate. That was worth nine points. He also revealed that his family of four plus cat have been running their own forecasting competition for some years, though he did not say if the cat ever won.

Anyway, the Watkin forecast puts the professionals to shame, and some prizes will be on their way to him. As a result of his success, this is an experiment we clearly have to repeat, so please send in your entries.

From The Sunday Times, December 27 2009

The table to accompany this article is in the print edition of The Sunday Times.

We have all lived through a remarkable time. As we approach the end of 2009, we are also preparing to say goodbye to a year that will go down as the worst for the global economy and world trade since the second world war.

It has also been, by a margin, the worst year for the UK economy since the Depression. Even if the figures are eventually revised up, as I expect them to be, that record will not be affected. On the Treasury's estimate of a 4.75% slump in gross domestic product this year, that is more than twice the decline recorded in the previous worst year, 1980.

For the global economy, the International Monetary Fund estimates that world GDP has fallen 1.1% this year. That does not sound much but is the first drop recorded on the IMF's database, which stretches back to 1970. Before that we had the post-war "golden age" of the 1950s and 1960s.

Advanced economies have seen a GDP fall of 3.4% this year, the IMF says. World trade has slipped before, falling 2.7% in 1975 and 0.9% in 1983, but this year's fall, 12%, takes us into new territory.

It may seem odd then to say that things could have been a lot worse. Part of my mission is to take the "dismal" out of the dismal science of economics.

The first thing to say is that the worst of the downturn happened quite a long time ago. The period between October 2008 and April 2009 was when global growth, world trade and the UK economy "fell off a cliff". Economies then stabilised and started on a modest path of recovery. That is true of the world economy and, notwithstanding the official GDP figures, of Britain.

The improved economic tone, and the rise in markets, has happened as we have come out of that sickening dive. Anything could have happened to the banking system, from nationalisation of every bank to the cash machines running out. Instead, as the Bank of England's financial stability report pointed out on Friday, the banks are a long way from being back to normal but an even worse crisis was averted, for which credit is due to the authorities.

In March, the world was looking at "mark-to-market" financial losses of £24.3 trillion. The recovery in markets has cut that to £6.3 trillion. House prices, expected to fall by up to 25% at the start of the year, will end with a modest rise. Sterling rose over the course of 2009 too.

There is other good news. Last week saw a flurry of concern about inflation, as headline consumer price inflation rose from 1.5% to 1.9% and retail price inflation turned positive (by 0.3%). There will be further rises over the next two to three months, before inflation comes down again.

Why is that good news? The dangers of prolonged deflation were exaggerated but the risk was there and has been averted. Had this crisis been followed by a prolonged period of deflation, comparisons with the 1930s might indeed have been justified. As it is, I would much rather have Britain's problems than those of Japan.

Best of all is the job market. Employers and employees have shown huge flexibility to get through this recession. Wage freezes, cuts and shorter working weeks mean employment has fallen by only a third of what it was reasonable to expect.

The government deserves a little credit for its labour-market policies, including job and training guarantees. Aggressively expansionary monetary policy and modestly expansionary fiscal policy have helped.

Last week brought news of the first drop in the claimant unemployment count since February last year. The wider Labour Force Survey measure held below 2.5m for the fourth month running, against high-profile predictions of something like armageddon in the job market.

One of the worst labour-market forecasters, interestingly, has been Danny Blanchflower, formerly of the Bank of England's monetary policy committee, who was appointed to the MPC for his labour-market expertise.

In January he predicted that unemployment would rise to 3m, or worse, over the following 12 months. In May, even when it was clear from the data that the claimant count was rising much more slowly than expected and that the wider jobless measure could be expected to follow suit, he predicted monthly unemployment rises of 100,000 for the rest of the year. Even as lower numbers came through, he insisted it was the lull before the storm.

It may still be, though it would be an odd recovery that saw job losses accelerate. Unemployment probably has further to rise and will be slow to fall. The Treasury expects the jobless total in 2014 to be some 50% above its pre-recession level.

Only if there is a "double-dip" in the economy, however, would you expect a big unemployment surge. The job-market numbers suggest the economy has been recovering for some months. The risk of that recovery running into a roadblock will be one of the key issues for next year.

There will be more to be said on this but let me just leave you with a couple of quick observations. We are clearly not yet out of the woods. The Bank, in its report, noted renewed worries about the vulnerability of the financial system to sovereign risk, because of Dubai and Greece. Many high-deficit countries, including the UK, have yet to announce the "credible fiscal consolidation plans" the Bank thinks necessary.

The banking system has to wean itself off emergency financial support and needs to get on with it. The Old Lady has taken the banks to her bosom but wants them to stand on their own two feet.

Banks should be doing more to help themselves. By reducing pay bills by 10% and cutting dividend payments by a third, they could rebuild capital by £70 billion over five years. They face big challenges, of big losses on commercial property and rolling over funding in the markets, though the Bank sees these as bumps in the road rather than roadblocks.

The debate about whether banks are lending enough to businesses — or whether the demand for loans has just shrunk — will continue. The return to normal interest rates (which the Bank thinks is 5%) will pose problems, though it will not happen over the next 12 months.

Having said all this, it is very difficult for Britain not to have a recovery if the world economy is growing. The UK is an open economy and 3% global growth next year, which is what the IMF expects, will lift Britain. Most recoveries are V-shaped and the strong likelihood is that this one will be, though there are any number of alternative shapes, including W, square root and saxophone, to debate.

But as we look forward to those debates and say farewell to a fascinating year, probably never to be repeated, we can breathe a sigh of relief that it was not even worse.

PS: We may be getting close to wrapping up 2009 but the excitement is not yet over. Next week will be my annual forecasting league table, which will make some people's Christmases and ruin a few others. This year's competition, as much a part of the seasonal ritual as mulled wine or carols from King's, has an added twist. Readers were invited to submit their own forecasts and some will have done well in comparison with the professionals. There will be prizes.

We are in an online age but the forecasting league table is best viewed on good old-fashioned newsprint. So make sure to get a copy of the paper, even if it means trudging through shoulder-high snowdrifts. Until then, I offer you my best wishes for Christmas.

From The Sunday Times, December 20 2008

After careful observation stretching back over the past 30 months I have come to a disturbing conclusion. There are two Alistair Darlings.

There is the Darling who, in setting things up for last week's pre-budget report (PBR), took the trouble to brief many journalists privately on the broad thrust of what he was trying to do. This was the Darling, an engaging enough fellow, who stressed that politicians had to be honest with people, that he wanted the outside world to know that he was serious about getting the budget deficit down and that he would do nothing to undermine the City.

This Darling was, according to him and his officials, determined to set out clearly how public spending would be brought to heel. He was also more interested in the City's long-term health, and rebuilding Treasury revenues from financial services, than bowing to calls from the mob to bash the bankers.

Then we had this other Alistair Darling, the Mr Hyde to his Dr Jekyll, who delivered the pre-budget report on Wednesday. The only public spending he told us about was spending he intended to increase, and he duly did so. As for the bankers, they were landed with a populist £550m windfall tax on their bonuses. How did it happen?

Let me say at the outset that bankers have only themselves to blame for being hated by the public. While the bonus culture probably played only a minor role in the crisis, they should have been brighter in seeing which way the political wind was blowing, and not just in Britain.

A period of lying low, for at least a couple of years, would have been the sensible thing to do. A bit of PR, like paying bonuses into a charity pool, might have helped.

Just because the bankers have been stupid, however, does not mean the chancellor should be stupid back. The windfall tax will cost taxpayers in the short run, and it will cost them even more in the long run.

Ben Broadbent, an economist at Goldman Sachs, is not a disinterested party but his numbers look plausible. He believes without the windfall tax, bonuses in the eligible period (until April) would have been about £2.5 billion, on which the Treasury tax take would have been more than £1 billion. The effect of the tax will be to reduce payments to £1.1 billion, on Treasury estimates, on which it will receive £550m windfall tax plus another £220m in income tax and a few million in National Insurance. The net effect will thus be to reduce Treasury revenues, compared with what they would have been, by £200m to £300m.

Longer term, of course, the effects could be much greater. As Broadbent put it: "If it increases the perceived likelihood of more such "one-off" measures in future, the levy has serious implications for the incentives to locate business in the UK — non-financial as well as financial." The price of this bit of political gratification could be high.

People used to talk of Labour's prawn-cocktail offensive to win friends in the City. Nobody told Darling you were not meant to pour prawn cocktails over their heads. This was symptomatic of a pre-budget report that, to me, defied any logic. Business hates the extra increase in National Insurance that it, and its employees, have been promised for 2011. The hated "tax on jobs" is creeping ever higher.

It has got the CBI's dander up, in combination with the latest reform of pension tax relief that it thinks will make most reasonably well-paid executives stay out of their company schemes, with damaging consequences for those schemes.

I think business could have just about been persuaded, however, if the extra tax was for the purpose of getting Britain's £178 billion, 12.6% of GDP, budget deficit down. But it was not, and I am genuinely puzzled. The chancellor raised National Insurance, froze the higher-rate threshold, taxed the bankers, introduced a 1% limit for two years on public pay settlements (which should have been a limit on the pay bill, to encourage the search for productivity and efficiency gains). Yet for what?

The PBR, despite the headlines, represented a net loosening of fiscal policy, as the Treasury admits. The Institute for Fiscal Studies (IFS) points out that extra spending on "frontline" health and education and maintaining police numbers adds up to £15 billion over the two years from 2011, against extra taxes of about £9 billion.

At a time when the priority should have been setting out a clear and decisive plan for getting borrowing down over the medium term, the chancellor made the challenge for him, or more likely his successor, even harder by adding to spending.

I do not agree with everything Vince Cable says but the Liberal Democrats' Treasury spokesman was right to say: "Alistair Darling should have laid out exactly where cuts would be made. Instead, he chose to pretend that everything was fine and that he could carry on with tax and spend."

As it is, nobody is fooled. Thanks to the IFS, we know the Treasury's numbers imply real cuts for departmental spending that is not ringfenced of 6.9% a year in real terms from 2011, or one fifth over three years. That is what the numbers imply, though after last week I have no confidence in the ability of this government to deliver them, even after a general election.

People have rightly drawn the contrast between Darling and Brian Lenihan, Ireland's finance minister, who on the same day announced deficit-cutting measures, overwhelmingly on public spending, of Û4 billion (£3.6 billion), 2.5% of GDP.

Where Lenihan was bold, Darling was cautious. He did not need to act immediately but the absence of a medium-term plan to deal with Britain's deficit, which is similar to Ireland's, was irresponsible. As the Reform think tank put it, the score last Wednesday was Ireland one, Britain nil.

Perhaps the real Darling got lost somewhere in Downing Street, diverted by a lot of Brown and a load of Balls, as has been suggested. Either way, given that the spring budget — if we have one — will be even more ostrich-like than last week's effort, the fiscal uncertainty will continue.

The markets and the rating agencies let Britain get away with it because it is bigger than Ireland, which is unfair. It would be unwise to rely on Britain getting away with it indefinitely.

PS: The Bank of England may be independent but it is having its card marked closely by the Treasury. The Bank, which left interest rates unchanged at a 315-year low of 0.5% last week, and signalled that it would persist with the existing £200 billion of quantitative easing until February, is seen as a vital cog in the recovery, to the point where the Treasury is even offering public views on where interest rates may be heading.

There we are. The Treasury expects Bank rate to remain around its present 0.5% for most of next year and thinks that, if it comes to helping out the economy, it need not rise as high as 4% in 2012. Mervyn King, the Bank governor, has been saying a lot recently about fiscal policy. It looks like the Treasury is getting its own back.

From the Sunday Times, December 13 2009

Long years of experience have taught me that nothing dates so quickly as eve-of-budget pieces. Tens of thousands of man-hours go into predictions that a few days later are overtaken by the event itself.

So, having written on this week’s pre-budget report (PBR) last weekend, let me just race through a few quick points before moving on to a bigger issue.

On tax, two things have dominated the build-up. One is that Alistair Darling will extend the temporary Vat cut to give the recovery time to gather strength. You can never say never but I would be gobsmacked if that were to happen, having been assured by everybody that it will not. So we should expect Vat to rise from 15% to 17.5% on January 1.

The second area of speculation is that this will be a “squeeze the rich” PBR, intended to reinforce political differences between Labour and the Conservatives and put a bit more oomph behind Gordon Brown’s declaration of class war last week.

On this, as on so many things, the chancellor is walking a tightrope. He will not, I think, want to raise capital gains tax, despite the gap between its 18% rate and the new 50% top rate of income tax.

Darling’s big reform before the crisis was to simplify capital gains tax to 18%, something that led to a small storm of protest from entrepreneurs. So I would be surprised if he were to raise it. Other ways will be found to clamp down on bankers who arrange to get their bonuses paid as capital rather than income, to minimise tax.

On the other hand, it would be very odd, given the politics, if the planned increase in April in the inheritance tax threshold from £325,000 to £350,000 (double that for couples). There may be a little tinkering around the new 50% rate but it is hard to see Darling as a modern-day Denis Healey, squeezing the rich until the pips squeak with even higher rates of income tax. The chancellor, after all, has said he would like to reverse the rise to 50%.

The bigger issue is whether the markets and the rating agencies will be convinced by his commitment to reduce Britain’s enormous budget deficit. The bad news is that the numbers Darling will present this week will show that deficit even more enormous, though only by a few billion on top of the existing £175 billion projection.

Britain’s flexible job market has been good at preventing a bigger rise in unemployment but the effect of wage freezes and cuts and shorter working weeks has been to cut the income tax and National Insurance take more sharply than expected.

The good news is that it will be downhill all the way from here for the budget deficit, if the Treasury is right, 2009-10 marking a peak that will be followed by a halving - at least - of the deficit by 2013-14.

Will that, and the fact that these reductions will be enshrined in the new Fiscal Responsibility Bill, convince doubters? Treasury insiders think they should be convinced and that Darling, in setting out “frontline” areas of spending to be protected in the coming squeeze, will in effect be saying that other areas are fair game. Wage and working-hour sacrifices by the private sector will have to be matched by the public sector, though probably not with a blanket public sector pay freeze.

The markets have two fears. The first is that even a government elected with a decent majority will not be strong enough to take the tough and unpopular action needed to get the deficit down. The second is that the outcome of next year’s election will be a hung parliament, followed by many months of dithering and delay.

Morgan Stanley made headlines last week by warning of the danger, though I’m not sure the investment bank’s reputation was well-served by that warning.

Tucked away in its Strategy Euroletter, were three “potential” surprises for 2010, were “the dollar may strengthen” and “the surprise sector trade could be pharma”. And, oh yes, set out in just four paragraphs, Britain could have a major fiscal crisis, combined with a sterling crisis, but “UK equities may benefit”. I expect at least a 40-page report for something as big as a full-blown UK fiscal crisis.

Morgan Stanley was, however briefly, giving voice to a widespread fear in the City. How serious is the danger of one of those fears, a hung parliament?

Hung parliaments are rare but are more likely than they used to be, notwithstanding the 13-point Tory lead in today's Sunday Times-YouGov poll. Peter Kellner, president of YouGov, the pollster, points out that in 1959 only seven out of 630 MPs were neither Labour nor Conservative. In 2005, in only a slightly larger parliament, that total was 92.

To get an outright majority, one of the two main parties has to beat both its opponent and this large rump of other parties. Not only that but the task facing David Cameron’s Conservatives - increasing their MPs by more than 130, or nearly 70% (just to get a slim majority) - is a formidable one.

That said, hung parliaments need not be a disaster. The largest party can form a minority government or enter a coalition. The toughest squeeze on public spending in the 20th century, the Geddes axe of the 1920s, was instituted by a Liberal-led coalition government. Currently, some of the toughest measures to cut the budget deficit are proposed by the Liberal Democrats.

There will be more to be said on this in the coming months. Will Darling do enough this week to convince the markets that he is serious about deficit reduction and preserving Britain’s AAA rating?

I am not sure. The tightrope he is walking is between honesty on the public finances and not scuppering Labour’s electoral hopes. It is alsof trying to engender optimism while stressing the fragility of recovery. Recent events in Dubai, the German government’s concerns about lending to “Mittelstand” businesses and the Bank of Japan’s sudden decision to lend trillions of yen to its banks underline that fragility.

One suggestion for him comes from Oxford University’s Centre for Business Taxation. Professors Mike Devereux and Clemens Fuest suggest an announcement now to increase Vat in 2012, by enough to raise 1.5% of gross domestic product in additional revenue.

This would require pushing the main rate of Vat up to 21% or so, or slightly less if the Vat base was widened. The pre-announcement would be a strong signal to the markets and rating agencies, while not getting in the way of growth during the recovery phase.

Will it happen? Politics would suggest it is a policy civil servants would describe as “brave”. The risk is that without something brave, the markets will continue to fear the worst over the next few months.

PS The pre-budget report is not the only event this week. The day after, if it chooses to do so, the Bank of England’s monetary policy committee (MPC) could deliver a critical verdict on the chancellor’s efforts. One member of the shadow MPC, which meets under the auspices of the Institute of Economic Affairs, thinks it should do so. Peter Warburton wants an immediate rise in Bank rate to 1%.

While some members want more quantitative easing, several think enough is enough. A similar debate has been taking place on the actual committee. As for interest rates, the debate will soon turn to when the Bank will consider it safe to start raising them. Though that is several months away, it will happen. The hope is that when it does, it will be a sign of confidence in the recovery.

From The Sunday Times, December 6 2009

Normally at this time of year I would be reflecting on the chancellor’s pre-budget report rather than looking forward to it. But the PBR is late - not until December 9 - so there are two Sundays to go.

As always with these things, that means a lot of decisions have yet to be taken. But the broad thrust of what Alistair Darling intends to say is taking shape.

There has been a subtle shift in the tone of the debate. Last week’s beauty contest at the CBI’s annual conference for the three main party leaders included tough talk on getting the budget deficit down, which the CBI liked, with David Cameron promising “a decisive plan that starts now”.

But there was also a lot of commitment to getting growth going. After the austerity message of the Tory conference, Cameron pledged an “emergency growth budget”, within 50 days of taking office. The only tax changes highlighted were cuts, reducing the main rate of corporation tax from 28% to 25% and the small companies’ rate to 20%, paid for by reducing reliefs.

Government advisers believe this shift reflects a concern among senior Tories that too much talk of austerity and getting down the deficit in a rush was starting to frighten both voters and some businesses.

That is why Darling’s message will focus on jobs and growth. Anybody expecting him to stand up on December 9, clad from head to toe in hairshirt, and issuing bloodcurdling warnings of how much pain is on the way, will be disappointed.

Though he would have liked to be armed with official figures showing a return to growth, rather than the revised 0.3% third quarter fall reported by the Office for National Statistics last week, he will stress the need to keep supporting the economy.

He will stress the fragility of next year’s predicted recovery. Dubai World’s request to creditors last week for a six-month debt standstill, which hit markets hard, was a reminder that while the worst of the crisis is over, the scope for aftershocks remains.

Independent forecasters have moved into line with the Treasury’s budget forecast of 1% to 1.5% growth next year but Darling is unlikely to revise his prediction much, despite the Bank of England’s expectation of 2% growth in 2010.

He will emphasise the jobs saved by government action in the recession, and the need to keep on saving them. In September Darling delivered the Callaghan lecture in Cardiff, in memory of the former prime minister, and talked at length of the “active state” and the enabling role of government.

He thinks this is the crucial political divide, exposed during the crisis. Without government, the recession would have been worse and the banking system would have collapsed, as last week’s Bank revelation of £61.6 billion of Treasury-indemnified lending to RBS and HBOS demonstrated. There was a bit too much fuss over that revelation but it makes the point.

Labour’s best electoral hope depends on a bit of a caricature; persuading voters that it was the government that acted to protect its citizens from the worst of the crisis, while the Conservatives would have walked by on the other side of the road and are slavering to slash spending.

How does this fit in with the spending cuts needed for the credible deficit reduction programme Mervyn King, the rating agencies and the markets are anxious to hear a lot more about on December 9?

The answer, it seems, is that outsiders will have to wait a little longer for the detail. Because there has been no comprehensive spending review (CSR), there can be no detailed breakdown of public spending beyond 2011. We know infrastructure spending will halve over the three years from 2011, though officials point out that even the level to which it will fall - £22 billion - is in line with its long run average.

On tax, there may be some unpleasant surprises, but plenty of tax hikes are in the pipeline, including the new 50% top tax rate from April and higher National Insurance contributions in 2011. Darling will not be aiming for headlines that scream of additional tax pain on the way.

Will this satisfy the markets? This is where the government’s Fiscal Responsibility Bill, announced in the Queen’s speech, comes in. Part of its purpose is getting through Labour’s “make me pure but not just yet” period leading up to the election.

The numbers from the PBR, implying a halving of the budget deficit by 2013-14 and a move towards a balanced budget that, will be embodied in the legislation. That way, ministers hope, they can negotiate the tricky few months leading up to the election, which will probably be on May 6.

Darling will also argue that the economics and politics run together on this and that taking an axe to the deficit too soon would snuff out the recovery.

A vigorous debate has broken out among the think tanks. Is it better to wield the axe on the deficit quickly, giving the economy room to breathe? This is still essentially the Conservative approach, despite last week’s shift of tone. Or is better to wait until the the recovery is well established?

Policy Exchange, a Tory-leaning think tank, has looked at 12 episodes of serious fiscal consolidation, six in Britain and six international. It concludes that, as long as the focus is on spending cuts rather than tax hikes, “fiscal consolidations can promote growth and recovery – particularly by enabling a looser monetary policy than would otherwise have been the case.”

The government, in other words, should get on with it. I have drawn comfort from one of these episodes, the 1990s, when Britain’s budget deficit moved from of 7.7% of GDP in 1993-4 to a surplus in five years.

Public spending dropped from the equivalent of 43.7% of GDP to 36.3%, while tax revenues rose from 31.8% to 36.3% of GDP. Much of this reflected the impact of recovery on spending and revenues, though there was also plenty of deliberate action. And, crucially, it did not prevent the economy growing well throughout the 1990s.

Another think tanker, Giles Wilkes of CentreForum, argues for caution. Interest rates and the pound are already very low and the extent of government involvement, most notably in the banking system, goes deeper than in the past. The history of the 1990s, he suggests, is unlikely to repeat itself, and relies on too rapid a bounceback in exports and investment.

There is something in both arguments. We should also remember that the weight of the fiscal consolidation by the Tories in the 1990s was not felt until 1994 and 1995, a couple of years after the economy began to recover. The markets and business want tough talk from the politicians on deficit reduction and that talk has to be convincing. It would be a mistake, however, for it to be converted into action too soon.

PS Sometimes I feel obliged to defend the family name. On the Today programme, my former colleague John Cassidy, interviewed about his book How Markets Fail (Penguin, £25), blamed the free-market economics of Adam Smith, adopted uncritically by Alan Greenspan.

In fact, as Cassidy makes clear in the book, Smith was even more sceptical of the motives of bankers as of most businessmen. He thought banks should not issue notes to speculative lenders and regulating them was as necessary as building party walls to prevent fires spreading. So don’t blame Smith. Blame those who misinterpreted him.

From the Sunday Times, November 29 2009

The word “nutter” and Bank of England are only occasionally used in the same sentence. It was used soon after Bank independence in 1997 when Diane Abbott, the Labour MP, accused the governor, then Eddie George, of being an inflation nutter.

It was used again recently by Adam Posen, the newest member of the Bank’s monetary policy committee, who referred to some of those worrying about the return of high inflation as “nutters”.

For the sake of clarity, Abbott and Posen have different definitions of inflation nutters. She was concerned about central bankers obsessed with keeping inflation ultra low, whatever the economic cost. He was referring to those who fear hyperinflation is lurking round every corner.

I should say too that nutter is being used here not to refer to people who go nut-hunting in the woods, still less those with mental conditions. A better expression might be silly bloggers.

Let me also make clear that not everybody who worries about inflation meets that description. It seems to me that we should think about inflation in three distinct time-frames. The first is the very short term; the next few months. The second is the short to medium term, the next 2-3 years. The third is the longer-term, say over 5-10 years.

We know what is happening in the very short-term. After hitting a low in September, figures last week showed the start of what the Bank expects to be a sharp rise over the next few months.

Consumer price inflation rose from 1.1% to 1.5%, while retail price deflation eased from 1.4% to 0.8%. The eight-month long curiosity of annual retail price falls, something not previously seen since March 1960, is now almost over.

Inflation will rise further. The Bank expects consumer price inflation to average 1.85% in the final three months, implying it will be above the 2% target by December, and 2.71% in the first quarter.

Some City economists think the rise will go above 3%, requiring Mervyn King to write a letter justifying a 0.5% Bank rate at a time of significantly above-target inflation. King does not expect to have to write, however, and is probably right.

Why is inflation rising? Mainly because of what was happening a year ago. In the autumn of 2008 plenty of prices were falling sharply, including petrol and diesel, which dropped by a record amount between September and October 2008. The contrast between those falls and this year’s modest rises is enough to produce a sharp rise in measured inflation.

The biggest effect of this type will come in January, when Vat goes back up to 17.5%, a stark comparison with a year ago, when it was cut in December.

This very short-term rise in inflation need not concern us even slightly. Not only does the Bank fully expect it but King has assured us that the MPC will look through the short-term rise to what lies beyond it.

What lies beyond, the Bank says, is prolonged low inflation. The second half of next year will see a drop back below target and it will not be until late 2012 until it gets back there. Some City economists point that the Bank’s recent record has been to under-predict inflation but if there is one lesson from Britain’s economic history it is that recessions are good at destroying inflation. That is usually why we have them.

Spare capacity, in the jargon a large output gap, keeps inflation tame. That will be true this time, as it has been on every previous occasion. Posen made the point that even if the Bank wanted to create inflation in current circumstances it could not do so.

“Long historical experience in the UK and elsewhere ... bears this out even for normal times,” he said, “let alone for times when the financial sector is so troubled and there is downward pressure on wage growth and prices.”

What is true for Britain is not necessarily true for other countries. Andrew Milligan of Standard Life makes the point that emerging economies like China that have introduced big stimulus packages but have been less affected by the global recession may be more vulnerable to an inflation rise over the next couple of years.

For advanced economies like Britain, the test will come in the longer-term. Contrary to many of the headlines you will have seen, last week’s official figures did not suggest the public finances have suffered another lurch out of control. The Institute for Fiscal Studies suggested the government is still on course for its £175 billion deficit projection for the current year. The Treasury appears to agree, and any revisions to this year's borrowing forecast in the pre-budget report on December 9 will be minor.

Even so, public sector net debt is up to 59% of gross domestic product and rising, as it is in other countries. How big will be the temptation, once some of that spare capacity is used up, to try and inflate away the problem of public and private debt? Inflation is a lot easier than the hard slog of raising taxes and cutting public spending.

That and the fact that the Bank may find it hard to raise interest rates and reverse quantitative easing is where the inflation danger could lie. As I say, we are not talking about the next 2-3 years but somewhere beyond that.

A debate has been running on the letters page of the Financial Times about whether the break-even inflation rate implied by the difference between conventional and index-linked gilt yields tells us markets are pricing in significantly higher inflation for the next decade. The high gold price, if it has any logic, must reflect inflationary fears. Rising asset prices could be a forewarning of inflation on the horizon.

How big are the risks? At some stage central banks will have to show they are prepared to be very unpopular. It is not hard to imagine quite a sharp rise in interest rates in the run-up to the election after next if the Bank is determined to stick to its 2% inflation target.

At the very least, just as the outlook is for a more unstable economy than in long run-up to the crisis, so inflation will be much more volatile. There is no need to worry about inflation over the next few months. There may be more cause to worry in the long run.

PS Should a state-owned bank be a permanent feature of Britain’s financial system? The issue came up at two separate meetings I attended last week. One was at the British Academy, which has been holding a series of events, including a seminar a few weeks ago which tried to answer the Queen’s question on the crisis: “If these things were so large, how come everyone missed them?”

Manufacturing has complained of being starved of finance for decades but the crisis has brought this home, while demonstrating that bankers were not nearly as good as they thought. State-owned banks provide seed and investment capital in plenty of countries. I never thought I would write it but is this an idea whose time has come in Britain too?

From The Sunday Times, November 22 2009

Life is full of mysteries. This week's is how to square the Bank of England's upbeat forecast for the economy a few days ago with governor Mervyn King's relentlessly downbeat tone in presenting it.

Though the Bank is enough of a tease not to give us precise numbers, a reading of its charts suggest its new forecasts are for growth of a little over 2% next year, rising to 4% in 2011.

The Treasury is in the process of putting together a new compilation of independent forecasts but its last set suggested a consensus prediction of 1.2% growth in 2010, rising to 1.9% in 2011.

The Bank is twice as optimistic as the consensus, so why the gloomy governor? One possibility is that he was a bit under the weather, the evidence for which is that a pink-jacketed flunky brought in a warming cup of something to get him through Wednesday's press conference. The pink jacket, by the way, is a 300-year old tradition and nothing to do with Sir Elton John.

The second possibility is that although King presented the forecast, he does not believe it. The inflation report forecast is, however, the judgment of the monetary policy committee (MPC) and he said differences between members were small.

Anyway, let me try to offer a guide as to how the Bank got to such an optimistic forecast, whether it is credible and what it may mean for interest rates.

The Bank expects a return to growth because of the combination of record low interest rates, the fall in the pound and £200 billion of quantitative easing. That is an unprecedented monetary relaxation. Combine it with a return to global growth next year — the International Monetary Fund expects more than 3% — and you have all the ingredients for a UK upturn.

The Bank acknowledges that there are factors that will hold down growth during the recovery period. It expects credit conditions to remain tight, knows that tax increases and public-spending cuts will squeeze incomes and activity, and thinks households and companies will be engaged in a period of "balance sheet adjustment" — putting their financial houses in order — which will restrain spending.

Those headwinds are quite powerful, so how does the Bank come up with such an optimistic forecast? Part of the answer is that most economic models, including the Bank's, are not good at allowing for some of the factors, particularly credit growth, that could keep growth weak.

The way these models work is that if there is spare capacity in the economy after a recession, in the jargon an "output gap", it will tend to be closed quite quickly. There are no bottlenecks, such as problems with getting hold of new workers, to get in the way. So faster-than-normal growth during recoveries is to be expected.

That is the theory, and the way the models churn out the numbers. What about the practice? Is it remotely possible that an economy emerging from a nasty recession in which asset prices have fallen sharply, the banks are carrying lots of bad loans, taxes are going up and public spending is being squeezed can grow by 4%?

Well, yes. This is exactly what happened in 1994. The economy emerged from the last recession in 1992, grew by 2.2% in 1993 and then by 4.2% in 1994, in the nearest thing we have seen to an export-led recovery in modern times. Then, as now, sterling had fallen sharply.

You may say that this time it is different, but one thing we have learnt in the past two to three years is that things are often not as different as all that. Economic history has a habit of repeating itself, both good and bad.

One area where things have been a little different is the job market. I have commented before on the flexibility of the labour market and how this has limited the peak-to-trough fall in employment to less than 2%, compared with a 6% fall in gross domestic product. The latest Labour Force Survey figures show that employment rose, albeit by a modest 6,000, in the third quarter and unemployment fell, if only marginally, in August and September. After confident predictions for the past three months that unemployment would rise above 2.5m, it remains below it.

We probably have not seen the peak in unemployment. The Bank warns that there may be job losses in the pipeline because the redundancy process takes time. It could be that when temporary assistance runs out, like the willingness of Her Majesty's Revenue & Customs to defer some business tax payments, there will be another wave of job losses.

Even so, the figures are inconsistent with the idea that the economy remains mired in recession. Without wanting to sound like a broken record, I think we have been recovering for four to five months, if not longer, and that in the fullness of time the figures will show this to be the case.

Let us assume that the Bank is right and that in 2011 we can party like it is 1994 all over again. What would that mean for interest rates?

King's insistence that it was wrong to assume the Bank had finished loosening policy (by which he means there could be more quantitative easing, not rate cuts), means it is much too soon to think about a tightening of policy.

Some in the City were thinking about the first rate rise happening as early as February but that looks highly unlikely. A big decision like this will probably require the backing of a new inflation forecast, and my judgment would be that the earliest we can expect even a modest upward tweak in interest rates is August.

That is in spite of the fact that the Bank has warned of a sharp rise in inflation over the next few months as the helpful effects of a year ago drop out.

Rate hikes could gather pace in 2011, if the economy indeed achieves 4% growth, but the Bank's hands will be tied by the fiscal tightening — tax rises and spending cuts — then occurring.

These things change and can change quickly, but my sense is that the MPC recognises that nursing the economy and the banking system back to health will require a long period of very low rates.

The interest-rate assumption used in preparing the Bank's latest forecast was that rates rise to about 1.5% by the end of next year, 3.25% in two years' time and 4% by late 2012. I would be inclined to bet that they stay somewhat lower than that.

PS: Has Lord Mandelson's car scrappage scheme been the most successful incentive measure ever? Despite scepticism, the scheme offering £2,000 trade-ins for cars more than 10 years old (the government contributes £1,000) has worked well since being introduced in May.

At the risk of sounding trendy, this might be one of those "nudge" type policies favoured by behavioural economists such as Richard Thaler. Scrappage schemes nudge owners of old cars into buying new by making them aware they could do it — and that plenty of others were doing so — while taking bangers off their hands. Clever. There must be other applications of the principle.

From The Sunday Times, November 15 2009

Another month, another £25 billion in quantitative easing from the Bank of England. The latest addition to the Bank's asset purchases will take the total to a nice round £200 billion.

The Bank seems to be winding down this phase of the policy, which began at a rate of £25 billion a month, then £50 billion over three months, and has now fallen to £25 billion over three months, assuming it lasts until February.

Given that the Bank seems to like operating in £25 billion units, logic would suggest that the process will end entirely in February, barring economic accidents. We may know more when the Bank publishes its quarterly inflation report this week.

Last week's move seemed well-judged. The question has arisen, however, about whether the Bank is part of a global conspiracy by central banks to drive up asset prices — shares, bonds, property, commodities — which is creating a bubble that will burst with devastating consequences.

Members of the Bank's monetary policy committee (MPC) are, of course, aware that quantitative easing is boosting asset prices. Indeed, it is an essential part of the policy, as described here last week, making it easier for firms to refinance themselves from equity and bond markets at a time when finance from the banks is rationed.

Some are concerned that this process should not go too far. Spencer Dale, its chief economist, warned in a recent speech that the Bank had to balance supporting economic recovery with the danger of pushing up the prices of shares, bonds and property too much.

"The substantial injections of liquidity might result in unwarranted increases in some asset prices that could prove costly to rectify," he warned.

Nouriel Roubini, the maverick New York University economist, took this argument a lot further last week with an article in the Financial Times warning that America's Federal Reserve, through its actions and its influence on other central banks, was creating a "monster bubble".

Roubini described a gigantic "carry trade", which is when investors borrow in low interest-rate currencies to invest in other currencies and markets. Japan used to be the home of ultra-low interest rates and the yen carry trade was legendary.

Now the low interest-rate currencies are the dollar and sterling. The combination of these near-zero rates, a weak dollar and the willingness of the authorities to support every market in sight is fuelling a dangerous global bubble, Roubini wrote. "One day this bubble will burst, leading to the biggest co-ordinated asset bust ever."

He is not alone in expressing worries. The current issue of Newsweek has a cover story headlined: "Warning: we are in the next financial bubble". Its fear is of the echo bubble that usually follows financial bubbles. History tells us that such echo bubbles, like their bigger brothers, usually burst, though less violently and with a smaller impact on the wider economy.

American markets are up by about two-thirds from their lows, while emerging-market equities have risen by 95%.

We should take Roubini seriously. Though Bill White of the Bank for International Settlements probably got it more right than anybody, Roubini was one of the few other economists who warned loudly of the crisis.

His calls this year have not been so good, however, perhaps suggesting that he has become a bit of a stale bear. In March, close to the low point for global stock markets, he predicted further falls as a result of the likely nationalisation of several American banks and the continued contraction of the American economy to the end of 2009.

Part of the reason stock markets have risen so strongly since then is because predictions like that — of a second Great Depression and further widespread bank nationalisation — have not come to pass.

The second reason is that the recovery news has come through more strongly, for both economies and companies, than most people in the markets expected.
Some of the recovery in asset prices is therefore real, and welcome. We have come back from the edge of despair to the point where the world economy is growing again. It would have been odd if markets had not responded to that.

There has also been a return to something like normality in terms of the pricing of risk. Having under-priced risk in the run-up to the crisis, markets veered violently in the opposite direction, particularly in the autumn of last year. Even blue-chip borrowers were, for a while, treated like lepers.

The debate is about the extent to which, over and above this, central banks are dangerously inflating asset prices, creating the risk, not just of a bust but of more general inflation. Bearing in mind that central banks wanted asset prices to rise, they will have to judge how much is too much. My sense is that Roubini is greatly exaggerating both the extent to which all these market rises have been driven by central banks and the risks of a bust.

Most commodity investors, after all, survived a fall in the oil price from $147 a barrel in the summer of 2008 to well under $40. Stock market investors lived through its plunge until March. A reversal of some of these market gains at some stage is inevitable. I doubt, however, that it will give us a new apocalypse.

The main risk to the markets is economic. If the global recovery turns out to be weaker than expected, or if it cannot survive unaided once all the various stimulus measures are removed, then asset prices will take a big tumble around the world. A "W" for the economy would also be a "W" in the markets.

That is why central banks are determined to give their economies a big enough heave to try to ensure they have enough momentum to continue on their own. It is right, in my view, that at this stage they are more concerned about that than talk of blowing bubbles.

PS: Can the internet ever deliver fair competition? Some of you may have seen Dixons' advertising campaign, the one in which it encourages people to try out electronic products at posh stores like John Lewis, Selfridges and Harrods but then buy them online at Dixons.

The OFT research also found, however, that the internet has not lived up to hopes of delivering what economists would think of as perfect competition. There are still surprisingly large price variations, even among competing online retailers. Price comparison sites, for a variety of reasons, have not eliminated such differences. People still go to retailers they trust. The Dixons advertising campaign is cheeky but it hasn't killed off John Lewis. Its weekly figures suggest it has been doing rather well.

From The Sunday Times, November 8 2009

To QE or not to QE? It is the big question for the Bank of England’s monetary policy committee (MPC) this week, and it is a big question for the economy.

After those unexpectedly weak gross domestic product figures nine days ago, showing that officially the economy remains in recession, the onus is on the Bank to do more quantitative easing (QE) this week. Will it, and by how much?

The story so far is that the Bank has done £175 billion of quantitative easing: buying assets, mainly government bonds or gilts. The MPC, while not claiming it has solved everything, is upbeat about its effects.

David Miles, who joined in June, said recently: “I believe the evidence is that QE is having an impact and that it is relevant to economic conditions right across the country. And not just in financial markets in London, but in high streets and factories and homes throughout the UK.”

Kate Barker, another MPC member, said a few days ago that it had helped ease the recession in the housing market, thus supporting house prices.

I don’t suppose many people discuss quantitative easing before sitting down to watch EastEnders but if the Bank is right, they should. It is as important in its way as changes in interest rates and the guide on the Bank’s own website provides a simple explanation why.

The Bank, it says, “boosts the supply of money by purchasing assets like government and corporate bonds”, adding: “Instead of lowering Bank rate to increase the amount of money in the economy, the Bank supplies extra money directly. This does not involve printing more banknotes.

“Instead, the Bank pays for these assets by creating money electronically and crediting the accounts of the companies it bought the assets from. This extra money supports more spending in the economy.”

It goes on to say that this extra spending is necessary to get inflation back to its target — inflation is the Bank’s only target — but I suspect most people would rather see the economy boosted in a more straightforward way, such as getting unemployment down and preventing firms going bust.

The question is when the process should stop. Is £175 billion enough, or should the Bank go further? Let me first offer a guide to how the MPC would like us to think of its approach to policy, then offer my view.

There will come a time, though perhaps not for quite a while, when the Bank raises interest rates. At least some of the headlines that will accompany that announcement will be something like: “Worried Bank slams on the brakes”.

That is not, however, how the Bank would see it. Interest rates are very low, the lowest in the 315 years of the Bank’s existence. At 0.5%, Bank rate is a tenth of what I would regard as the modern-day norm, 5%.

So the way the Bank sees it is that as long as rates remain below 5%, then even if they are rising, monetary policy remains expansionary. So the right headline when, say, Bank rate goes up from 0.5% to 0.75%, would be: “Bank eases off the accelerator.”

The same applies, though in a slightly more complicated way, to quantitative easing. There are three ways any decision on interest rates can go: up, down or sideways.

There are also three ways this week’s decision on quantitative easing could go. The equivalent of a cut in rates would be announcing more easing, in other words more asset purchases.

Sticking with the existing £175 billion but not committing to any more would be like an interest rate “hold”.

An announcement that some of the gilts and other assets were to be sold back into the markets would be the equivalent of a rate hike, though it could still be argued that the policy would remain expansionary until they have all been sold back.

No such sell-off announcement will happen this week. The debate is about whether the Bank announces further easing or stops at what it has done so far.

It is of intense importance in the City, where the programme of asset purchases is seen to have helped lift markets (which the Bank acknowledges and welcomes). A halt would bring an immediate adverse reaction, most notably by pushing up the yields on gilts and corporate bonds.

It is also very important, if Miles and Barker are right, in high streets, factories, estate agents and homes up and down the country.

It matters too for the pound. The Bank’s aggressive easing programme has helped push sterling lower against other currencies though, as I shall try to explain, that might be a perverse reaction.

What will it be? MPC-watchers say October’s meeting offered few clues, merely putting off the decision until this month, when the existing programme runs out.

The shadow MPC, which operates under the auspices of the Institute of Economic Affairs, has been keen on quantitative easing from the start and thinks it would be a mistake to stop now.

Tim Congdon, one of its members, did an impassioned presentation at a recent meeting, arguing that Britain stood out in its policy response.

The easing programme had lifted growth in the money supply at a time when it was heading down worryingly in both the euro area and America. On his analysis, the currency markets should be concerned about recovery in Europe and America, not Britain.

A more cautious note is struck by Chris Williamson, chief economist at Markit, which produces the monthly purchasing managers’ surveys. He is convinced on the basis of these surveys that the economy has been recovering for some months.

The danger, he suggests, is that the Bank pumps in more money at a time when the economy does not need it, risking that the inflation already present in asset prices extends to other parts of the economy.

He has a point, which is why I think the Bank, which also has its doubts about the official statistics, needs to proceed with caution. It is too soon to stop the asset purchases altogether, not least because of the adverse reaction in markets that would result.

It is fair to argue, however, that the economy needs less of a boost than it did. At its peak, the Bank was doing £25 billion of easing a month. In August it slowed the monthly rate to £17 billion-£18 billion. I would slow it further, to perhaps £10 billion, implying that the Bank should announce a further £30 billion of purchases this week. Let’s see what it does.

PS: Many have written books on the credit crunch — I’m just putting the finishing touches to one — but not many people have written two. So I take my hat off to Graham Turner, founder of GFC Economics, for his second; No Way to Run an Economy.

By “socialising” the banking industry’s losses, he argues, governments have been unable to offer a proper Keynesian response to the crisis. As you might expect, he is not optimistic about the outlook.

From The Sunday Times, 1 November 2009

Shooting the messenger is never a good idea. Even so, on Friday the Treasury must have thought about getting up a posse and heading down the M4 to the Office for National Statistics in Newport.

Time and again in this recession, the ONS has come up with gloomier gross domestic product numbers than anybody expected. It did so again on Friday.

The debate had been whether GDP would be flat or show a small rise. Government and opposition were gearing up for a political spat on what the end of recession meant.

The Bank of England's monetary policy committee said in its minutes last week that GDP in the third quarter appeared to be in line with its August forecast, which was for a rise of nearly 0.2%.

Instead, we had a 0.4% fall on the quarter, making this the longest continuous period of falling GDP on record, though not yet the longest recession. The official statisticians have proved, at the very least, they are no propaganda machine. Other than that, we should treat these early estimates with a huge pinch of salt because they are so out of line with survey evidence.

In time the GDP figures will be revised but, when they are, it will not be news, merely of interest to number-crunchers. Meanwhile, we have seen some consequences of the weak numbers for sterling, which fell, and in expectations that the Bank will extend its programme of quantitative easing.

What about the public finances? Let me take you back to the recession's start, and Alistair Darling's first budget in April 2008. It included a forecast for public borrowing for 2009-10 of £38 billion, 2.5% of gross domestic product. The government's net debt would remain below 40% of GDP, the official ceiling, through to 2013.

A year later, the picture was shockingly different. The borrowing forecast shot up to £175 billion, 12.4% of GDP. That's right, borrowing equivalent to 10% of the economy, in a single year, added to Treasury projections in just 12 months. Debt, by the way, is now 59% of GDP and rising.

Treasury officials are working hard on the appetiser for Darling's third budget, the pre-budget report (PBR), to be released in late November or early December.

It is very significant, not least because many feared another big upward revision of borrowing. That and the absence of new measures could have got the rating agencies sharpening their pencils to downgrade Britain's AAA sovereign debt rating.

The numbers are not yet complete but the Treasury suggests things are broadly on track to meet the budget forecast. Dave Ramsden, its chief economist, set himself the goal in the budget of not having to revise the borrowing figures up again. It looks as if he may have succeeded.

At least one independent economist thinks the Treasury could go further. Karen Ward, UK economist at HSBC, has gone through the assumptions the Treasury used in doing its forecast in April.

Those assumptions, some of which have to be approved by the National Audit Office, were made at the time of deepest gloom, in March, when shares were low, the oil price was weak, and economists were at their gloomiest about unemployment.

Ward has gone through these assumptions one by one and concluded that there is a small pot of gold for the Treasury in them. The higher stock market, for example, should give the Treasury an extra £3.1 billion of revenue this year, the higher oil price £4.2 billion, lower-than-feared unemployment £1.8 billion, and so on.

The result is that she expects this year's borrowing to be £153 billion, 10.8% of GDP, more than £20 billion below the Treasury's forecast, with the improvement running through to future years. Under her projections, cumulative borrowing over the period from 2009-10 to 2013-14 will be £131 billion lower than the Treasury expects.

There are a couple of caveats. The first is that, as Ward points out, these only change the public finances "from appalling to merely very bad". Most other independent economists still think, moreover, that the risks to borrowing are on the upside.

The second caveat is that I would not expect big revisions from the Treasury in the PBR in either direction. The important part of the borrowing story will not be known until the final months of the fiscal year — January, February and March. The Treasury would not want to revise down now only to have to revise up later.

Even so, the HSBC forecast reminds us it is too easy to fall into the trap of believing things can only ever get worse. The experience of the 1990s, when Britain moved from a budget deficit of 8% of GDP to a surplus of 0.5% in five years should be one that guides us through these dark days.

In the meantime, there is no shortage of ideas for getting the deficit down. My wish is that we should stop expressing every tax change in terms of how many pennies on income tax it would be equivalent to.

The National Institute of Economic and Social Research, for example, said last week that the government could raise the basic rate of income tax by 7p in the pound — which is not going to happen — or bring forward even more the raising of the state pension age, and to aim for 70.

I like the approach of Reform, the think tank, which identifies £31 billion of "middle-class" welfare, including child benefit, tax credits, maternity pay and the state pension, and say half these outlays should be cut immediately, whatever the squeals. Even if the public finances improve, these debates have a long way to run.

PS: How do you solve a problem like Mervyn? For many months intelligent people have been working hard on how to make banks more risk-averse and less prone to excesses. Then along comes the Bank of England governor.

King, however, is vague. In Commons Treasury committee evidence earlier this year he said "narrow" banks would not work because people would favour riskier banks offering higher rates for savers. Even without explicit guarantees, no government would let millions lose their savings, which is true. If there is a King blueprint we have yet to see it.

From The Sunday Times, October 25 2009

An interview with Adam Posen of the Bank of England's monetary policy committee

After spells at the Federal Reserve Bank of New York and as No 2 at Washington’s leading economics think tank, Adam Posen might by now be setting monetary policy in America.

Instead he answered an advertisement to serve as an external member of Bank of England’s monetary policy committee (MPC).

Posen — the second American to serve on the committee after DeAnne Julius — did not, he said, join as a “newbie” on the British economy.

He has followed the economy for a long time and has previously spent seven months at the Bank on a fellowship.

Posen, 42, engaging and inquisitive, has spent the time since his appointment to the post, which carries a salary of just under £100,000, reading up on the economy and meeting economists. He has a clear diagnosis of why we got into trouble.

“The UK suffered from two blows,” he said. “There was the almost inevitable fact that we were going to have a recession and that some correction in asset prices was going to happen and was going to slow the economy, and not to a trivial degree. Then we had the financial panic of a year ago and the risk of the end of financial life as we knew it, and that made things much, much worse.

“Where we are now, I think, is that the Bank and the government — and other leading governments and central banks — have pulled us back from the brink and ruled out the worst possible outcomes. Now we are back to coping with a normal recession. It’s pretty severe but we are five quarters in and it looks like we are bottoming out.”

So is it a question of waiting until the recovery comes through in the normal way? What Posen describes as a “race against time” is under way to discover whether the banking system will be strong enough to support a sustained recovery.

“We are going to have a stable financial system but the structural problems of that banking system haven’t been resolved. That shouldn’t be shocking news to anybody.

“Two of your big banks are in government hands and by universal acknowledgement there are a lot of bad assets on the books. The biggest risk to a sustainable private-sector recovery is that the banking system problems are not fully resolved by the time we have to pull back.”

For him this is the critical question. Though it is now more than a year since the worst of the crisis, it is still not clear that the banks will be able to support the upturn.

“Time heals all wounds but you would prefer the banks to be engaging in some sort of physical therapy and getting on their feet rather than lying there and waiting for it to happen,” he said. “You don’t want other parts of the economy getting ready to recover but being constrained by misallocation or too limited credit.”

His criticism of the banks does not stop there. Even a brief immersion in Britain’s banking system has convinced him the structure is wrong. The problem of “too big to fail” is not just about big global banks — it starts right here in Britain.

“There were some fundamental problems in the system that were exposed by the crisis, including the behaviour of ‘too big to fail’ institutions and the severe concentration of the banking sector in the UK, and I think those two things compound each other,” he said. “There may be a case for limiting bank size, full stop.”

What might that mean in practical terms? If he had his way, it would mean the break-up of some of Britain’s banks.

“We have to think about restructuring the banking system, especially where the government already has huge stakes, and that’s not just in the UK, but obviously starting in the UK,” he said. “That’s where the debate has to move.”

Both Royal Bank of Scotland and Lloyds Banking Group are big, and the government has large stakes in both. “There’s no reason we shouldn’t be able to say, if we decide: ‘Sorry, super big banks don’t make any sense — the costs are too great’,” he said. “You don’t necessarily return the banks in government hands to the private sector in the form and size that you started with.”

One of Posen’s main research interests is Japan, and how it got bogged down in stagnation and deflation.

Japan pioneered quantitative easing, so he knows a lot about its experiment. Though the Bank started quantitative easing in March, while Posen was watching the British economy from the other side of the Atlantic, he is an enthusiastic supporter. “It’s perfectly sensible and it seems to be working,” he said. “It’s what you do. You know that the sign on the economy, meaning the direction, is going to be towards more growth, towards reflation, towards other assets, and you know you have to do a lot because there are a lot of assets out there. It was always an illusion to believe you could do it with pinpoint accuracy.”

He draws the analogy of driving a new car along the motorway and doing the same journey on back roads in a 10-year-old Vauxhall Astra: “I know I’m going to get there but it might take a little longer.”

As for inflation, he draws on his experience of Japan. “Because we are making purchases now doesn’t mean that it has a huge effect on prices in the future,” he said. “There are simple ways of looking for that in the data and it’s not there but the best example is Japan. Japan did huge amounts of quantitative easing and they are still fighting deflation.”

Though some of his language is dovish, Posen insists he approaches the question of meeting the inflation target in an even-handed or symmetrical way, giving equal weight to deflation and inflation.

The big debate within the Bank will be whether to extend quantitative easing beyond the £175 billion mark. Sterling received a boost last week after one MPC member, Paul Fisher, hinted that there may be a pause in the process next month. Posen is not so sure, suggesting that if it were left to him, he might go further.

What about when the Bank stops quantitative easing? What will be the exit strategy?

“This is why we are paid the medium-sized bucks because it’s not an easy choice,” he said. “This is not November 2008 or February 2009 ... there will come a point when it’s not needed. One thing the world doesn’t need now is disorderly markets. From a monetary-policy point of view we want to make this a smooth transition.”

From the Sunday Times, October 18 2009

(1)

It should have been what golfers call a "gimme", in other words an easy tap-in, but the formal end of the recession has turned into a cliff-hanger.

On Friday, the Office for National Statistics will publish gross domestic product (GDP) figures for the third quarter of the year. Expectations that they would show a rise were tempered by weak industrial production figures a few days ago.

The National Institute of Economic and Social Research, which has cornered the market in guessing GDP numbers in advance, thinks those production figures mean we will get a flat figure. That, to mix metaphors, would be a goalless draw, enough to signal the end of recession but not to show that recovery has started.

The Treasury never had great expectations for the third quarter. Its forecast is turning out to be wrong not because it thought growth would be back by now — it assumed a flat third quarter — but because of a big slide, 2.5%, in the first quarter.

We shall see what the GDP figures bring but we should also note that if the recession is not declared officially over, it should be. Last week brought two separate bits of good news from the jobs market. They do not mean that unemployment has peaked and they do not necessarily tell us that it will be onwards and upwards for jobs from now on. But in the context of what until even very recently were exceptionally bleak forecasts for unemployment, some of them verging on the bonkers, they were very welcome.

The first was from the Department for Work and Pensions. Yvette Cooper, its secretary of state, ordered an investigation into why the two main unemployment measures, the claimant count and the Labour Force Survey measure, were diverging. The former was just above 1.5m but the latter racing towards 2.5m.

Part of the answer was that the Labour Force Survey measure is swelled by more than a quarter of a million full-time students looking for jobs. They are not entitled to benefits, which is why they are not in the claimant count.

There is nothing wrong with students looking for part-time jobs to stretch their loans but they should not be in a true measure of unemployment.

Unemployment among 16-24 year-olds is 945,000, which is unacceptably high. Take out the 257,000 students, however, and it comes down quite a bit. More than three-quarters of "unemployment" among 16-17 year olds is school or sixth-form college students looking for Saturday jobs or other part-time work.

This affects perceptions about unemployment levels but also rates of change. In the latest three months (June-August) unemployment among 16-24 year-olds went up by 19,000. All but 2,000 of that rise was among full-time students.

The second bit of good news was in the broader job-market picture revealed by the latest figures. It has been clear for some months that the underlying unemployment picture has been improving. The claimant count, which rose by 500,000 between October and April, then slowed to show monthly increases of between 20,000 and 25,000; last month's rise was 20,800.

Some of us thought it was only a matter of time before this showed in the wider Labour Force Survey measure and it has.

Unemployment in the June-August period rose by 88,000 to 2.469m, less than a third of its 281,000 rise in the March-May period. The latest figure was marginally lower than the 2.47m recorded as the May-July average, so if you wanted to push it you would say unemployment is falling, as some newspapers reported, though the margins of error in the data are large.

The picture for employment was even better, a drop of only 45,000 in June-August, compared with 269,000 over the previous three months. The figures are probably robust enough to conclude that employment has ticked higher — the June-August average was 61,000 above May-July.

We should celebrate the fact that something extraordinary has happened in the UK labour market. Compared with a 5.6% fall in gross domestic product, employment has dropped only 1.6%, in contrast with America, where GDP is down less than 4% but employment, depending on the measure, has slumped by 5% or more. America's unemployment rate has doubled.

I have written before about the flexibility the job market has shown — workers have accepted pay freezes and cuts in working hours.

Some credit, perhaps quite a lot, should also be given to policymakers. Nearly a year ago, Alistair Darling committed £5 billion to labour-market measures — training and help to get the unemployed back into work.

The Bank of England, through aggressive interest-rate reductions and quantitative easing, has also helped, though we will probably never know by how much.

Where next? There are three ways unemployment could go from here. One is that this is a false dawn and that this winter will see an unemployment shake-out every bit as bad as last, taking us scooting up to 3m and beyond.

Some people worry that the trigger will be public-sector cuts. I think this is misplaced. Less than a third of the rise in total employment from 1997 to 2008 was in the public sector. From 1991 to 1998, public-sector employment fell 816,000 but overall employment rose more than 600,000. Public-sector jobs will not be cut overnight.

The most likely prospect is that unemployment will continue to rise but at a progressively slower rate. Logically, the jobless total should increase more slowly as the economy recovers but not stop rising until the economy is growing at or above its trend rate. That will take a while but should keep the peak below 3m.

The most optimistic outcome of all would be that unemployment is close to its peak. Under this scenario employers, fearing something worse than has happened, have found themselves short of workers and could have begun to hire again. Maybe the economy did bottom out in the spring, as some of the surveys suggested.

We are unlikely to have seen the peak in unemployment — in all probability it still has significantly further to rise. But the fact that it is even worth thinking about shows how far we have come from the all-pervading gloom of a few months ago.

PS: I'm getting a bit worried about markets. My former colleague John Cassidy has written a book How Markets Fail, out next month. Roger Bootle, founder and head of Capital Economics, has just pipped him with The Trouble With Markets, out last Thursday. We shared a platform the other day to talk about it.

One way of preventing financial markets from inflicting short-termism on corporate behaviour would be to bar short-term shareholders from receiving dividends. As for making the City safer, he is drawn to the era before the Big Bang of 1986. Partners then were careful not to bet the company by taking excessive risks because it was their own money at stake. Happy days.

From The Sunday Times, October 18 2009

So what, now the party conferences are over, do we know about how the budget deficit will be tackled? The answer is not enough, but we are slowly getting there.

Who is making the running? On tax, Labour is still out there, including its 50% tax rate kicking in at £150,000 in April, higher National Insurance contributions from 2011, and the squeeze on tax allowances and the tax relief on pensions.

A strong theme of last week's Conservative conference in Manchester was that Gordon Brown and his ministers are in denial about the need to tackle the public finances. That is unfair on the chancellor, though perhaps not the prime minister.

There was also an element of denial from the Tories, however. Listening to them, you got the impression that the only tax changes they are contemplating are cuts. They are committed to raising the inheritance-tax ceiling to £1m during the next parliament, and want to reverse the rises in NI and higher-rate income tax.

Before that, we may get the rise in Vat to 20% I wrote about in July, though the Conservatives are not encouraging that speculation. Things are different, they say, to when Sir Geoffrey Howe raised Vat in 1979 and Norman Lamont did so again in 1991.

On spending, while the Tories have much left to announce, George Osborne managed to leapfrog Alistair Darling and, even with a fairly modest set of proposals, turn himself into a credible cutter.

The chancellor, having seen Osborne's hand, will get a chance to raise him in his pre-budget report in a few weeks' time. Despite an attempt to get in on the act by announcing a freeze on salaries of higher-paid public-sector employees, Darling had the initiative snatched away from him.

I have left the Liberal Democrats out, though Vince Cable has the most comprehensive plan to cut public spending and described Tory proposals as "Lib Dem lite".

Even so, they were proposals from a party that expects to be in government soon. They included a public-sector pay freeze in 2011 for anybody earning over £18,000; a reduction in tax credits for the better off (household incomes above £50,000); a £3 billion annual cut in the cost of running Whitehall and quangos; and ending child trust funds for all but the poor and disabled.

Together these will save £7 billion a year by the end of the parliament, 2014-15.
Longer-term savings will be achieved by raising the state pension age to 66, beginning with men in about 2016. The burden of unfunded public-sector pensions will be tackled by limiting them to £50,000 (those whose rights already exceed this figure will have their entitlements frozen).

As always with politicians, it is wise to count your fingers after shaking hands. Osborne's one-year freeze on public-sector pay was presented as necessary to preserve 100,000 "frontline" public-sector jobs. But public-sector employment will have to be cut, even with the wage freeze.

Both Osborne and David Cameron presented their proposal for raising the state pension age as a trade-off for restoring the link between pensions and earnings.

That link, raising state pensions in line with earnings rather than prices, is due in any case to be restored in 2012, at least four years before any increase in retirement age. The Tory argument is that only this will make restoring the link sustainable.

The proposed increase in the pension age, politically very significant, was not handled astutely. The Tory leader got into a muddle over the calculations, an estimated £13 billion reduction in the budget deficit. The shadow chancellor's team relied on research by Martin Weale of the National Institute of Economic and Social Research (NIESR). He calculated it needed a one-year increase in the retirement age to generate that £13 billion. But because many people retire early and because not everyone's decision to retire depends on the state pension age, this requires it to increase by at least 18 months and possibly two years.

The Tories got to their figure by basing it, not on today's prices, but those that will prevail by the time the policy is in place many years from now, which is not the usual way of measuring these things.

This decision will help, and is the right thing to do. By my rough calculation, a state pension age of 66 for men in 2016 and women in 2020 will cut the budget deficit by £7-8 billion (in today's prices), though not until the 2020s.

To be fair to Osborne, he has not pretended his £7 billion of annual cuts are the last word. Treasury plans imply a £35 billion real cut in departmental spending by 2014, so his proposals represent about a fifth. If the Tories want to cut the deficit faster, as they say, the party will need to identify, not only a further £28 billion, but more.

One interesting question is what a big tightening of fiscal policy means for monetary policy. Will it constrain the Bank of England from raising interest rates?

The answer, according to research to be published this week from the Centre for Economics and Business Research (CEBR), is a firm yes. The CEBR, run by Doug McWilliams, assumes a new government will seek to get the budget deficit down more quickly than implied in the Treasury's current projections, reducing it to below 2.5% of gross domestic product by 2014-15.

The CEBR calculates this will require £100 billion of fiscal tightening, split between £20 billion of tax hikes and £80 billion of spending cuts. If, at the same time, the Bank was raising interest rates, the economy could be squeezed too much.

The Bank likes to distinguish between putting on the brakes and easing off the accelerator. When Bank rate is below, say, 5% that accelerator is being pressed. The CEBR says it will have to be kept close to the floor for some time to compensate for the fiscal squeeze. It predicts another £75 billion of quantitative easing, taking it to £250 billion, and that no assets purchased under the programme will be sold back into the market before 2014. It also thinks Bank rate will remain at 0.5% until at least 2011 and stay below 2% until 2014.

What is good for borrowers is not great news for savers. Policy announcements mean older workers can anticipate being forced into later retirement. Those who are already retired will have to get by on low income from savings for quite a few years.

PS: The only time most of us notice the gold price is when it hits a record, as last week. What does a gold price of more than $1,050 an ounce tell us? The answer, as always, is a mix of sensible argument and daft rumour.

That leaves the dollar. A report by journalist and Middle East expert Robert Fisk suggested it could be abandoned as the currency for pricing oil. He pointed out, however, that talks on this subject had been taking place for a couple of years and, if there is a shift, the target date is 2018. Gold will rise and fall. The dollar is going to be around as the world's reserve currency for a long time.

From The Sunday Times, October 11 2009

From Brighton to Manchester. The lower reaches of the football league, the old Division Three, to the top of the Premier League. The analogy is not perfect — the Conservatives are losing their way in Europe — but it will do. For the first time in nearly two decades they are holding a pre-election party conference with a reasonable chance they will form the next government.

That means there is added pressure on the party to lift the veil on policy, particularly economic policy, where we have had plenty of generalities but few specifics.

Before getting into that, let me destroy one or two myths. First, for all the talk from David Cameron about fixing the roof when the sun was shining, the public finances going into the crisis would have been no better under a Tory government.

The Tories, in their 2005 election manifesto, promised to match Labour spending on the NHS, schools, transport and international development and spend more on police, defence and pensions. Despite this, the party said it would save £12 billion on spending, £4 billion for an immediate tax cut, £8 billion to cut borrowing.

That £8 billion is roughly what Labour raised in additional taxes after the 2005 election. So, even if the Tories had managed to squeeze £12 billion out of spending, government borrowing in 2007 would have been similar under either party.

Second, the public finances in the recession might have been slightly better under the Tories but not significantly. Alistair Darling introduced time-limited tax cuts and brought forward some government spending in a textbook Keynesian response to a recession caused by an external economic shock. Those measures helped.

It is no use asking retailers if the Vat cut helped. It increased households' after-tax income, some of which was spent. Unless retailers have taken to asking their customers where they got their money from, they have no way of knowing whether the cut worked. The plain fact is that retail sales held up a lot better than they or most other people expected, partly because of Vat.

The car scrappage scheme, initially £300m, now £400m, worked even more convincingly. The aim was to keep the motor trade ticking over until company car sales come back on stream, and it has succeeded.

The point is that Darling's mini-stimulus had an impact, and generated some revenue. The Vat cut and other measures were not self-financing but they made a contribution to preventing an even deeper recession. Britain, in the G20 chair, probably also needed a modest fiscal stimulus in order to look other countries in the eye and persuade them to do likewise (and more), to the benefit of British exporters.

The bigger point is that the overwhelming reason the public finances are in the state they are is not due to deliberate policy actions but the impact of recession, the so-called automatic stabilisers. This recession exposed vulnerabilities in the public finances that nobody — government, opposition or independent experts — expected. Of the £175 billion budget deficit, all but a tiny amount reflects those vulnerabilities.

Third, there is some truth in Gordon Brown's charge that the Tories were found wanting in the banking crisis. We cannot know exactly what they would have done, availed of the expert advice available to the Treasury. There were, however, Tory reservations about government intervention, which came out over Northern Rock.

As an opposition, the Tories did not cover themselves in glory, in some cases adding to a difficult situation. A year ago, following a meeting with Mervyn King, George Osborne was accused of blurting out the outline of the government's recapitalisation proposals before the Treasury had finalised details. David Cameron's frequent suggestions that Britain might have to be bailed out by the IMF were, as Vince Cable has said, daft and irresponsible.

The Bank of England is pleased with the effects of quantitative easing, as a speech by monetary policy committee member David Miles made clear last week. He argued it had boosted demand in the economy and begun the process of a welcome shift away from excessive reliance on bank finance to, in the case of companies, the corporate bond market. The "shadow" MPC, by the way, thinks quantitative easing should be extended beyond November and the current £175 billion planned.

The Tories did come round to backing quantitative easing — the party has high hopes of the Bank — but Osborne's initial response condemned it as the last resort of a desperate government.

That is all water under the bridge. What will the shadow chancellor tell us this week? The prime minister has promised to enshrine in law a requirement to halve the budget deficit over the next four years.

Osborne wants as his main priority to get it down more rapidly than that and will have his own Office of Budget Responsibility to help him in that task. Politically, it makes sense. A Tory government will want to get as much of the fiscal pain out of the way while it can still be blamed on Labour.

Economically, getting the public finances back into shape without undermining recovery has to be right. Guessing when the next recession might be is a mug's game but we will not have as long an upturn, 16 years, as last time. So it makes sense to recession-proof the public finances as much as possible long before then.

Osborne's second broad aim is to rebalance the economy between savings and investment. I discussed savings last week, expressing scepticism about whether we will ever become a nation of savers.

But he is right to look for a better balanced economy and a future in which there is less borrowing for "unproductive" house purchases and government spending, and more for productive investment, though that has been the holy grail for chancellors for at least the past 50 years.

Brown promises a £1 billion National Investment Corporation, a fund for new and innovative businesses. Osborne has in mind something like the Industrial and Commercial Finance Corporation, established by a Tory government, which evolved into 3i. As with all these things, the devil is in the detail. It is not clear how much detail we will get this week.

In some ways Osborne's task is straightforward. He has to show the Tories are not slavering to slash public spending but can cut intelligently. He also has to set out a realistic but optimistic vision for the economy. People don't like voting for misery, though they may get some.

PS Perhaps there is such a thing as a free lunch. Last week saw the launch, at the Treasury, of Pro Bono Economics (probonoeconomics.com), whose aim is to get economists to undertake free assignments in the charitable sector.

The government's 1,000 (yes, 1,000) economists have been encouraged to sign up and the hope is that many in the City and the wider private sector will do so. My pro bono contribution is mentioning it here.

From The Sunday Times, October 4 2009

Will we be spenders or savers? It is a big question for the economy. Without a rise in consumer spending it is hard to get economic growth. It is also a big question for retailers and other businesses relying on consumer demand.

The evidence on what has been happening so far is mixed. Official figures suggest that retail spending has held up better than many other parts of the economy, with a 2.1% rise in sales volume last month compared with a year earlier.

The British Retail Consortium said sales value was down 0.1% over the year on a "like-for-like" basis, though total sales (unadjusted for new store openings) were up 2.2%. The BRC is downbeat, particularly about non-food sales.

It is outside retailing, however, that consumers have been cutting back most. Official figures for overall consumer spending show a 3.4% drop in the second quarter against the corresponding period of 2008, one of the sharpest falls on record.

Non-retail spending, such as that on cars, restaurant meals and consumer services, has clearly been very weak, though the Bank of England, in its monthly minutes last week, suggested the most recent consumer data could be revised higher.

Even so, there are hints from retailers of other potential problems. Relative to income, young people are the nation's big spenders. One generally successful retailer, JD Sports, which owns the Bank and Scotts fashion chains, said sales in recent weeks had dipped, possibly as a result of a rise in unemployment among 18-24 year olds. The rate for that age group is now 17.5%.

Unemployment is one potential constraint on spending. The bigger question is whether the combination of tighter credit, a rise in the saving ratio, and tax hikes will strangle any consumer recovery at birth.

Let me start with household debt. This time last year it stopped rising. Outstanding lending to households, £1,457 billion at the end of July, is fractionally lower than in September last year.

Some of this is due to deliberate decisions to repay debt. Mostly it is happening because the supply of new lending is less than the flow of redemptions. The fall in house prices, before their recent small recovery, also stemmed the rise in debt.

Household debt is overwhelmingly — well over 80% — in mortgages, and Britain has high owner-occupation. There is a natural tendency for mortgage debt to rise because new entrants to the housing market have more debt than those leaving, who have usually paid off their loans years ago. That effect has been halted in the past year by limited mortgage availability.

To what extent will people be driven by a desire to pay down debt? Kate Barker, a member of the Bank of England's monetary policy committee, said in a speech last week that it was not clear before the crisis that, except for a tiny minority, household debt levels were unsustainable.

Spencer Dale, her MPC colleague and the Bank's chief economist, made the very good point that, while household debt rose substantially in the years leading up to the crisis, so did financial assets owned by households. A kind of conveyor belt operated. As he put it: "The money borrowed by young families ended up in the bank accounts of older households."

Most of that money was not spent — consumer spending did not rise as a proportion of gross domestic product — but invested. There was a 10-year rise of £1,000 billion in debt alongside a £750 billion increase in household financial assets.

People may change their views on how much debt they want to carry as a result of the crisis, and it is no bad thing that the overall amount has levelled off. It will fall for a while in relation to income. But a healthy scepticism is in order about this.

The vast majority of borrowers had their mortgages in place before the crisis, and the advent of a 0.5% Bank rate. The gradual return to a semblance of interest-rate normality, probably starting next year, is not going to result in a scramble to deleverage. They can leave that to the banks.

What about a related aspect of this, the saving ratio? Previous recessions have seen reductions in the growth of borrowing and a rise in saving. In the recessions of the early 1980s and early 1990s, the saving ratio hit 12% of household disposable income.

The saving ratio in the first quarter was 3%, down from 4% in the final quarter of 2008. Figures this week should show a second-quarter rise. If it were to hit 12%, consumer spending would indeed suffer.

Many people think that Britain's low saving ratio reflects our modern-day, plasma-screen, get rich quick society. If only we were as prudent as, say, in the 1950s, before the credit card era, when it was safe to leave your door unlocked at night.

In the 1950s, however, the saving ratio was zero, on average. It normally rises at times of economic distress and high unemployment. In both previous recessions, it peaked close to the economy's low point. If it were going to rise sharply, therefore, it probably should have done so by now.

One reason it has not is staring us in the face. Household saving reflects the interaction between borrowing and saving, and includes a large element which is out of people's hands, such as contributions by firms to pension schemes.

To the extent that it does reflect decisions by individuals, though, there has not been much incentive to save of late. The Bank, in another contribution to the spending-saving debate in its latest quarterly bulletin, out last week, noted "the substantial stimulus provided by monetary policy" had cushioned the rise in saving. A Bank rate of 0.5% will not bring out the inner squirrel in anybody. Policy has been aimed at dampening down the saving ratio rise.

So we should not exaggerate the likely effect of debt aversion or saving on spending. Taxes may be a different matter, but that depends on how draconian the next government intends to be.

The past, as always, may be the best guide to the future. After the recession of the early 1990s, taxes were raised over a number of years. There was a housing and debt hangover.

Yes, consumer spending growth averaged 2.75% a year over the first four full years of recovery. Nobody would be too upset, or surprised, if it were a bit weaker than that over the next four years. Beyond that, however, don't expect a new age of austerity. Britain's consumers may be down, but they are certainly not out.

PS Finally, very many responded to my request for suggestions of actors to play the main UK roles in a reconstruction of last autumn's banking meltdown. Leaving aside a remake of The Muppets, or George Clooney to play Alistair Darling — which may have come from Mrs Darling — the judges have chosen.

As for Gordon Brown, another Scottish actor, the crumpled Ken Stott, gets it. He played the lead in the TV series Messiah for some years. Given the current edition of Newsweek has "My Plan to Save the World" by our prime minister, who could be more appropriate? Books will be on their way to James Brown, no relation, Mark Pierson and David Wileman.

From The Sunday Times, September 27 2009

Unemployment up, wages down, or at least slowing to a record low. It is the story of Britain's labour market now, and it is likely to be so for some time to come. Within that story, however, there are more silver linings than you might expect.

The latest figures showed the broader jobless total up 210,000 to 2.47m, 7.9% of the workforce, in the May-July period.

The growth in average earnings, meanwhile, slowed from 2.5% to 2.2% excluding bonuses, its lowest since the current series of statistics began in 2001 and, one suspects, for many decades before that. With bonuses, the figure was even lower, 1.7%.

The fact that earnings growth is falling as unemployment is rising will not surprise fans of the Phillips curve. This was what AW "Bill" Phillips, a New Zealander who came to the London School of Economics in the 1940s, would have expected.

In 1958 he published findings showing that, over a century, unemployment and the growth of wages in Britain were inversely related. If unemployment rose, the growth of wages fell, and vice versa.

The Phillips curve was not his only claim to fame. He built the first working models of the British economy, made of hydraulic tubes, some of which survive.

The Phillips curve, however, fell into disrepute in the 1970s, the stagflation era, when sharply rising unemployment did not result in lower wage settlements. So why does it appear to be working now?

One reason is that in the 1970s the job market was distorted by excessive union power. The Trades Union Congress held its conference last week. These days, unions matter in the public sector, where 59% of workers are members, but less in the private sector, where only 16% are.

The latest pay figures either make the case for belonging to a union or demonstrate how unions stand in the way of necessary adjustments in the labour market. Public-sector earnings are rising by 3.6%, twice the rate in the private sector. If bonuses are included, the gap is even bigger.

This cannot last. Vince Cable, the Liberal Democrat Treasury spokesman, has taken himself off the TUC's Christmas card list by suggesting sensible proposals for cutting the budget deficit, a freeze on the public-sector pay bill and a 25% reduction in the amount paid out to government employees who earn more than £100,000.

The second factor is that people believe they will not be stung by inflation and so do not need big pay rises. Unlike the 1970s, inflation expectations are, in the jargon, "anchored". The Bank of England's latest survey shows people expect inflation of 2.4% over the next 12 months.

What is also striking about the labour market is that it has been much less badly affected by the recession than feared. The economy has shrunk by 5.5% over the past year but employment, currently just under 29m, has fallen by only 2%.

This could tell us the growth numbers have exaggerated the recession. Or, taking them at face value, it shows Britain's job-market flexibility is limiting the unemployment pain of the recession. The experience in America, where the fall in employment matches or exceeds the fall in gross domestic product, has not been as good.

A report last week from the Organisation for Economic Co-operation and Development (OECD) noted that Britain's jobless rise has been less pronounced than in America, Ireland and Spain.

Nearly a third of UK employees involved in formal settlements have accepted pay freezes, according to Incomes Data Services, the data firm. Others have gone further, agreeing to go on four-day weeks for 80% of salary (though often 100% of the work). Inventive schemes to keep people in work, even on reduced pay, are widespread.

The rise in unemployment, while bad — particularly for the young where the biggest increases have been concentrated — has therefore been less than feared.

The Centre for Economic and Social Inclusion, which digs deep into the figures, took encouragement from improvements in vacancies and a drop in the number of new claims for the jobseeker's allowance. The claimant count will not fall for a while, but its rise was only 24,400 last month. The worst of the job-market shakeout appears to have come to an end during the early spring.

How quickly will employment pick up and unemployment fall? This is where flexibility gets interesting.

What will employers do as business recovers? Those that have introduced short-time working will start to move people back to normal hours and pay. Firms that imposed pay freezes or cuts will not expect to be able to do so for a second year and normality will be restored there too. Only then, after the slack has been taken up, will new people be taken on. The flexibility that limited the rise in unemployment could make it slower to fall.

Added to this is the risk that the recovery will not be strong enough to generate a net increase in employment. This is the OECD's fear — it thinks globally there are another 25m jobs to go and UK unemployment will stay high throughout next year.

John Philpott, chief economist at the Chartered Institute of Personnel and Development, also warns that the recovery, if not "jobless", will be close to it.
"Unless the economy rebounds from recession far more strongly than most economists expect," he said, "the likelihood is that the recovery will be broadly jobs-light, resulting in a slow grind back towards the pre-recession rate of unemployment."

It is going to be interesting. After the last recession it took nine months for unemployment to start falling. If repeated, that would see the total begin to fall next March. Sooner than that and flexibility would have proved itself in the upturn as well as the downturn.

PS: Thanks for the many suggestions on who should play the main British characters in a dramatisation of last autumn's banking crisis. Plenty of good ideas for Gordon Brown and Alistair Darling, some printable. Mervyn King is proving the toughest, so I'll give it another week.

That's enough name-calling. Attention this week will focus on the Bank's September minutes and whether the governor's hint about cutting the rate on some commercial bank reserves held at the Bank (to perhaps a negative rate) meant this was discussed by the MPC. The prospect knocked the pound. My sense is that it may have been a shot across the bows at the banks to stop them hoarding reserves rather than a policy that is ready to roll but we'll see.

From The Sunday Times, September 20 2009

Recessions usually end with a whimper rather than a bang. They peter out as downward momentum fades and the levers turn from negative to positive. What was a torrent of bad news becomes matched, then bettered, by good news.

That is the process we have been going through for a few weeks, as I noted a fortnight ago in my piece on the stock market. The National Institute of Economic and Social Research estimates that the economy hit bottom in May, which chimes with surveys such as those from the purchasing managers.

Industrial production figures from the Office for National Statistics (ONS) gave a solid hint that it will declare the recession over next month, when releasing its first estimate of third-quarter GDP.

You cannot rule out the ONS bowling another googly, as it has a few times recently, but the evidence is against it. Industrial production, on which it has the fullest information at this stage, is significantly above its second-quarter average and service-sector surveys have been upbeat.

A return to growth now will tell us a few things. On currently available information, the recession has been twice as bad as in the early 1990s but not as severe as in the 1980s. The proviso, which I repeat, is that recent figures are likely to be revised up.

A positive GDP number this quarter will also mean that, despite everything, the recession will have been of normal length — five quarters. Its unusual feature was the "falling off a cliff" moment between October and April, for Britain and many other economies, as global trade collapsed. UK GDP fell 4.2%, a record over two quarters.

For many months I have been talking of the battle between the banking shock and the aggressive policy stimulus, particularly big cuts in interest rates but also quantitative easing. I thought the stimulus would win out in the end, and it has.

Now the question comes on to how sustainable the upturn will be. That is worth a series of articles and I shall return to the banks and what happens when the monetary policy stimulus comes off.

This week, however, let me address it in the context of the topic of the moment, public spending. The government's tone on spending has shifted, thanks to the efforts of Alistair Darling.

Instead of Gordon Brown's "investment versus cuts", the debate is "our cuts will be less damaging to services than yours". The chancellor, giving the James Callaghan Lecture in Cardiff, made the point that the state's enabling role in the economy does not apply only in times of crisis. On spending, though, he used the "c" word: "more efficiency, continuing to reform, cutting costs", which is a step in the right direction.

In the Treasury, the public-spending division is working at full pelt, going through programmes. There will be no comprehensive spending review and all that is certain in the autumn pre-budget report is that the spending "envelope" will be extended for another year until 2015. The official machine, however, stands ready to cut.

David Cameron promised a £120m cut in the cost of parliament, neither here nor there in the grand scheme of things but designed to show intent. George Osborne, shadow chancellor, has promised to learn lessons from councils that have cut spending without undermining services.

The shift in the political debate is welcome, and makes the loss of Britain's AAA sovereign debt rating even less likely. Outside government, meanwhile, the spending debate is intensifying. The Institute of Directors, with the Taxpayers' Alliance, have proposed more than 30 measures that would cut public spending by £50 billion.

It does not sound much when public spending is £671 billion but it shows how tough the choices may become. Labour sacred cows such as Sure Start and Building Schools for the Future would go and spending on private consultants would be halved, something that might not go down too well with all members of the Institute of Directors.

This week the Institute for Fiscal Studies will set out options involving tax rises, general reductions in spending and specific cuts in welfare to reduce the deficit. Robert Chote, its director, points out that the battle between the Tories and Labour over who will tighten first is rather phoney.

Even without further surgery, Treasury plans imply departmental spending will rise only £3.2 billion, or 0.7%, in 2010-11. Allowing for inflation, that means real cuts. The government needs recovery to be established or risks being accused of cutting when the economy can least take it.

This raises a general point. Can public spending be tightly restrained without seriously undermining recovery? Has not Britain become so dependent on the government that once the taps are turned off the economy will be becalmed?
The answer is no and, indeed, periods when public spending has been held down have tended to be times of good economic growth.

Looking back on the recent past, the arithmetic tells us that even when public spending is rising strongly, it makes a modest contribution to growth. 2000 to 2008 was Gordon Brown's "splurge" period, when public spending grew roughly 4% annually in real terms, well above the economy's overall rate of about 2.5%.

Over that period, GDP rose £224 billion, just over 20%, in real terms. Government spending rose by just over £50 billion. It contributed only just over a fifth of growth even when ministers were spending fit to bust. This kind of static comparison, more-over, probably overstates the public contribution. Had spending not risen, and the taxes needed to pay for it, private-sector growth could have been stronger.

This is the way to look at it for the future. A paper by Goldman Sachs, called Fiscal Consolidation and the Exchange Rate, argues that in an open economy like Britain's, public-spending cuts affect the composition of economic growth but not its pace. This is because sterling is a safety valve.

A tightening of fiscal policy, accompanied by a weak currency, means that what you lose in government spending, you gain in exports. Sterling is well below fair value against the euro, so this effect is ready to roll as the global economy picks up.

Nor is this just theory. "It is worth looking at what happened to the economy the last time the UK tightened fiscal policy aggressively, during the mid-1990s," write Ben Broadbent and Adrian Paul of Goldman Sachs. "It performed well.
Coming out of deep recession, and aided by a small acceleration in eurozone activity and a big decline in the currency, investment and exports bounced strongly. Aggregate demand grew by 3.5% a year."

This time it may be different, for other reasons. But we should not worry unduly that putting the brakes on public spending will kill recovery.

PS: The reviews were mixed but I enjoyed last week's BBC2 drama The Last Days of Lehman Brothers. While it featured a lot of British actors playing Americans, and doing so rather well, I did not spot any British characters. The nearest was when Hank Paulson rang Alistair Darling to check whether Barclays would be allowed to buy Lehman, but we only got the former US Treasury secretary's side of the conversation.

This may have been because the casting challenges were too great. Who would you get to play convincingly Gordon Brown, Mervyn King or Darling? Even Rada's finest would struggle. Unless, of course, you know better. Suggestions welcome, and I have some crunch-related books as prizes.

From The Sunday Times, September 13 2009

As we approach the first anniversary of the great meltdown (having passed the second anniversary of the start of the credit crisis), many questions are unanswered.

Financial markets are calming now. The gap between money-market interest rates and Bank rate is returning to something like normal levels and stock-market volatility (the surges and slumps in prices) has also subsided. But the questions, and challenges, remain.

Some go to the heart of economics. Not only did conventional economic models fail to predict the crisis, it is said, they failed because they were based on a flawed view about markets.

The idea that markets work, on this view, has been seriously challenged. Free financial markets led us into this mess and therefore should be more controlled. Once you accept this for financial markets, maybe others markets should be reined in too.

At the heart of these criticisms of markets is the efficient-market hypothesis. This emerged four decades ago, in a seminal 1970 paper by Eugene Fama, a financial economist at Chicago University.

What it said, simply enough, was that prices in financial markets, say a company’s share price, reflect all known information at the time. There were plenty of embellishments of the hypothesis, but that, in a nutshell, was that.

Markets were the most efficient way of taking all available information and distilling it into a single measure: the price. Anybody claiming to consistently beat the market or predict with certainty where that price would be tomorrow should be treated with the deepest suspicion.

Yet that idea has apparently got us into trouble. Lord Turner, chairman of the Financial Services Authority (FSA), in his now famous Prospect interview, said: “We have had a very fundamental shock to the efficient-market hypothesis, which has been in the DNA of the FSA and securities and banking regulators throughout the world.” It had become, he said, like a religion.

Paul Woolley, the fund manager and academic, said the theory of efficient markets had been discredited. Lord Skidelsky, who has produced a new book, Keynes: The Return of the Master, and who has probably written more Keynes’ books than the man himself, weighed in with an article in the Financial Times. The theory of efficient markets had, he wrote, “led bankers into blind faith in their mathematical forecasting models. It led governments and regulators to discount the possibility that financial markets could implode”.

Willem Buiter, a maverick former member of the Bank of England’s monetary policy committee (MPC), said economics had swallowed efficient markets “hook, line and sinker” and so come unstuck.

You challenge such people at your peril. They have enough intellectual power to light up a small town. I am no market fundamentalist and do not know of many people who are. The kind of people who tell you “the market is always right” are either that type of City trader who wears white socks or the oddballs you occasionally meet at some think tanks.

My view of markets is like Churchill’s view of democracy: their faults may be many but they are far superior to the alternatives. In particular, I think the efficient-market hypothesis — and Fama — have been unfairly castigated.

Let me explain. The rocket scientists on Wall Street and in London built the models that led to the creation of the complex securities and derivatives that caused the damage, but they did not simply plug in the efficient-market hypothesis and let the computers whirr away.

That may have been the approach that helped bring down Long-Term Capital Management, the big hedge fund that failed more than a decade ago. It believed it could profit from temporary market inefficiencies or, as one of its founders described it, picking up the nickels other investors ignored, on the assumption that these inefficiencies would be quickly corrected.

The more recent vintage of dodgy investments, toxic securities, mainly failed because of man-made assumptions. American sub-prime securities, and derivatives based on them, went wrong because their underlying assumptions were incorrect — it was believed that American house prices would not fall because they had not since the 1930s, and that default rates on mortgages would remain low.

As for economic forecasting models, their problem was not that they were fatally corrupted by the efficient-market hypothesis — it was that they assumed finance, like hot and cold water, would always be on tap. Modellers are furiously trying to incorporate a more sophisticated version of banking into their models.

Turner, who is always thought-provoking, was not trying to exempt the FSA from blame, merely pointing out that the culture of regulators had been to believe in efficient markets a little too much. I think he is being too kind to regulators. A proper interpretation of the efficient-market hypothesis should surely have told them that there were no free lunches as far as investment returns were concerned.

The period up to the crisis was one in which many fund managers and investment banks appeared able to achieve exceptional returns in a world that should have been characterised by low returns, with little inflation to flatter performance.

Exceptional returns were claimed by fraudsters such as Bernard Madoff, but also by plenty of non-criminal investment banks during the “search for yield” phase of a low-yield era. Regulators should have asked more questions about how risky such returns were. Markets can only be efficient if they know what is going on.

Andrew Haldane, Bank of England executive director for financial stability, estimated an investor doing due diligence on just one of the notorious CDO-squared instruments (collateralised debt obligations with knobs on) would have had to read a billion pages of documents.

These products were shadowy and mysterious, as was much of the shadow banking system. Information was kept from shareholders and, in many cases, was kept from bank boards. The blame for this lack of transparency must rest with bankers, and the way banks were run and regulated, not the market per se. It was starved of much of the essential information.

Markets are not perfect, and never will be. Nobody with sense thought the market was always right and could peer indefinitely into the future, or avoid occasional herd behaviour. Even this could be consistent with efficient markets, in that part of the information that establishes a market price is knowledge of what others are buying.

The danger is that an anti-market fundamentalism takes over, in which the market is seen to be always wrong. That would set financial markets back. It would also be a retrograde step for the economy.

PS: For this week at least, it looks like a case of All Quiet on Threadneedle Street. Mervyn King, the Bank governor, has long wanted to make monetary policy boring and this month he should succeed. Anything other than the MPC keeping Bank rate at 0.5% and leaving the existing programme of quantitative easing in place would be a shock. An even bigger one would be adoption of a Swedish-style negative interest rate on commercial bank reserves at the Bank.

The shadow MPC says it should go well beyond £200 billion to achieve the necessary lift in the money supply and cement recovery. An important debate, but not one to be resolved this week.

From The Sunday Times, September 6 2009

Late August is a dangerous time to write about the stock market, ahead of the autumn storms. This time last year I might have remarked on the solid gains shares were showing during the holiday month, with the FTSE 100 up more than 300 points.

Then banking armageddon arrived, pushing the index down nearly 2,000 points over the next couple of months. Not every autumn has a global financial meltdown and, fingers-crossed, history will not repeat itself. And we should not get too hung up about the seasons.

As Mark Twain memorably put it: "October. This is one of the peculiarly dangerous months to speculate in stocks. The others are July, January, September, April, November, May, March, June, December, August and February."

Economists are not necessarily best-qualified to tell you where the stock market is going. Nouriel Roubini, the New York University professor, has made his name in the credit crisis. A nice piece on Bloomberg last week, however, noted that if investors had followed his stock-market advice in recent months they would have missed out on the "rally of the century", with the S&P 500 up 52% in six months, and the MSCI world index up 58%, the biggest gain since it started life in 1970. The FTSE 100's rise is nearer to 40%, impressive but continuing its relative underperformance of recent years.

Roubini's downbeat view of the American economy and the stock market may yet be right — but timing is everything.

Some fund managers, on the other hand, have what economists would regard as highly unusual views about the economy. Neil Woodford, head of investment at Invesco and one of Britain's top fund managers, said: "I do not see economic recovery happening in the next three to four years", and this informs his investment strategy.

That would imply the longest period of recession*/stagnation in Britain's modern history and, together with the downturn so far, would be twice as long as Britain's slump in the 1930s. Nothing is impossible but, given that recovery has almost certainly already begun, this is highly unlikely.

The Bank of England's latest forecasts, published this month, imply the UK economy will be more than 9% bigger in mid-2012 than now. I would have a small wager that its forecast will be closer to the outturn than no recovery at all.

Why have stock markets risen so strongly? It has been a two-stage process. The initial spurt from the dark days of early March came with a realisation that the world was not entering a second great depression (third if you count the end of the 19th century) and that not all banks would have to be nationalised. Markets were priced for disaster and decided this had been averted.

The second leg has been driven by good figures. "Economic data generally continue to be better than expected, which suggests that we are emerging from the longest and deepest recession [since the second world war]," says Bob Doll, chief equity investment officer at Black Rock.

The figures suggest growth will have turned positive in every G7 country, including Britain, this quarter. France, Germany and Japan are already there. Germany's Ifo measure of business confidence has soared, a reflection of the fact that export demand has turned the corner. China has led a turnround for the hard-hit Asian economies, acting as the region's locomotive. America's housing market, where the recession story began, is showing strength in both activity and prices.

Normally, economic recovery is tinged with a fear in the markets that the authorities will take action to dampen it down, notably with higher interest rates. However, central bankers made clear at their recent annual gathering at Jackson Hole, Wyoming, that this is not on their agenda. The markets have an unusually clear run.

In Britain, while figures last week showed a nasty 10.4% fall in second-quarter business investment, the credit crunch still biting hard on spending by firms, most of the figures have surprised on the upside.

House prices and housing activity are up, with Nationwide reporting a 1.6% rise in prices for this month, a fourth consecutive increase of 1% or more. Prices are up more than 6% from their February lows, suggesting the big correction happened last year. While there are caveats about the housing recovery, Michael Saunders of Citigroup points out that it has positive implications for consumer spending and the banks, and supports his view of a stronger UK recovery than the consensus expects.

Not so long ago it was fashionable to say that this recovery would have to be without the help of overindebted consumers, who would be forced to deleverage (reduce their borrowing) rather than spend. What is clear, however, is that they can do both.

Darren Winder, economist and strategist at Cazenove, calculates that as a result of sharply lower mortgage rates and to a lesser extent falling energy prices, the amount households have available for discretionary spending is up by a striking 20% this year. That is why the numbers for retail sales have been strong and it is why retailing shares in the UK have virtually doubled from their lows.

More importantly, the economy has turned sooner than firms expected. After an avalanche of earnings downgrades earlier in the year, this month has seen 100 upgrades. Even more than the macro numbers, this is what drives stock markets.

We should not read too much into share prices. One thing we have learnt during this crisis is that markets are skittish, and hugely influenced by confidence and mood. There are solid economic reasons why the stock market has risen, however. Cazenove, taking the bull by the horns, says there is still plenty of value in British shares and limited downside risks.

The key influences on markets will be surprises. On the plus side, markets have priced in a recovery, both in Britain and globally. On the minus side, that recovery is expected to be weaker than usual, because of the banking system's long period of convalescence, tight credit and a throbbing fiscal hangover that will require years of tax increases and public spending cuts.

Where the stock market goes depends on where the news comes in relation to these expectations. There is scope for disappointment — so far the global economic turnround has been faster and stronger than investors feared and these things never proceed smoothly. But there is also the potential for positive surprises.

Economies may shrug off the effects of the recession more quickly than feared and companies, having taken decisive action to keep afloat during the crisis, may see their profits benefit disproportionately from the upturn. Subdued wages growth, which is what we have, is good for profits.

Whichever way share prices go, they do not start from very demanding levels, even after the recovery of the past six months. The FTSE 100 is 30% down on its December 1999 peak, and nobody expects it to get back there soon. Cazenove's estimate, based on trend earnings, is that the FTSE 100 is 15% undervalued relative to fundamentals.

One day it will get back to that 1999 peak, by which time central bankers will be worrying about asset price bubbles again.

PS: It has been a lonely job counting skips all these years so I was intrigued to get a release from a company called Erento, apparently Britain's fastest-growing online rental marketplace. It reports a 38% rise in demand for skips in July.

But the rise does appear to be genuine, and part of a trend. After the doldrums of winter and early spring, demand for skips rose 26% in May and by a similar amount in June. A green shoot in a yellow skip.

From the Sunday Times, August 30 2009

So there we were, celebrating the fact that Britain's recession was over bar the shouting, a fact endorsed by sterling's climb to $1.70, its highest level against the dollar since October.

Not only that but the evidence was becoming compelling that Britain's recovery will arrive sooner than in most other economies, and certainly those of the eurozone. It was too soon to declare that happy days were here again but it was certainly a lot better than it had been.

Then along came the Bank of England with a large bucket of cold water in the form of £50 billion of additional quantitative easing, creating money through asset purchases. I don't think it was necessarily the Bank's intention to play the party pooper — but that was the effect.

Many column inches and broadcasting minutes have been devoted to reporting and analysing Thursday's decision from the Bank. It is August after all. There are, however, a few points worth making.

The decision to announce an additional £50 billion of asset purchases between now and November came as a big surprise to the markets. True, I reported last week the recommendations of the Institute of Economic Affairs' shadow monetary policy committee (MPC) that a big addition was needed to the quantitative easing programme and that "stranger things have happened" than the Bank making such an announcement.

It was a surprise, however, and it was the second in a row. The Bank wrong-footed the markets last month by announcing a brief pause in the programme and it did so again on Thursday, having made noises between the two meetings that many interpreted as signalling that the pause would continue. As Oscar Wilde might have said, to mislead once is a misfortune, to do so twice smacks of carelessness.

The Bank has made a technical adjustment to the policy, extending the range of gilts (government bonds) it will purchase either side of the current 5 to 25-year range. Buying more short-dated gilts should help at the margin to stem rising interest costs on fixed-rate mortgages.

Fundamental questions remain. Why did the Bank do it, and should it have done so? The MPC acted, it seems, because it believes the official figures more than it believes the upbeat business surveys.

So the die was probably cast when the Office for National Statistics released estimates showing gross domestic product fell 0.8% in the second quarter, more than was expected. The Bank has previously been sceptical of the ONS's initial estimates.

The other trigger was continued weakness of bank lending to the corporate sector and of money-supply growth, M4. This is despite the fact that Mervyn King, the Bank governor, has warned it will take time for the easing to show up in lending. The money numbers, meanwhile, on the face of it much weaker than they should be, are not easy to interpret and appear to reflect the fact that the banks are taking the opportunity to rebuild capital.

That may change, though there was not much sign of it in the bank reporting season last week. The banks claim weak corporate lending reflects a desire among firms to reduce borrowing, not an unwillingness to lend. Plenty will dispute that.

Was the extension of the easing programme the right thing to do? I have to say that, armed with the publicly available information on Thursday morning, I would not have done it. I can see the argument for a degree of overkill. Inflation, as the Bank will make clear this week, is not a problem for the foreseeable future.

However, I share with Sushil Wadhwani, a former MPC member, a slight sense of unease. The Bank has expanded its balance sheet enormously, giving it a potential exit-strategy headache when the time comes. You expect central bankers to be cautious about this kind of thing. Thursday's decision was not cautious.

Where does it leave us? We have had false dawns. In June the National Institute of Economic and Social Research said March was the recession's trough. Markit, which produces the purchasing managers' surveys, put May as the low point.

These predictions, while slightly off beam, show we have been there or thereabouts in terms of the recession's end. In the purchasing managers' surveys the index numbers for manufacturing and services are now above the 50 break-even point, the latter for the third consecutive month.

Goldman Sachs said these surveys, which measure business-to-business activity, are consistent with annualised growth in the economy of 1.5% to 2% — no boom but much better than we have had.

Even the official figures for manufacturing, with a decline of only 0.2% in the three months to June, compared with 5.5% in the three months to March, show near-stability. New-car sales, helped by the government's much-criticised scrappage scheme, were up 2.4% in July on a year earlier, and more than 33% for private buyers.

Newsweek, the American magazine, last week put "Shrinking Britannia" on the cover of its European edition and said the International Monetary Fund predicts the UK's slump will be deeper and longer than that of any other advanced economy.

The IMF point is wrong — Germany, Japan, Italy and Spain are predicted to have worse recessions. Evidence of an earlier UK upturn, meanwhile, comes through clearly in the purchasing managers' surveys. In contrast to America and the eurozone, only Britain is seeing growth in both manufacturing and services.

None of this means things will be immediately hunky-dory. Figures this week will show another rise in unemployment and that pattern will continue.

There can be no guarantee either, after recent downside surprises, that the ONS's first estimate of third-quarter growth will show a rise. But if Britain had the equivalent of America's National Bureau of Economic Research business cycle committee, it would be declaring the recession's end. Not that you would know yet. The NBER took until December 2008 to declare America's recession started in December 2007.

The most tangible effect of the Bank's move was to take sterling, which had hit $1.70, down several pegs. This was logical in the short term. Any monetary easing, whether in the form of lower interest rates or via the quantitative route, would normally be expected to weaken a currency.

It may have been deliberate. The Bank has seen a lower exchange rate as important to both recovery and rebalancing the economy. Before Thursday, the pound had risen by nearly 25% against the dollar and 15% on a trade-weighted basis.

It may rise again. If quantitative easing works, it will cement recovery prospects and enhance sterling's attractions. But we will have to wait a while for the proof.

PS: I last warned of a suckers' rally in the housing market in November 2005, after the pause of 2004-5. It was, but not before prices rose nearly 20%. They are rising now. Halifax, part of Lloyds, said they are up 3.3% in the past three months. Nationwide has a 4.4% rise since February. What kind of rally is this?

On the demand side, there is a significant pent-up element, though some of those who became accidental landlords may decide to sell into a stronger market. It is a market, though. Trying to predict the balance between buyers and sellers over the next 12 months is hard. The best outcome will be if that balance gives us a period of stability.

From The Sunday Times, August 9 2009

When does unemployment among young people become as big a political issue as it did in the 1980s? Perhaps not before too long. Nearly a fifth of 18 to 24-year-olds in Britain are out of work, part of a 5m army of young unemployed across the European Union.

David "Danny" Blanchflower, until earlier this year a member of the Bank of England's monetary policy committee, thinks unemployment among under-25s in Britain will hit 1m by September, from 927,000 now. Not so long ago that would have been a bad figure if spread across all age groups. As it is, two in five of the unemployed are under the age of 25.

This has implications for the wider economy. It suggests the rise in "breadwinner" unemployment is not as extreme as in the recession of the early 1980s, which may explain why some spending has held up better than feared. For the young, however, it is bad news. Another 730,000 of this age group are economically inactive — not in education, employment or training (Neet).

Last week Yvette Cooper, the latest in a long line of Labour work and pensions secretaries, announced 47,000 jobs and work-experience places for young people funded by the £1 billion Future Jobs Fund.

In his April budget Alistair Darling, the chancellor, announced additional resources for Jobcentre Plus and the Flexible New Deal, and the offer of a guaranteed job, training or work placement for all 18 to 24-year-olds unemployed for 12 months.

All this activity is for a reason, which is that the problem of unemployment among young people is going to get worse before it gets better. That is true in Britain, and it is true in the rest of Europe.

Spain is the youth unemployment capital of Europe, with a jobless rate among under-25s of 33.6% in the first quarter, but 12 of the EU's 27 members had youth jobless rates above 20%. Honourable exceptions with rates below 10% were Austria, Denmark and the Netherlands. The Dutch rate for under-25s was a mere 6% in the first quarter, though latest national figures suggest it has risen to more than 11%.

Why are young people so badly affected? In Britain there is the curiosity of rising employment among oldies — those beyond normal retirement age of 65 for men and 60 for women — alongside falling employment among younger people. Older people's employment is up 48,000 over the past year, as more choose to stay on at work, partly as a result of poor pensions performance and a sharp drop in savings income.

The number of 16 to 24-year-olds in jobs, in contrast, has slumped by 319,000 over the same period. To a certain extent young people are always likely to suffer worst in recessions, as Ian Brinkley of the Work Foundation points out.

They suffer most when employers stop hiring because so many of them are new entrants to the job market. The impact of a hiring freeze is thus more keenly felt among younger age groups. They have the alternative of continuing with education but otherwise their first welcome to the job market is the grim reality of unemployment.

Young people are also likely to be the first candidates for redundancy because many of them will still be establishing themselves as vital to the operation and also, to be blunt, because they are cheaper to lay off.

In addition, school leavers with few or no qualifications are caught in a particularly savage pincer movement. Research from the Chartered Institute of Personnel and Development (CIPD) shows that "blue collar" unemployment has risen at three times the rate of white-collar and professional workers in this recession. The unskilled are being hit hardest.

This is the group that for years has faced the toughest competition from migrant workers. Though some migrant workers have returned home, the pool remains significantly larger than it was even a few years ago. Many traditional first jobs for unskilled school leavers — in hotels, catering or other low-skilled service or manufacturing occupations — have for some years been taken up by migrant workers, who have the advantage of experience.

This problem is particularly acute for school leavers. The CIPD's most recent survey of employers showed that half intended to take on graduates this year, a third planned to recruit 18-year-old A-level school leavers but only a sixth intended to take on 16-year-olds.

Blanchflower, now watching Britain's labour market from New England, where he holds a professorship at the Ivy League Dartmouth College, makes another point. In the 1980s unemployment among young people was swelled by 1960s-born baby boomers entering the job market. They are now in their forties and the mainstay of the economy.

There is, however, a second bulge now passing into the labour market, sometimes known in America as the echo boomers (children of the 1960s boomers). This bulge is not as big as in the 1980s, and will be followed by much weaker growth in numbers of young people entering the job market, but it is with us for a while. Currently, there are some 840,000 20-year-olds in Britain. In 10 years' time, official projections show a drop to 750,000 people of that age, even in the context of a rising population.

That leaves the problem of today's generation. Research cited by Blanchflower suggests that those who experience unemployment when young suffer from permanent job-market disadvantages, because they miss the chance to build up experience and because when things do turn up, their education is rustier than the next lot of youthful new entrants to the labour market. One study showed that lifetime wages for those who suffer unemployment when young are between 13% and 21% lower than for others.

It is not all gloom. When labour demand turns, young people benefit. The unemployment rate among 18 to 24-year-olds peaked at 18%, similar to the current rate, in the recession of the early 1990s before dropping steadily as the economy recovered.

But younger workers, probably more than other groups, need a hand. Government schemes, which invoke memories of the Youth Training Scheme of the 1980s, have something of a bad name. Used intelligently, however, active labour-market policies of this kind make a lot of sense. At least until the real jobs turn up.

PS: Two sets of figures in recent days, the GDP numbers nine days ago and the latest money-supply figures last week, were weak enough to argue for a policy response from the Bank of England. Since interest rates are as low as they are going to go, this means more quantitative easing: creating "money" by buying assets, mainly gilts.

Shadow MPC member Roger Bootle suggests it should get permission for an extra £300 billion, though not necessarily expect to do that much, while Tim Congdon argues for another £50 billion to take the Bank through to the autumn.
Will the Bank do more this week? It would be a significant surprise, but stranger things have happened.

From The Sunday Times, August 2 2009

One story that will not go away is the dreadful state of the public finances. It will be around when politicians return in autumn for their party conferences, it will be the defining theme of the run-up to the general election, and it will dominate much of the next parliament.

What I want to do is first assess how much we really know about how bad things will be over the medium term. Then, given that all the emphasis has been on cutting public spending, I want to look at the inevitable tax rises that will accompany such a squeeze. What will they mean for the economy?

Alistair Darling has been criticised for not holding a review of public spending, a comprehensive spending review (CSR), to set out in detail government plans.

This would normally have been done in the summer and, while the chancellor said he will not leave voters in the dark about tough times ahead for spending, the Treasury argues that to set out detailed plans beyond 2011 would be a huge hostage to fortune.

That, of course, is politically convenient but is not indefensible. Look, for example, at how the prospect for the public finances has changed in the past 12 months.

Last week the National Institute of Economic and Social Research published its latest quarterly forecasts. As always, the NIESR's analysis was comprehensive and thought-provoking. On the public finances, it set out a couple of scenarios.

In one, public borrowing peaks at nearly £169 billion next year and then comes down gradually to a still-high £122 billion by 2013-14, but only if public spending is squeezed hard, with capital spending slashed and departmental spending cut in real terms. If not, borrowing stays high, only slipping to £160 billion, before which point the credit-rating agencies would have something to say about Britain's sovereign debt rating.

The NIESR is right to point out the dangers and the need for action. What is also striking is how wildly wrong assessments of the public finances have been. If we take NIESR's previous projections — and everybody was in the same boat — in January it expected a borrowing peak of £134 billion and a drop to £111 billion, even with a much gentler squeeze on spending.

In the summer of last year, before Lehman Brothers collapsed, a crisis figure for UK public borrowing would have been £70 billion. NIESR's July 2008 forecasts had it peaking at under £46 billion in 2010, before falling to £39 billion on the back of a modest fiscal tightening.

Given the dramatic changes in the numbers over the past year, we should be cautious about pretending we know what the budget deficit will be in four or five years.

In the 1990s, when Britain went from a budget deficit of 8% of GDP to a surplus in five years, even the Treasury was caught out by the pace of the improvement.

Policymakers have to plan for the worst, while hoping for the best. There is no doubt that in Treasury folders presented to the incoming government next year (blue for Tories, red for Labour, orange in case something really strange happens) big tax rises will be recommended, alongside the toughest squeeze on spending in the modern era.

We know from inadvertently leaked documents that last year the Treasury contemplated putting up Vat beyond 17.5% some time after the temporary cut to 15% runs out at the end of this year. You can bet a Vat rise will be among official proposals.

A Vat hike to 20% would raise a decent annual amount, £12.5 billion, would give us a neater tax system (20% income tax, 20% Vat) and be compatible with rebalancing the economy away from the consumer. It would be bang in the middle of the EU range, 15% to 25%, for main rates of Vat.

There are also arguments against. At the margin, it would increase the incentive for people to operate in the black, or "cash" economy. Any tax rises are unwelcome.

The Tories, who have form on Vat, raising it in both 1979 and 1991, have not said anything yet. The nearest thing to a broad hint of where indirect tax rises might come is that they will be used to promote greener behaviour, which implies higher duties on petrol (always a bit risky) and other environmentally unfriendly products.

The trouble is there are few taxes that generate big money, Gordon Brown having used up most of the "stealth" options. The big taxes are Vat, income tax, National Insurance (NI) and corporation tax. A small (0.5%) increase in employers' and employees' NI in 2011 is already planned. Nobody would want to raise the main income-tax rate, though Labour might seek to reduce the income level (£150,000) at which the new 50% rate comes in.

Let us suppose Vat is the centrepiece of a tax-raising strategy that brings in, say, an additional £20 billion a year, a figure recently floated by the Centre for Economics and Business Research. The rest could come from a 1981-style freeze on personal tax allowances and a range of smaller measures, including some with a green tinge.

How quickly would you want to introduce such a tax rise and what effect would it have? A new government would prefer to get the bad news out of the way quickly with an emergency budget, and show it meant business on the public finances.

The trouble is that a summer 2010 Vat rise to 20% would mean two hikes in a year, with the rate already going back up from 15% to 17.5% on January 1. In general, while it is good to announce tax rises quickly, it probably makes sense to spread them over two or three years.

This is what the Tories did in 1993, using two budgets that year to increase the level of taxation by the equivalent of much more than £20 billion, but spread over the following three years. Not all the additional burden fell on individuals but quite a lot did, including a 1% NI increase, a freeze on personal tax allowances and over-indexation of petrol duties.

Famously, tax increases did not prevent economic recovery, though it made voters more disgruntled. Consumer spending had one bad year as tax rises came through, growing only 1.4% in 1994, fortunately a year when exports and investment grew strongly. Otherwise, spending grew pretty well, 3% in 1993, 2.6% in 1995, 3.1% in 1996 and an exuberant 4.2% in 1997, which sadly for the Conservatives did not help during the election that year.

History may not repeat itself, for all sorts of reasons. Higher taxes do not, however, necessarily knock growth on the head.

PS: Is it a case of farewell quantitative easing, we hardly knew you? Before the July meeting of the Bank of England's monetary policy committee (MPC), the City expected a further £25 billion of purchases of assets, mainly gilts, to take them up to £150 billion. Then the Bank would put in a request in August to the chancellor to extend purchases beyond the previously agreed £150 billion limit.

What the Bank also did was to remind the markets that what matters for quantitative easing is the stock of assets purchased, not the process of purchasing them. Analysts had believed it would go on buying at £25 billion a month until evidence of recovery was incontrovertible. The Bank's view was that it was important to buy the gilts, and quickly. Then it could wait for the normal lags in policy to kick in and for the boost to come through fully. That, barring further surprises next month, looks to be more or less where the Bank has got to.

From The Sunday Times, July 26 2009

The temptation this week is to focus on last week's big rise in unemployment and whether it changes the outlook. The subject has had a good going over, but let me deal briefly with it.

Essentially, unemployment rose by a record 281,000 in the March-May period on the Labour Force Survey (LFS). The claimant count, in contrast, showed its sharpest rise back in February and has had progressively smaller increases since then, including "only" 23,800 in June.

It suggests the job-market picture has been getting better — or less worse — as do some of the surveys produced independently of the Office for National Statistics. The LFS, based on a survey of 60,000 households, on the face of it suggests things have been deteriorating rapidly.

One view is that the difference between the two measures is explained by redundant City and other high-salary people not signing on. Another is that the government is pulling out all the stops to get people off the claimant count.

I don't think, however, we need either of these explanations because the difference is largely a statistical illusion. The LFS measures average unemployment in the March-May period compared with December-February, and showed a rise of 13% between the two.

Using the same approach for the claimant count, there was an 18% rise between the two periods, reflecting the fact that average unemployment for March-May was pushed up sharply by the huge monthly increase, 136,600, in February.

If this is right, reading across from the claimant numbers, there will be a smaller quarterly rise in LFS unemployment in April-June and, if the improvement in the claimant count continues, we should see smaller increases in the second half of the year, though the impact of summer school and college leaving is awaited.

We will have to wait for that, but what I want to talk about this week has been one of the questions most put to Charlie Bean, the Bank of England's deputy governor, on his "quantitative easing tour" of Britain. This won't be remembered as long as, say, the Rolling Stones' Bridges to Babylon tour (1997-8), but Bean is to be congratulated for taking the message out to the country.

The question put to the deputy governor, particularly by smaller firms, was: when are the lending taps going to be turned on? It is a question Alistair Darling, the chancellor, intends to ask the banks when he invites them to 11 Downing Street shortly.

It is also one of the central questions for the economy in the coming years put last week by the International Monetary Fund in its annual assessment of the economy. Is the banking system big enough and strong enough to support a recovery, or will any upturn founder on a lack of credit?

I have mentioned before the historical precedents for recoveries from financial crises being subdued because they are "creditless" — credit growth does not pick up for several quarters after the economy has turned. Is this the outlook facing Britain?

We know Britain has suffered a serious loss of lending capacity. In the mortgage market this means a loss of wholesale funding that, in the first half of 2007, provided funds for 60%-70% of new mortgages.

For business lending, the big effect has been the withdrawal of foreign banks from the British market. Between 2005 and 2008, they contributed nearly half of the rise in business lending. Now they are not providing any, at a time when British banks, while insisting they are doing their bit, are also severely restricting their lending.

The banks are an easy target, particularly when the bonuses start flying round, but it is easy to forget how close to death some of them were a mere few months ago. That means, while business would like them to be going a lot faster, a gentle jog is all they can manage. A record low Bank rate, now reflected in very low money-market rates, does not help them greatly if the only funding at those rates they can get is very short term. Retail banking margins and profitability are being squeezed, in spite of appearances to the contrary.

So despite all that taxpayer support, with various schemes running into hundreds of billions of pounds, the banks are still convalescing. That is why UK Financial Investments, the body responsible for managing taxpayer stakes in banks, says it will take years to sell them off.

The Bank set out some of the fragilities in its recent Financial Stability Report. The "funding gap" of big UK banks — the difference between customer loans and deposits — continued to rise after the crisis broke and on Bank estimates was £800 billion last year. That gap has been filled in large part by government support but the Bank warned this cannot continue indefinitely.

"The leading UK banks might need to shrink their balance sheets or find alternative sources of funding of around £500 billion over the period to 2013, as various forms of public-sector financing are progressively withdrawn," the Bank said.

You might ask why the government cannot just keep propping up the banks until funding markets return to normal. Perhaps they will between now and 2013. But the Bank is concerned that an open-ended taxpayer commitment to the banks could hit the UK's sovereign debt rating.

It is not hard to avoid the conclusion, then, that banking in Britain is likely to remain seriously impaired for some time. On top of the loss of capacity from the withdrawal of foreign players, British banks are facing severe balance-sheet pressures. Deleveraging — reducing debt — will be a priority for them in the years ahead.

It is not all bad news. So far, the effect of taxpayer support, and possibly quantitative easing, has been to prevent bank lending growth turning significantly negative, as has happened in previous banking crises in other countries, and in Britain in the secondary banking crisis of the 1970s. Firms that are able to do so are accessing funding in other ways, through equity and bond issues, which is one reason why the investment banks, which get fees from such issues, are doing so well. Venture-capital firms, some of which have done very little business in the past year or so, have pools of cash ready to invest.

The latest Deloitte survey of chief financial officers shows that credit availability for larger firms has improved for the second successive quarter but that companies are not looking to banks for finance. Equity is currently the most popular form of finance, bank borrowing the least, exactly the opposite of the situation two years ago.

We still need bank lending, however, and smaller firms in particular need it to survive the recession and expand into the recovery. For them, the continued problems at the banks are their problems too.

PS: Readers keep asking me what my skip index is saying and I can't keep it from them any longer. The index has tracked the recession pretty well. Ahead of the big autumn downturn, it was holding up at two (skips in the street), pointing to trend growth in the economy. Then it plunged to zero, staying there all winter, until some friendly yellow skips reappeared around Easter.

Scotland leads the way in such searches, followed by Northern Ireland and Wales. Proportionately, people in the south of England are half as interested in finding their local Jobcentre as those in Edinburgh. That must tell us something, though I'm not sure what.

From The Sunday Times, July 19 2009

When people say to me they are confused about what is happening in the economy, I am not surprised. For weeks the talk has been of the recession ending and the possible start of recovery.

Then along comes the Office for National Statistics with an eyecatching set of data revisions and we are apparently back mired in the sharpest downturn on record (the ONS’s quarterly gross domestic product records go back to the mid-1950s) and the biggest quarterly drop in GDP since the second quarter of 1958.

The key point is that last week’s figures, which were published on June 30 (the end of the second quarter) were a revised estimate of what happened in the first quarter.

The first three months of the year are not exactly ancient history but they came ahead of data and surveys suggesting the economy has begun to stabilise. So the scary ‘slump’ headlines on the back of the ONS’s third guess at first quarter GDP were consistent with the recovery headlines that came after the following day’s purchasing managers’ index, which suggested Britain’s troubled manufacturing sector is close to the end of its recession.

As an aside, older readers may be surprised to learn that 1958 saw a bigger quarterly fall in GDP than the 2.4% plunge we have just had. This was the post-war golden age for the economy, the Harold Macmillan “you’ve never had it so good” era.

It was also, however, the stop-go era, in which one-off falls in GDP were common, though not on that scale. People forget, too, that Macmillan’s immortal phrase, which was actually “most of our people have never had it so good”, uttered in July 1957, was intended to reassure a public far from convinced about his government’s economic management. A sterling crisis in September of that year had to be met with a sharp rise in interest rates. Something must have worked; he was re-elected two years later.

The ONS has reignited the debate about the severity of this recession compared with its predecessors. Any doubt about whether this is worse than the early 1990s has been erased; the peak-to-trough fall in GDP then was a mere 2.5%, only slightly more than in the first three months of this year alone.

Is it worse that the recession of the early 1980s? Then, British manufacturing was more than decimated; it lost a fifth of capacity. The severity of that recession is open to some statistical debate but if you measure the drop in GDP from its peak during 1979 to the 1981 trough, it was 5.9%, compared with 4.9% so far this time. So my view is that this is not as bad yet, though whether it gets that bad depends on the next couple of quarters. Economists are looking for a flattish second quarter, with some even predicting a rise. We will get a first look at the numbers on July 24.

I shall repeat the point about it being impossible to judge how serious this recession is compared with its predecessors until we have been through many data revisions from the Office for National Statistics. At this stage, much of the information about the first quarter remains much more tentative than the precision of the ONS figures suggest. There is a lot of guesswork and modelling in these numbers.

Revisions will not see the recession melt away but they may make it look different. Take 2005. At the time this was thought to be the year when Britain stopped. Economists believed growth had slumped to 1.5% or less. Now it is 2.2% and rising.

In the last recession of the early 1990s, the Treasury late in 1992 was working on the assumption that the economy shrank by 2.5% in 1991, slipped by a further 1% in 1992 and would grow 1% in 1993. The figures now for that period are -1.4%, 0.1% and 2.2% respectively.

But we have to work with the material we have now until those future revisions come along. What do the numbers tell us?

They confirm the role of inventories - stocks - in this recession. Mervyn King calls it “the Honda effect”, a slogan the company has taken to using in its advertising. Honda chose to supply customers from stock, shutting down production at its Swindon factory. Last month it restarted.

In the eye of the recessionary storm, the six months from October 1 to March 31, GDP fell by 4.2%. Of this nearly half, two percentage points, was due to the rundown of inventories. At some stage that will be reversed, and it is probably happening already. If it occurred quickly it could produce an unusually strong but short-lived bounce in quarterly growth.

As it is the first quarter figures have not changed the view of most economists that the current quarter will see only a modest GDP decline, or better. That is partly based on the view that the inventory cycle has turned, a view supported by purchasing managers’ indexes for Britain and other countries. The GDP figures tell us it was a steep bungee dive. Subsequent information tells us we have stopped diving.

Amid the wreckage there was another encouraging feature in the GDP figures, highlighted by Michael Saunders of Citigroup. Companies and households, the non-bank financial sector, had a financial deficit 0f 0.9% of GDP as recently as the third quarter of 2007. Now they have a surplus of 7.9% of GDP, a rapid turnaround.

According to him: “This is the highest since detailed data on private savings began in 1987, while partial data suggest private savings are now the highest since 1980.” One of the stories of the recession has been about the need for the private sector to undergo a painful adjustment process. For the financial sector that process has a long way to go.

But for companies and individuals, the new numbers are encouraging. They suggest, according to Saunders. “the main part of the inevitable adjustment is probably behind us”. For firms more interested in seeing their customers spend than save that has to be good news.

PS: With Bank rate stuck at 0.5% and unlikely to change for quite some time, you could be forgiven for thinking that this week’s meeting of the Bank of England’s monetary policy committee (MPC) will be a non-event. Not so.

In the markets, there is a debate about whether this “unconventional” policy from the Bank will be inflationary. For me, much more debate is whether it will work in boosting the economy. We still cannot be sure of that.

From The Sunday Times, July 5 2009

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 al