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Archives for March 2010

Questions for debate

Stephanie Flanders | 21:27 UK time, Monday, 29 March 2010

The men who would be chancellor had a spirited debate this evening - with each playing to their strengths. Chancellor Darling put the emphasis on "judgement calls"; Vince Cable on his honesty; Mr Osborne on the need for change.

Alistair Darling, Vince Cable and  George Osborne

We'll wait to see how voters viewed the debate, to the extent that they viewed it at all. Even I might wonder whether an hour of debate on economic policy would set the airwaves alight.

The only news I spotted was the chancellor's admission that the government would not be proposing a death tax as the single means of paying for social care for the elderly, though it might be one of a range of options. It turns out the prime minister was supposed to be confirming that tomorrow.

But Mr Osborne did have to defend his promise to avoid Labour's "tax rise on jobs". After a day of claim and counter-claim on his proposals, this, I think, is where we are.

First, the Conservatives have done what we've been asking all the parties to do: they've suggested how they would cut spending this year: by £6bn in 2010-11. That's in addition to the roughly £7bn in savings Mr Osborne proposed last year, most of which - like the targeted public sector pay freeze - will only kick in from 2011.

Conservative officials insist that these cuts will accumulate over time, meaning that borrowing after 2010-11 under the Tories would be lower than Labour now plans. That may be so. But they haven't given us any firm targets for borrowing this year, or any other year. And they haven't even given us a guess as to how the efficiency savings announced today would continue to cut spending after 2010-11.

Given what senior Conservatives have said about government efficiency drives in the past - they will perhaps not be surprised if we don't give them the benefit of the doubt for 2011-12 onwards.

As for the 2010-11 savings outlined this morning: as I said earlier, it matters whether any of these are included in the government's own efficiency drive for this year.

The Conservatives say absolutely not. Labour says they might well be. But when they have yet to identify £26.5bn the £35bn they've promised in efficiency savings by the end of this fiscal year, Labour won't be surprised if we don't give the government the benefit of much doubt either.

Second, the Conservatives are swapping a certain tax rise next year for an uncertain spending cut this year.

The tax rise, they say, would have penalised employment - and hurt job creation - at a crucial time for the recovery. That may be. But by paying for the tax rise with new spending cuts this year, Labour and the Liberal Democrats say the Conservatives risk hurting the economy this year instead.

Of course, they may all be right. Given the weakness of the economy, most governments would rather not take £6bn out of the recovery at all. But unfortunately, we're borrowing nearly 12% of national income.

With luck, the equivalent of roughly half of a percent of national income won't make a key difference to the recovery in 2010 or 2011. But the Conservatives seem to be saying that £6bn is a hugely damaging number for the economy when it's a tax rise - but when it's a spending cut, it's a bagatelle.

In fact, when you add in the child trust fund and child tax credit changes they have committed to implement this year, the spending difference between the Conservatives and the other two major parties in Westminster this year is now more than £7bn.

There are some academic studies suggesting that tax rises are more harmful to growth than spending cuts at times like these. Equally, it's quite possible that greater spending cuts this year will not put the recovery at risk. It's impossible to know.

I return to my earlier point: if the savings are real, then so will be the effect on the economy, even if the private sector makes up the gap. And even if the hole in the public finances - under the plans that the Conservatives have revealed so far - ends today almost exactly what it was at the start.

Bonfire of the inefficiencies

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Stephanie Flanders | 11:51 UK time, Monday, 29 March 2010

"Back-office staff spend money too." That would be Labour's response to George Osborne's list of efficiency savings for this year - if it weren't so easy for the opposition to portray Labour's own thinking on efficiency savings as already hopelessly confused.

The Conservatives believe that Sir Peter Gershon and Dr Martin Read have identified efficiency savings of around £12bn that can be implemented within the coming financial year 2010-11 - of which about half will be re-invested in health, overseas development and the Ministry of Defence.

The remaining £6bn will come straight from departmental budgets - meaning, by their own calculation, a 2.8% real cut in spending by those departments. This, in turn, will make it possible to cancel a large part of Labour's planned National Insurance rise for 2011-12.

Do the numbers add up? As a matter of arithmetic, I'm sure they do. Especially since the Conservatives have already asked the IFS to give them the once-over.

Taken together, the National Insurance changes announced since the 2009 Budget were due to raise £6.9bn a year. The IFS reckons the Tory proposals, which would raise the thresholds at which National Insurance Contributions are made, will cost £5.6bn in 2011-12.

With a shaky recovery, it's perfectly reasonable to want to delay tax rises which increase the marginal cost of employing people, and are likely to hit workers' disposable incomes. But if you're also committed to cutting the deficit more quickly than Labour, it matters how you say you will pay for that change.

Which brings us back to those £6bn in net savings to be taken from non-protected departments. The first big question to ask is whether any of these savings are included in the efficiency plans already under way for this year?

The Conservatives say not, but given that Labour has not even identified two-thirds of the savings promised for this current spending round, it's hard to say one way or the other.

Of course, if any of them are already included in departmental plans, the difference between Labour and the Conservatives would simply be that Labour will "reinvest" all of them - while the Tories would "reinvest" only half.

But assume they are not part of existing plans. Then we have what amounts to a cut in departmental spending in 2010-11, which will bring public borrowing down faster than Labour plans. This is what the IFS has to say about it:

"The Government is currently planning to cut public services spending outside the NHS, defence and overseas aid by 2.4% in 2010-11, after adjusting for whole economy inflation. We estimate that the additional £6 billion cut planned by the Conservatives would increase this to 5.1% and would leave these unprotected areas of spending 2.8% below the level planned by Labour. (The figures do not sum precisely because of rounding and we cannot be entirely precise about the declines until new 2010-11 Departmental Expenditure Limits are published in the Treasury's next annual public spending statistics). The largest unprotected area would be schools."

George Osborne may be entirely right that these cuts can be achieved without hurting "frontline services". As I said in my Friday post, these savings do exist. We've just stopped believing in them because Labour has given us no way to measure the impact on individual budgets and services.

Mr Osborne has not given us spending totals for individual departments this morning. But we might derive them from applying the £6bn cut across the relevant departments, because he has told us that spending in non-protected departments will actually be cut in line with these savings. That is more than Labour has done.

However, even if a spending cut doesn't affect frontline services, if it cuts the budget, then it has to affect the economy. And it has to affect the number of people earning public sector salaries.

Philip Hammond said this morning there was "no plan to cut jobs" with these savings. That may be grammatically true, but it's disingenuous. If you don't fill vacancies, then you are deciding to cut the number of jobs in the public sector. Real people who would have been on the public sector payroll will not be on the payroll as a result of this cut.

Likewise, companies whose public sector contracts are re-negotiated will find they have lower revenues than they expected. The individuals involved in those cancelled IT projects will find they don't have that work after all.

Now, all of this lost demand might be made up by new private sector contracts and jobs. Indeed, it's part of the Conservatives' whole argument about the deficit that if you cut borrowing faster, you create private sector demand by raising financial confidence.

They may be right. The net impact on the total demand in the economy might be negligible - there are even studies suggesting it might be positive (see my post from 5 March).

But either the savings cut spending - or they don't. If they do, that is demand being taken out of the economy. That may not hurt the recovery overall: we don't know. But the Conservatives cannot deny that public sector demand is being cut. As the IFS has now pointed out:

"Combined with Labour's existing plans, it would increase the discretionary fiscal tightening between this year and next to £29 billion or more than 2% of national income - significantly larger than that planned for subsequent years, even though the recovery should by then be stronger."

Labour may say all of this in their response to the Conservatives' proposals. But it's difficult for them, because the Conservatives have identified a weak link in Labour's plans. It really does sound silly to say you've identified waste but you're not going to do anything about them for another year.

As Ken Clarke suggested in the press conference, if that's a fiscal stimulus programme it sounds like a pretty silly one to ordinary voters. In that sense, Labour's own confused approach to efficiency savings may have played into the Tories' hands.

But, to return to the larger point: a saving either saves money, or it doesn't. I don't know how many of our leading politicians believe in the immaculate conception. But many of them do seem to believe in immaculate consolidation. That's when you cut borrowing, but somehow leave everything else in the economy unchanged. Apparently, they think that voters believe in it too.

Phoney deficit wars

Stephanie Flanders | 09:18 UK time, Friday, 26 March 2010

Increasingly, three phoney debates about the future of Britain's public finances are distracting from the lack of serious ones.

The politicians won't say how, exactly, they'd get rid of the bulk of the deficit - so instead we're debating the meaning of the word "bulk". Neither the government nor anyone else will put numbers on departmental budgets after this year - so instead we're debating whether an "efficiency saving" counts as a cut. And we trade ever more pessimistic visions of the future for individual departments, because large parts of spending are being counted out.

That first debate - about the meaning of the word "bulk" - is well-known to readers of this blog. But it just got even more rarefied, because the difference between Labour and the Conservatives on the deficit seems to have shrunk to just £8bn.

To recap, the Conservatives have not set a formal target for the deficit, but they have indicated that they would like to balance that part of the structural deficit that is not due to investment - the current structural deficit - by around 2014-15. As the IFS confirmed yesterday, the Budget book now suggests this measure of the deficit will fall to 0.6% of GDP by 2015-16, not 1.1%, as forecast in the PBR. As a result, the Conservatives would apparently only need to find an extra £8bn in spending cuts or higher taxes - on top of the chancellor's existing plans - to meet their target, not £15bn as previously estimated.

As we know, another version of the Tory target is that they would eliminate "the bulk" of the structural deficit. Evan Davis had a ludicrous exchange with George Osborne yesterday morning about whether the more than two-thirds cut envisaged by Labour constituted "the bulk"; and if not, what would. Let's just say he didn't get far. But this is what we're reduced to, when faced with the politicians' stonewalling on how, exactly, that borrowing is going to go away.

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The same dynamic is operating in the debate over the government's "efficiency savings". If re-elected, the government says it will look to public spending cuts to achieve £38bn of the reduction in borrowing between now and 2013-14. Ministers have offered up £11bn in operational efficiencies to help achieve that, which were re-announced on Wednesday with great fanfare.

But the IFS was having none of it. For one thing, they pointed out that these efficiency savings have a habit of not materialising - we're still waiting to see two-thirds of the efficiency savings that were promised by March 2011.

For the IFS, there's a more fundamental problem with this discussion. Because, even if these savings are achieved, they are not the same as reducing the deficit - because many of them would have occurred in the natural course of events. That means they won't necessarily narrow the gap between the public services we would have had without cuts - and the public services we're going to get now.

I sympathise with this view. There isn't necessarily a direct read-across from 'savings' to cuts. But even so, some of them measures can and will save money, in ways that protect the vaunted 'frontline'.

Take the plan to save £550m by reducing staff sickness absence, which has been widely pilloried. It sounds fanciful. And maybe it is. But the NHS employs 1.3m people, who on average miss work more than 10 days a year due to sickness, compared to an average of about six days a year in the private sector.

An external report commissioned by the NHS last year did the math and suggested you could save £550m by cutting the number of lost days by a third. Maybe that's ambitious. But it's not mad. If you read the report you find examples of hospitals that have cut sick days dramatically by doing quite simple things.

For example, West Suffolk Hospital Trust introduced a system which swiftly referred injured staff to a physiotherapist (these kinds of injuries seem to be a big part of the problem in the NHS. Contrary to popular belief, it's not staff catching infections from patients). In the first nine months of the scheme, the number of lost days fell by 40%, and they saved money on treating the injuries as well.

No, I don't think we can have all our our efficiency savings and eat them too. Not all of these savings are going to happen. Plenty of other hospitals have not had this kind of success - and, self-evidently, those that have already cut lost days by a third are unlikely to be able to do it again.

And yes, even if they all happen, these 'efficiencies' are not going to fix that deficit problem by themselves. Far from it.

My point is just that big savings are possible, and they can happen in ways that have relatively little impact on all of us who use these services. If you talk to senior officials in the NHS they will tell you the same thing. But we don't believe in them - can't believe in them - because the government has given us no reason to.

If the chancellor had given us departmental spending totals for 2011-14, we could measure how these efficiencies might help departments do the same with less. We could actually measure the effect on the bottom line. Instead, we have overall spending numbers, and a lot of "ring-fencing" from Labour and the Conservatives. Without the individual departmental budgets, all talk of "savings" is understandably given short shrift.

Finally, the IFS has once again calculated the implications of the budget for departmental budgets that are not ringfenced. On "plausible assumptions", it says that departmental spending will need to fall by £46bn in real terms by 2014-15. Depending on whether health and education are protected for the entire period or not, this would mean that unprotected departments face real budget cuts of 20-25%

But remember that those "plausible assumptions" include the assumption that the 45% of public spending that is not part of departmental budgets will not be affected by the search for cuts.

That includes the £173bn that is spent on benefits, tax credits and public sector pensions: the Child Trust Fund, Child Benefit and child tax credits, free bus passes for pensioners - the lot.

Just today, David Cameron promised to 'protect' free bus passes - and the Conservatives have said they will protect a bunch more of these benefits (of which more later). But whoever wins the next election, literally no one involved in this debate thinks that it this part of spending will be left untouched. Yet we paint ever more apocalyptic visions for individual departments, based on the assumption that it will.

This is not to criticise the IFS. They have no basis for making the calculation in another way (though it is a stretch to call this assumption plausible.)

To repeat: these are the phoney debates we're reduced to, when politicians have decided the real ones are too tough.

The count-yourself-lucky Budget

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Stephanie Flanders | 16:39 UK time, Wednesday, 24 March 2010

"It's bad, but not as bad as we thought - and not nearly as bad as it would have been under the Conservatives." Strip away the distractions and the gimmicks, and that was basically what the chancellor wanted to tell us in his Budget statement today.

A man watching the chancellor deliver his speech on TV

There's no getting away from the depth of this recession. But on some key measures - especially unemployment, but also the number of house repossessions, and the number of companies going bust - it's been much less bad than the headline 6% drop in output would have led you to expect. It will have given the chancellor great pleasure to point out that the claimant count is still lower than it was in 1997. The way he told it, all of those upside surprises are down to Labour policies.

Never mind that companies themselves came into this recession with stronger balance sheets than in past recessions. Never mind that the independent Bank of England cut interest rates further, and earlier than in any past downturn. Never mind that millions of people across the country have accepted steep cuts in their earnings in order to stay in their jobs - or take a new one.

Tax credits, the time to pay scheme for companies and the government's extra investment in job centres have all helped. But it goes without saying that they are far from the whole story. Yet, whether or not it can take credit for this better outcome, the government did today reap the benefits, in the first significant downward revision in the government's borrowing forecasts for at least a decade.

We can all be glad that public sector net debt will be £67bn lower in 2014-15 than he thought in December. That's £67bn down - only £1406bn to go.

As I mentioned earlier, by 2014-15, the structural on the public finances is now expected to be 2.5% of GDP, instead of 3.1%. A small part of that - just 0.1 percentage points - comes from measures announced today, notably the rise in stamp duty on houses worth over £1m. You'll note that the tax rise is permanent, whereas the tax cut for first-time buyers only lasts two years. The rest of the improvement in the structural deficit comes through more benign forecasts for spending and revenues.

The City will see that two-thirds of that improvement has fed through into lower borrowing overall in 2014-15. The City reaction to this Budget was muted today - my hunch is that will stick. This is not like the PBR, when the City saw the downside the following day. The forecast for gilt issuance next year is exactly what the City analysts were expecting.

Fitch, the ratings agency, has given a muted welcome to the Budget, though it has warned that the public finances are still vulnerable to shifts in confidence down the road. Here's what one of its economists has said:

"The lower than expected outturn for borrowing in 2009-10 is welcome, particularly in the face of weaker than expected economic growth. There has been some restoration of government's fiscal forecasting credibility following several years of deficit overshoots even before the recession. New measures to support the economy appear, by and large, to be funded by spending cuts elsewhere, or from bonus tax receipts, with the majority of the £11bn tax windfall devoted, appropriately, to lower borrowing."

Politically, he's delivered a very small net giveaway of £1.5bn for 2010-11, which gets clawed back in future years. Others will judge whether the mix of measures he's announced will do Labour any good. As I said earlier, they have clearly been chosen with Conservative discomfort in mind. But when you're borrowing £167bn, that £1.5bn figure looks like pretty small beer.

But for me the most interesting point about this Budget is what it says about Labour's strategy for re-balancing the economy. I haven't been able to go through all the numbers, but it looks to me as though that re-balancing has been rather put on hold. Growth in private investment as a share of the economy has been revised down for next year and 2012. Along with the measures to support business, he's announced new measures to boost the housing market - and consumption.

It's helpful to the Treasury in the short-term if the economy isn't going to re-balance after all: given the way the tax system is structured, it brings in a lot more in tax revenues from an economy that's "excessively dependent" on the City, property and consumption than one built on exports and investment. If the Treasury now thinks we'll see less re-balancing, in the next few years, that could explain the greater optimism on tax revenues and structural borrowing. But that short-term good news for the chancellor could still be bad news for the economy long term.

Borrowing headlines

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Stephanie Flanders | 13:09 UK time, Wednesday, 24 March 2010

The chancellor has announced a net borrowing figure for 2010-1 that is £13bn lower than forecast in the PBR. The figure for 2009-10 is nearly £11bn lower, but the revisions for future years are a bit smaller: he's taken £7bn off the borrowing figure for 2013-14.

Net debt hasn't fallen much: the forecast is now that it will rise to 75% of GDP in 2014-15, instead of 78%

I said focus on the structural deficit numbers. We now know that the structural deficit in 2014-15 is forecast to be 2.5% of GDP by 2014-5, down from 3.1% previously. The City will note that two-thirds of that that improvement in the underlying situation has been put into cutting total borrowing in 2014-15: that's gone down from 4.4% of GDP to 4%.

Update 13:19: As I expected, he's revised down slightly the growth forecast for 2010. The borrowing forecasts now assume growth of 3% next year, not 3.25%. But the chancellor has stuck to his view that the recovery will be stronger than the City expects. The Bank of England is on his side on this one. And 3% still looks like a weak recovery, given the recession we've just had.

As I also expected, he has announced a new national investment fund - OK, he calls it a corporation - to support private investment. This will be hard for the Conservatives to oppose though the figures involved do not seem to be large.

Update 13:26: We're waiting to see the numbers in the Budget book, but the chancellor is clearly spending a lot more time and money on the measures for companies and boosting investment than he is on voter-friendly measures like the cut in stamp duty.

Update 13:52: The stamp duty cut is even cheaper than I thought: the Budget book shows it costing £230m in 2010-11 and £290m in 2010-11.

Update 14:20: Where he is spending money, the chancellor is spending it on things that it will be very difficult for the Conservatives not to match.

A case in point: the single most expensive measure in this Budget is the increase in winter fuel allowance for older pensioners. At his press conference yesterday, David Cameron yesterday was cornered into promising to keep winter fuel allowance "as he inherits it". The cost of the allowance this year has just gone up by £600m.

A winding road

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Stephanie Flanders | 10:15 UK time, Wednesday, 24 March 2010

Alistair Darling presents himself as a chancellor who plays it straight, and today was supposed to be no exception. Others might be lurching wildly - torn between Labour's position in the polls, and the cost of government debt.

Westminster Clock TowerMr Darling, we were told, was a man who sticks to the path he's set. Maybe that's what we'll hear later on. But it seems there's going to be a couple of detours.

We now know that stamp duty is going to be abolished for first-time buyers purchasing houses for less than £250,000. On the face of it, this is completely at odds with the government's strategy for the recovery, which is to re-balance the economy away from consumption and debt - in favour of exports and investment.

The best that can be said of this change is that it doesn't cost much: when George Osborne proposed it in the autumn of 2007, he said it would cost £400m. That sounds about right - though even that could be a bit high.

According to the Treasury's own ready-reckoner, raising the threshold for everyone would cost £910m in 2010-11 and £1.1bn next year. Usually, first-time buyers account for about 40% of housing transactions, though that share has fallen sharply in the past two years.

You'd also expect the average purchase price for first-time buyers to be lower than for the broader population. That would push down the cost as well.

The other news is that the increase in fuel duty pencilled in for next month is going to be introduced in stages. In last year's Budget and the pre-Budget report, the chancellor announced fuel vehicle excise duty increases worth £1.8bn in 2010-11. It will be interesting to see how much of that he's going to reverse. My bet would be less than half.

How will this square with all the talk about supporting jobs - and boosting private investment? We will wait to hear. But as I said on the Today programme this morning, I will be looking to compare the size of this consumer giveaway with the giveaway for companies, and the "takeaway" from the banks.

If the Alistair Darling we read about plans to make an appearance in Parliament today, he'll want to show that boosting private investment is a higher priority than winning votes.

And he'll want to show he's paying for those trinkets for tax-payers by extracting a "payback" from the banks, and without compromising his plans for the deficit.

Though they seem at odds with the long-term strategy, the stamp and fuel duty "giveaways" do provide useful cover for the chancellor in his argument with the Conservatives over the timing of budget cuts.

For some time now, I and others have been pointing out that the gap between them was more rhetorical and real - not least, because the government was planning to withdraw more than £20bn from the economy this year by reversing the special stimulus.

By introducing these measures - and probably some new spending in 2010/11 on helping the unemployed - he can claim the government is supporting the economy, at the margin, where the Conservatives would cut.

That may help the rhetoric. But when it comes to the macro-economy, remember that the impact of returning VAT to 17.5% will be far greater than any modest spending measures he announces today. And - once again - it will be important to see how he pays for those changes. He may not be "spending" any extra money at all.

In all this I haven't mentioned the markets. Investors' expectations of Mr Darling were the focus of my piece on the News at Ten last night. But clearly, they too will be looking to compare the amount spent on voters and companies with the amount raised on the financial sector - and, crucially, the amount put into lowering the deficit.

On borrowing - keep your eyes on one number: the structural deficit in 2014-15. If it's lower than 3.1% of GDP (the forecast in the PBR), then that means the Treasury thinks the job of fixing the public finances has got easier.

Investors will want to see that he has used that as opportunity to finish the task more quickly, not spend more on coaxing voters today. If the total figure for public sector net borrowing in 2014/15 has not also fallen, that will not go down well at all.

As for that rhetoric about "supporting the recovery'" - the key will be to look at the Budget measures taken together. If the net effect on the government spending and revenues is broadly neutral, then the impact on the economy will probably be neutral as well.

Labour would argue that the money spent on, say, giving temporary jobs to young people will boost demand more than raising taxes on very high earners will reduce it. And yes, it's unlikely that people on more than £150,000 are going to be shopping in Aldi as a result of the 50p rate.

But even so, you're still talking about a very modest net impact on the recovery this year. The effect on the chancellor's reputation is even harder to judge.

Budget overview

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Stephanie Flanders | 16:11 UK time, Tuesday, 23 March 2010

I've written a more general overview of the budget elsewhere. Something to cut out and keep.

Squaring the circle

Stephanie Flanders | 11:45 UK time, Monday, 22 March 2010

There are always three audiences for a Budget: voters, the City and the chancellor's own party.

Alistair DarlingThe challenge for Alistair Darling this week is that for once, all three of them will be listening. Expect modest good news on the deficit; cautious language on the economy; and a "bold plan" to spur private investment in future growth.

We know what many in his party want: a Budget statement which actually helps Labour's standing in the polls. As Nick Robinson has pointed out, they never have in the past.

They also want him to make a link between government action in 2009, and the recovery in 2010. And to show that savings from the smaller than expected rise in unemployment can now be invested in Labour priorities, notably training and jobs.

We know what the City wants: a faster timetable for bringing down the deficit, an/or more clarity on how, exactly, it will be done.

Yes, investors know there is an election on. The bond markets are unlikely to be spooked by the chancellor leaving his deficit plan roughly where it is. But they will be very alert to backsliding.

He knows the City will not take kindly if he spends improvements in the underlying deficit rather than using them to cut overall borrowing. He did that in the pre-Budget report: arguably, he only got away with it because traders didn't think there was any chance that Labour would win.

And voters? As ever, voters are a not a uniform bunch. Nor are their polling answers consistent. We're told that voters will reward politicians for "telling it straight". That is the box that all three major would like to tick. But according to an Ipsos MORI poll last week, only 50% of people believe that public spending cuts will be needed to get the public finances in order.

Given that, perhaps it's no surprise to see from another poll this weekend that only 64% expect Alistair Darling to tell them the truth about Labour's plans. The figure for George Osborne was 62%.

Can the Chancellor square the circle? We find out on Wednesday. But here are my top predictions.

First, there will be no major change in the timetable for bringing down the deficit, or the balance between tax rises and spending cuts to achieve it. But I believe the chancellor will revise down the forecast for the structural deficit through to 2014-15.

That could raise an interesting quandary for the Conservatives. In their rhetoric they have seemed to focus on the current structural deficit - the part of the structural deficit that is not due to net public investment.

If the chancellor leaves his forecasts for net investment unchanged, then the structural current deficit could fall to less than 1% of GDP by 2014-15 in the Treasury's revised forecasts. The Tories will have to say how much further they would go.

Second, the improvement in the underlying picture will probably prompt a slight downward revision to the growth forecast for 2011. Other things equal, that would cause a rise in "cyclical" borrowing over the next few years. But that need not push up the headline borrowing numbers, if the structural deficit ha been revised down.

A slightly lower growth forecast for 2010 would give the chancellor another opportunity to talk about the "fragility of the recovery", which would otherwise look a bit strange next to a forecast for 3.5% growth in 2010.

But expect the Treasury forecast will stay well above the private sector consensus for 2011 - which is currently for growth of 2.1%. Officials think that is too gloomy, and they may be right. Remember that even 3.5% growth, after the two years that the UK economy has just had, would be much weaker than the recoveries we've seen in the past.

Third, the chancellor will not yield to business pressure to re-think the reduction in pension tax relief for high earners.

He knows it's going to be horrendously complicated to administer for companies with final salary pension schemes. He also knows there are other ways to prevent high earners from parking their income in pensions to avoid the new 50p rate - for example, by cutting the lifetime cap on the tax-free pensions pot, or the cap on the amount that can be contributed in a single year.

The problem is the Treasury doesn't think these steps would be as effective. And crucially, they don't think it would raise nearly enough cash.

Fourth, along with everyone else, I expect some modest new spending on jobs for young people, but no big giveaways which have "six weeks before an election" written all over them. Mr Darling ruled them out explicitly yesterday talking to Andrew Marr.

However, it is clear to me that there will be a major new initiative to stimulate private and public investment - along the lines of a national investment fund or bank.

As I've said before, this is something the Treasury have been thinking about for some time, to complement quantitative easing. It is also something that many city economists would welcome, assuming it doesn't try to micro-manage where or what the investments will be.

Such a scheme would give the chancellor something positive to say about the re-balancing of the UK economy, at a time when the other leg of that re-balancing strategy, a surge in exports, is looking very fragile indeed.

It is also something the Conservatives and Liberal Democrats would find it hard to oppose, given that they have talked about creating something similar themselves.

We've had a lot about taxing banks in the lead-up to the Budget. I'm sure that will play a role as well - which is, of course, why the Conservatives felt they had to get in first.

On the day, Darling will also be trying to make this a Budget for investment. In theory, all three audiences - voters, the City and his party - will be able to warm to the theme of raising UK investment. But only if they can see through the pages and pages of red ink.

Not lagging, but not leading either

Stephanie Flanders | 10:57 UK time, Wednesday, 17 March 2010

This is not the UK labour market of old: the headline unemployment numbers are moving with the economy, not lagging far behind as they have in the past.

Job centreBut there's nothing in these figures to suggest the labour market is leading triumphantly ahead.

The employment picture for the next year looks even more fragile than the economic recovery.

The total UK claimant count in February has seen the largest one month fall in more than a decade, and the surprisingly sharp rise in January has been revised down.

The broader measure of UK joblessness also fell by more than 30,000 in the three months to January, though the regional figures suggest unemployment is still rising in Scotland and Wales.

So, the unemployment numbers appear to be flattening out much sooner than in past downturns. The number of vacancies is also rising surprisingly soon.

But there's still plenty to be concerned about: not least, the fact that employment also fell over those three months, by 54,000.

A very large rise in inactivity made up the difference: some 149,000 people have dropped out of the jobs market altogether. It's difficult to draw any firm conclusions about that rise: two-thirds of it - 98,000 - was made up of students reporting that they were no longer in the market for paid work.

There were also significant increases in the numbers taking early retirement - and choosing to stay home to look after family.

The bigger picture is that the jobs market is still a highly uncertain place. As I've said in past months (see Both accident and design and Which side are you on?) the smaller than expected rise in unemployment this time around owes much to private sector workers taking a hit on their earnings.

The Bank of England warned earlier this week that employers could find it hard to keep on workers in a weak recovery, if employees try to make up the ground they've lost.

Though it must be said that so far there's little sign of that happening, even with the recent sharp rise in headline inflation.

But note how much public sector jobs growth continues to flatter the figures.

The number of public sector workers grew by 7,000 between September and December, while the private sector workforce shrank by 61,000 over the period.

With job losses already being announced in town halls, we cannot expect that to last.

The incredible shrinking gap

Stephanie Flanders | 17:42 UK time, Tuesday, 16 March 2010

It's no surprise that the European Commission would like Britain to bring its deficit down faster than the government plans. Potshots from Brussels have been a feature of HM Treasury life since the "excessive deficit procedure" began - and this time, the UK is far from alone. Nearly every EU country now has a deficit over 3% of GDP. Sources in Brussels tell me the UK will not be the only government this week that the commission tells to shape up.

European flags outside the European Commission's Berlaymont buildingWhat's interesting about this story is the light it has shone on the two largest parties' plans for the deficit. Once again, we find that the chasm between Labour and the Conservatives on this central electoral issue is more of a ditch. And a fairly shallow one at that.

This will not come as a surprise to readers of Stephanomics. But the commission report has helped underscore the point. It has also highlighted a distinct lack of clarity in the Conservatives' position.

We keep hearing that the government wants to halve the overall deficit by 2015. We will hear it again next week in the Budget.

Another way to describe the government's plans would be to say it plans to cut the structural deficit - the borrowing that won't go away with the recovery - from 9% of GDP in 2009-10 to 3.1% of GDP in 2014-15. In other words, they would reduce the structural deficit by two-thirds over the period.

On the Today programme this morning, Ken Clarke initially suggested the Conservatives would eliminate the structural deficit by 2014-15. But he later stepped back from this, to return to the more usual script, which is that a Tory government would get rid of the "bulk" of the structural deficit.

A few observations about this.

One is that on the big macro question of this election - cutting the deficit - the Conservatives have actually given us less detail than Labour. yes, they have offered micro tasters: a few benefit cuts here, a public sector wage freeze there. We haven't had many of those from the government.

But on the basic question of how much they hope to cut the deficit over five years, Labour has a clear answer. With numbers attached. The Conservatives do not. If Ken Clarke, probably the most experienced - and certainly one of the most economically literate - members of the shadow cabinet, cannot stick to a single answer in the course of a 10-minute interview we can be fairly sure they haven't got one. Or at least, not one that is ready for prime time.

So, what is the difference between the parties? Well, that gets us back to the parlour game of what counts as "the bulk" of the structural deficit. We are told that the Conservatives are hoping to echo the language of the governor of the Bank of England on this point. He talked about getting rid of a "large part" of the structural deficit over that same time frame.

Is two-thirds a large part? As I've said before, if you took half of my dinner I would consider that a large part. If you took away two-thirds I'd feel seriously cheesed off. I might well complain that the 'bulk' of my dinner had been nicked.

Reading between the lines, the IFS have previously concluded that the Conservatives would like to eliminate the current structural deficit - the part of the structural hole that is not due to public investment - by 2014-15. On current Treasury forecasts for the economy, it thinks that meeting this target would involve "extra" cuts in borrowing of just over 1% of national income, or £15bn in today's money - on top of the 4% of national income cumulative cuts in borrowing by then that Labour has set out.

But note that this is simply the IFS interpretation of Conservative policy, based on what George Osborne has said. It is not official policy, and behind the scenes, officials will neither confirm nor deny that this is what they have in mind.

This is their right. In fact, you wouldn't necessarily expect precise expenditure totals from a party in opposition. But in a campaign centred around bringind down the deficit you might expect a precise target.

Yes, the government has not said much about how its overall spending plans would be reached. And yes, it's true that the numbers are subject to huge revision. What we thought was a £37bn structural hole 18 months ago, was revised up to £90bn a year ago, and then revised down to £73bn in the November PBR. If the Tories tied themselves down to a fixed target, they could find the spending and tax implications vary hugely from year to year.

Perhaps this is their reasoning. But if so, maybe George Osborne and his colleagues should say that, rather than simply claiming - in effect - that whatever Labour plans to do on the deficit, they would do more.

Another key point, which the IFS's director, Robert Chote alerted me to, is that, on this interpretation, the Conservatives wouldn't be tough enough for the European commission either.

Brussels always looks at the "treaty deficit" - the deficit as measured under the Maastricht Treaty, which excludes public sector corporations, and is therefore a bit bigger. In the leaked report, the commission says it wants the UK to bring its "treaty deficit" down to 3% of GDP in 2014-15, instead of the 4.6% forecast in the PBR.

Other things equal, that implies an addition 1.6% in fiscal tightening by that year, versus an extra 1.1% by 2015-16 under the Conservatives. If so George Osborne's Treasury might not measure up either.

Now, the Conservatives may say this misreads their position. But to do that, they would presumably need to say what their position is. Until then, we can only conclude, once again, that the difference between the parties is less than they would have us believe - and that's not just on the short-term approach to cutting the deficit, but into the future as well.

Poetic injustice?

Stephanie Flanders | 20:14 UK time, Friday, 12 March 2010

"First you trash our balance sheets, then you have the cheek to complain about them". If Western governments could talk to the international financial markets, this is surely what they would say.

Think about it. First, everyone in the financial system - especially the banks and bond traders - made a lot of money using complex new financial instruments to lay bets backed by mountains of debt. Then the crisis came, and the bets turned bad, threatening to bring the global financial system with it. Governments around the advanced economies had to spend hundreds of billions of dollars propping up banks and standing behind the likes of AIG, and hundreds of billions more dealing with the global recession which the credit crunch had caused.

Now, economists and traders at some of the same financial institutions have the audacity to look shocked (shocked!) at the amount of debt which has gone onto the governments' balance sheets. And we know they will punish them with high interest rates if the politicians don't show how, exactly, they are going to clean up their act. Talk about poetic injustice.

Of course, no self-respecting expert would ever talk about it in such a simplistic way. They know that the institutions and investors that are now raising the alarm about sovereign debt aren't necessarily the same ones that had to be bailed out.

The experts would also probably point out that "Western governments" and "international financial markets" can't talk to each other, because abstract nouns can't talk.

But I'm surprised that non-experts don't draw the link. After all, everyone gets very upset about bankers in bailed-out institutions awarding themselves big bonuses. But the economists and bond vigilantes who complain about the scale of government borrowing could ultimately cost us all a lot more money and pain.

It was "heads I win, tails you lose" for bond markets before and during the crisis (unless, that is, you happened to hold Lehman Brothers bonds). Now the average punter would say the same thing is happening in the market for sovereign debt: or it could, if governments don't impress the markets with their dedication to slash their deficits.

If any institution has come to embody the skewed odds for the big players it is Goldman Sachs. The New York Times has already skewered them by revealing how the investment bank had helped Greece disguise some of its debt. This week the newspaper reported how Goldmans had last summer started recommending credit default swaps to its clients, as a way of shorting sovereign debt. The article continued:

"One report said the price of swaps "may be too cheap as it may underestimate the risks to developed countries who have recently issued large amounts of debt." "Buy C.D.S. of developed sovereigns," the report said. Again, no countries were singled out.
Despite such advice, Goldman promptly went back to work for the Greek government. Since last September, the bank played a role in underwriting more than $33 billion of new bonds for Greece, Spain and Britain, according to data compiled by Dealogic. Those three countries are among the most heavily indebted developed nations, as measured by their debts relative to economic output.
Goldman Sachs, in a statement, said its reports merely outlined a variety of trading strategies. The bank said it saw no conflicts in its various roles."

Here you have one arm of an institution recommending to clients, in effect, that they short debt which another arm has helped to sell.

As it happens I don't think there's anything surprising about this. In many ways, it's what being an investment bank is all about.

Greece didn't need Goldman Sachs - or the financial crisis - to mess up its public finances. It did most of the job itself. But if and when things turn nasty in the bond markets for other governments in Europe and the US, there is clearly going to be more debate about the role of the financial markets in making a bad sovereign debt situation even worse.

There's a foretaster in the recent talk of banning sovereign credit default swaps (CDSs). Governments are going to try to stop "speculators" from benefiting from their fiscal woes, even if there is no proof they directly caused them.

If you think some of this sounds a bit radical - I recommend you read the extraordinary interview with Bill Gross, the co-founder of Pimco, in today's Guardian. The world's most important bond vigilante says "Wall Street has had it too good for decades. It's time for Main Street to go on the ascendancy."

Gross wants governments to raise taxes on bankers, and they should ban sovereign CDSs. He would choose Labour if he could vote in the British general election, and he thinks "favouring employment versus the financial markets is a decent policy."

But if any government does seem to be putting the financial markets second, he's also quite clear that Pimco is going to extract its pint of blood. In his day job he still tells his clients that Britain is a "must avoid" area, and says its gilts are "resting on a bed of nitrogylcerine". Crazy guy. Crazy world.

The activist Mr Brown

Stephanie Flanders | 17:19 UK time, Wednesday, 10 March 2010

When it comes to the government's budget plans, we know that Gordon Brown does not always tell it entirely straight. Remember last summer, when he was still refusing to utter the word "cut"? But listening to him today, you have to say he's consistent.

Gordon BrownIn today's interview with Nick Robinson, the prime minister once again clung to the thought that Labour was continuing the stimulus this year - even as retailers count the cost of the recent rise in VAT, accountants across the country lick their lips at the thought of the tax rises coming in a few weeks' time. He said:

"We have got to decide whether to continue the stimulus until the recovery is fully sustained, or whether we go back to the old days of just letting things take their course."

For an activist like Gordon Brown, to accuse someone of "letting things take their course" is a grave insult indeed. But in these still perilous times, he does think there is something worse than inaction.

"In a situation where growth is uncertain... you cannot afford to withdraw this stimulus and therefore return yourself to a position where you're not able to say you're fighting for growth..."

"Withdraw the stimulus now, withdraw it completely as the Conservatives would do, and then you would find yourself in a position not to be able to secure growth for the future."

It's stirring stuff - as Nick says, all designed to take us back to Gordon Brown's "save the world" moments in the autumn of 2008 and the G20 Summit a year ago.

There's just one problem. In just a few weeks' time, Gordon Brown's government will have withdrawn the stimulus as well. It is withdrawing it "completely". To all intents and purposes, it is an ex-stimulus. It has ceased to be.

This will not be news to readers of Stephanomics. But let me quickly run through the facts.

Since the 2008 Budget, the government has announced several stimulus measures, on both tax and spending, designed to boost the economy. According to the IFS, these changes - the temporary VAT cut, for example - had the effect of raising borrowing by £9bn in fiscal year 2008-9, and £23bn in 2009/10.

You may or may not believe that these steps kept unemployment down, or limited the number the repossessions, or whatever else the government claims to have achieved with them. But they did constitute a bona fide economic stimulus, worth about 1.6% of GDP in 2009.

What is the stimulus in 2010, to "secure growth" in this fragile and uncertain year? The answer is zero. There is none. Almost alone among G20 economies, we have no discretionary stimulus planned for 2010 at all.

You might say the government was "letting things take their course". Certainly, it is letting the other parts of spending take their course - like the higher cost of debt interest, and previously agreed pay rises in the public sector. That is why spending is still going up in 2010/11, and why the deficit may also rise, albeit very slightly.

But, when it comes to direct policy measures, the government is tightening fiscal policy by 1.6% of GDP. That's VAT going back up. That's the new 50p rate of income tax. That's the £1.2bn rise in fuel duty coming in April.

Don't expect the Conservatives to make too much of this. They're got enough trouble on their hands explaining how, exactly, they would tighten further in 2010. But the next time you hear Gordon Brown or the chancellor talking about the folly of withdrawing the stimulus, it could be helpful to bear these figures in mind.

PS. Let me also point out that the "£3bn" that the prime minister claimed would be saved from the public sector pay freeze he re-announced today does not seem to allow for the fact that these workers will paying less income tax as a result. Taking those losses into account, the IFS has previously said the net savings would be more like £2.1bn.

Rebalancing, deferred

Stephanie Flanders | 16:57 UK time, Tuesday, 9 March 2010

Maybe we can't devalue our way out of trouble after all.

That was one of the fears sending the value of the pound down again this morning, when the January trade figures showed a surprise widening in the UK trade deficit from £2.6bn to £3.8bn, the highest since August 2008.

The figures showed that lower exports - not higher imports - were responsible for most of the change. Excluding erratic items like oil, the volume of good exports fell by 6% during the month. Imports, on the same measure, actually fell by 1.2%.

Yes, these are only one month's figures, which may have been distorted by the bad weather. But this is not the first time that the trade figures have disappointed. Whether it's the GDP data or the trade figures, you'd be hard-pressed to find any evidence of export-led growth. Quite the reverse.

According to those recent GDP figures, net trade actually subtracted from growth throughout the second half of 2009. This, despite the fact that the pound has lost about 28% of its value, in trade-weighted terms, since mid-2007.

What's supposed to happen when a country's currency depreciates is that its exports become cheaper, in terms of foreign currency, and imports become more expensive. In other words, its terms of trade deteriorate: you can buy fewer imports for one unit of exports.

Though Harold Wilson famously tried to claim otherwise, that means that "the pound in our pocket" is worth less in the global marketplace than before.

But, other things equal, it should also mean that UK-manufactured goods do better against their competitors - both abroad and in their home market. As a result, we should be buying more UK-made products because they're cheaper. And so should foreigners.

Except, as I've mentioned before, that is not what we've seen. What we've seen is exports and imports falling - along with the wider economy - but exports more than imports. And there has been almost no change in our terms of trade.

In other words, UK manufacturers seem to have taken the opportunity to increase their margins - here and abroad - rather than pick up new sales.

Chart showing the UK terms of trade and the sterling effective exchange rate

Melissa Kidd, at Lombard Street Research has alerted me to a recent article on this subject from the Bank of England. As that note points out, there are lots of reasons why Britain's terms of trade [439KB PDF] might not have responded to the fall in sterling.

Over time, the higher margins could still attract more companies into the export sector and thus encourage more rebalancing of the economy, along with lower export prices.

That is more or less what happened after we left the ERM in 1992. As the same chart shows, the terms of trade didn't fall very much then either, but we did - belatedly - enjoy a brief period of more balanced growth.

There is no doubt that the sharpest fall in the value of sterling since the war happened at a bad time for exporters to make the most of it. As the pound was falling, so were our export markets - right off a cliff.

Under the circumstances, it's perhaps not surprising that our exporters tried to extract every last penny out of the demand that was still there.

By supporting cashflow, this response to the lower pound may even have contributed to the smaller number of insolvencies in this recession, relative to the decline in output.

On this optimistic view, a pick-up in export volumes is only a matter of time. As the world recovers, so will exports. (True, we don't export much to the markets that are actually growing at the moment - like China. But remember this is supposed to be the optimistic view.)

Exporters have been making positive noises in recent company surveys by both the CBI and the PMI. Here, as elsewhere, the hard numbers may be a few steps behind reality.

However, the pessimists would say that, in a global economy, 28% depreciations don't buy as much growth as they used to.

With global supply chains now so much more integrated across borders, even self-described "exporters" will rely a lot on imported components as well as raw commodities.

That means the net benefit from even a significant depreciation is almost certainly lower than it used to be, even if it's unlikely to be zero.

Indeed, it could be that in this globalised world. The big gainers from depreciation are not UK exporters, or workers in UK factories, but UK shareholders in UK-listed companies who operate around the world and can now expect the sterling profitability of those operations to go up.

Supposedly, that kind of optimism about future earnings has helped drive the recent rise in the FTSE. Though today, even that recent rally seems to have petered out.

Oh yes, and there was a disappointing housing-market survey, and some words of warning about the deficit from Fitch, the leading ratings agency. All in all, not a good day for UK plc.

A European Monetary Fallacy?

Stephanie Flanders | 09:46 UK time, Tuesday, 9 March 2010

"Something must be done to deal with the eurozone's sovereign debt problems. This is something. Therefore we should do this."

Philosophers call this the fallacy of composition, and it's behind many a "bold new policy initiative" - in Britain and around the world.

Now the same screwy logic is causing a flurry of bureaucratic activity in Brussels and Berlin regarding the creation of a European Monetary Fund (EMF), which will be discussed later today at the European Commission's weekly meeting in Strasbourg.

The first half of the argument is right. As I've said before, (see The new eurobillions lottery and Thinking the unthinkable) the economic problems afflicting the so-called periphery of the eurozone (Greece, Spain, Portugal and the rest) are worrying in their own right.

Angela MerkelBut what makes them downright scary is the lack of any decent mechanism for dealing with them. An IMF-style source of conditional liquidity to help the likes of Greece might be helpful; that is, assuming one could ever be agreed - a big conditional in itself, as the German chancellor pointed out yesterday.

But that's a short-term solution, at best. There are two larger problems standing behind the liquidity one.

One is the problem of diverging European competitiveness. If they don't want the problem to recur, it is in the interests of the eurozone as a whole that deficit countries like Greece restore their competitiveness; ideally without a decade of grinding deflation and meagre growth.

They aren't going to achieve that without more balanced growth across the zone, and stronger domestic demand in the trade surplus economies: primarily Germany and the Netherlands.

The other problem is solvency. Even if the outsiders restore some of their lost competitiveness - for example, Ireland has been doing, something I'll discuss in a later post - many economists think that the peripheral members of the eurozone are going to come out of this process with unsustainable levels of public debt.

I know I keep banging on about this, but I'm convinced that sooner or later, we're going to have to come up with a mechanism for "safely" restructuring sovereign debt in Europe.

When the bomb squad doesn't think it can safely defuse a bomb, it finds a way to explode it in a contained environment.

Economists of a historical bent who look at the public debt mountain weighing on the global economy are starting to wonder whether we should do the same with suspect sovereign debt. The trick would be to indeed keep it "contained".

Funnily enough, the then deputy managing director of the IMF, Ann Krueger, did propose a new Sovereign Debt Restructuring Mechanism for similar reasons, back in 2002.

It was a fairly modest proposal to begin with - more for developing countries than the likes of Greece. It was then watered down even further, largely by European members of the Fund, and it came to nothing. Now you wonder whether she was onto something.

So much for the history lesson. Would the European Monetary Fund - as discussed by the German finance minister, Wolfgang Schauble, this weekend - solve any of these larger problems? The answer seems likely to be no.

German officials have two reasons for supporting the idea. First, they would like there to be a way to give financial support for future Greeces without involving the IMF, or incurring the wrath of the German constitutional court by seeming to involve German taxpayer funds in a European bail-out.

Second, they would like a tougher mechanism for forcing deficit countries to clean up their act: a Stability and Growth Pact (SGP) with more teeth, perhaps withholding structural cohesion funds for countries that misbehave.

You might wonder why countries would slavishly toe the EMF line, when they were so happy to ignore the demands of the SGP.

You might also wonder whether it was worth creating an entirely new institution, simply to spare the blushes of Europeans who are embarrassed to bring in the IMF.

But these are not the biggest problems with the plan. The biggest problem is that there would be no symmetrical obligations on surplus countries to do their bit for achieving more balanced European growth.

Without that kind of symmetry, any such institution could well exacerbate the economic problem it was intended to fix, by putting an even more impossible burden on the periphery without any correspondent obligations on Germany - either to change policy, or to cough up for Club Med.

That imbalance in Germany's favour is probably the best reason to doubt the EMF will actually happen. There's just too little in it for everyone else.

If it did happen, would the EMF include any mechanism for restructuring sovereign debt? This was a key part of the original proposal floated last month by the European economists Daniel Gros and Thomas Mayer - and a welcome one.

As the US expert on financial crises, Carmen Reinhart, has said, an organization that could oversee orderly sovereign defaults in the eurozone would fill a useful gap in the existing financial architecture". I am told that it is still part of the draft proposal circulating in Strasbourg. But don't hold your breath.

Again, I have serious doubts as to whether an EMF will get off the ground - at least in the next year or so. But if it does, the risk is it will be the wrong kind of EMF, for the wrong sorts of reasons.

To return to where I started, the eurozone needs a crisis response mechanism for dealing with the likes of Greece. It also needs "bold new policy initiatives" to help the eurozone grow together over the next few years rather than deflate apart. It is less clear than it needs a German version of the IMF.

New take on reducing the deficit

Stephanie Flanders | 12:43 UK time, Friday, 5 March 2010

It's not what you do, it's the way that you do it. That is the message of a recent contribution to the debate on how and when to cut UK borrowing - from two city economists.

In essence, they say if you're worried about the economic impact of bringing down the deficit, you need to think hard about the balance between spending cuts and higher taxes.

"Not more guff from competing economists", I hear you cry. You have a point. The recent "war of letters" over the deficit - played out in the pages of the Sunday Times and the FT - didn't exactly enhance the profession's reputation for giving advice.

But there is grandstanding, and there is reasoned argument. This new paper from Ben Broadbent and Kevin Daly, from Goldman Sachs, falls into the second category, even though the Conservatives have inevitably claimed it for their camp.

The two economists have some good news for the government: they don't think the UK public finances are "as cataclysmic as some commentators suggest", they're fairly optimistic about the recovery - and they think growth will go some way to bring down borrowing.

Like me, they think the Treasury may well be overestimating the size of the structural deficit (though, with borrowing this high, nothing can be taken for granted).

Broadbent and Daly are also of the school that thinks a falling exchange rate will help support growth even in the face of tough budget cuts (see Monday's blog post). Even though most in the city seem to think the pound would be stronger, on balance, under the hawkish Conservatives than under Labour.

However, they do think Britain needs to get serious about the deficit - surprise surprise. And, "if past experience is anything to go by the manner in which this is done will have implications for the economy."

Specifically, "There is a significant body of cross-country evidence suggesting that during the transition, the economy fares better in corrections driven by reductions in current spending - better, even, than when no correction is made - than in those driven by cuts in investment or higher taxes."

This is not a new argument. Research by Alberto Alesina, Roberto Perotti and others has tended to show that efforts to cut borrowing which emphasise spending cuts tend to do better than ones centred on tax rises.

But in this paper the Goldman Sachs duo have updated and extended this analysis - using data for 24 OECD economies from 1975 onwards. They draw some striking conclusions.

One is that with large fiscal tightenings, centred around spending cuts, the government debt ratio starts at a higher level but then falls sharply. Whereas large, tax-centred deficit reduction programmes don't seem to cut the debt ratio at all, as their graph below shows.

Expenditure debt graph

Another is that tax-driven adjustments "have proved very damaging for growth" (see the graph below) - or at least, growth relative to other OECD countries. Whereas expenditure-driven budget cuts seem to actually boost relative performance, at least after the first year.

Interestingly, they don't find much difference in the behaviour of the exchange rate, raising a question about as to where the growth actually comes from.

Expenditure graph

At first glance, these results look like the "proof" that the Conservatives have been looking for. No wonder they've been firing off copies of the research to everyone they know.

The results do, at some level, make sense. Remember the sample relates to "large" fiscal adjustments, which only tend to occur when governments have got themselves into trouble. And when governments have got in a mess, the public may be more likely to worry about future fiscal pain, even when the pain has yet to start.

That is why some have said that when borrowing and debt are high, governments need to get tough adjustments over with quickly, so the private sector can stop worrying and start growing again.

Equally, we know - and if we didn't, the Conservatives are happy to remind us - that the financial markets can push up long-term interest rates (bond rates) if they're worried about the level of borrowing, meaning that governments can find they have no alternative but to cut borrowing, because the risk premium on borrowing would otherwise make it impossible to grow.

Arguably, that was Ireland's position last year. It is clearly Greece's situation now.

There are also possible explanations why it might be less costly for growth cut spending rather than raise taxes. For example, consumers might find it easier to "fill the gap" left by lower government borrowing, if they're not having to pay higher taxes at the same time.

In normal times, this would not be considered especially controversial among economists. Whether anyone else would sign up to them is another matter. Preferring spending cuts to tax rises is practically a mandatory condition for joining the economist club.

The key question is: what bearing does this have on the current debate in the UK? There, I'm afraid, there's still room for plenty of debate.

First, the government's own fiscal plans, over time, rely more on spending cuts than on tax rises to bring down borrowing. Though, perhaps worryingly, there seems to be more emphasis on tax rises in the first few years, and cuts in investment do play a significant role.

Second, looking at the experience of other countries, it's actually hard to distinguish discretionary spending cuts (ie "tough government action") from declines in spending that occurred due to economic growth ("safeguarding the recovery".). Some of the supposedly 'expenditure-driven' adjustments in this research may have simply been due to the fact that the economy grew faster than spending, not any great spending control.

This, of course, is at the crux of the Labour argument about the next year or two - and it is why they keep banging on about the billions in savings they have reaped from unemployment being lower than predicted.

Finally, and most importantly, we have not been here before. Since 1975 the advanced economies have not been in a situation remotely like this.

In the wake of a global financial crisis, the usual economic relationships may not apply. Monetary policy is less powerful than it was. Deficits are high nearly everywhere. And growth is expected to be sub-par across North America and Europe.

That makes the usual exit strategies seem more questionable. We can't all export our way out of growth. And we can't be sure that private sector demand will recover when consumers and the financial sector are each facing years of reducing their overhang of debt.

In other words, what happened when governments cut deficits before may not be an accurate guide to what will happen now.

So yes, this research has some very interesting lessons for the fiscal debates to come. But it won't resolve them.

Advantage Greece

Stephanie Flanders | 12:25 UK time, Wednesday, 3 March 2010

Greece looks to all the world like a country with its back against the wall, forced by the markets and the European Commission to spit out new austerity measures this morning, in advance of the Greek prime minister's crucial meeting with the German chancellor on Friday.

But don't count them out yet. The Greeks have three cards up their sleeve. And make no mistake: behind the scenes they are playing them for all they are worth.

The first is that if there's one thing the European Central Bank hates more than profligate governments, it's the overpowerful - and oh-so-American - ratings agencies. And right now, as Greek officials keep reminding their eurozone colleagues, one single ratings agency has the capacity to send the Greek financial system over the edge.

I'm exaggerating. But trust me, so are the Greeks.

As I've discussed before, the ECB has been giving back-door help to the likes of Greece since the start of the financial crisis, by letting eurozone banks post lower-rated sovereign debt as collateral for oodles of cheap liquidity.

Those rules were supposed to go back to normal at the end of the year. As of today, Greek debt would still qualify. But if Moody's follows the other leading ratings agencies and further downgrades Greece, Greek debt would be beyond the pale.

That could have a massive effect on the price of Greek debt: arguably, the single most important factor propping it up in the past year has been that it can be swapped for free money at the ECB.

And if Greek debt tumbles in value, that, in turn, could cause big problems for not just Greek banks but all the many other banks across the Eurozone who are holding Greek sovereign debt.

Yesterday, Ewald Nowotny, a member of the ECB Governing Council, said it was "an unacceptable situation" that "the fate of Greece, and if you are going to be more dramatic, the fate of Europe depends on the judgement of one ratings agency."

The ECB President Jean-Claude Trichet has always said the Bank would not change the rules for just one country. But it can and will change the rules for the sake of the eurozone banking system. Especially if can take the US ratings agencies down a few pegs at the same time.

When the terms of the European support package for Greece are revealed, expect the ECB and its collateral rules to be in the mix.

The Greeks' second secret weapon is that there is, in fact, nothing to stop them going to the IMF - with of without the EU's blessing. If their European partners push them too hard, that is almost certainly what they will do.

Threatening to go to the IMF is a last resort (it could also backfire - because it's not clear that the IMF, on the basis of Greece's, "quota share" at the Fund, would be in a position to give it a big enough loan.) But given French and German hostility to the idea of an IMF deal, it's a useful card for the Greeks to have.

Finally - there's that secret weapon which is not a secret at all. Greece is in the eurozone. And there is zero confidence that a Greek meltdown could be contained within Greek national borders. If Greece goes down, most in the European Commission now think Portugal and maybe Spain will follow.

As I've said before, there ought to be a way for Greece to restructure its debt, without the sky falling in on everyone's heads.

When Argentina defaulted on its sovereign debt at the end of 2001 the short-term results were extremely ugly. But the economy grew by more than 8% a year from 2003 to 2007.

For all that, when you talk to officials in Brussels or Frankfurt, they cite Argentina as the example to be avoided at all costs.

For the powers that be in the eurozone, it is simply inconceivable that Greece should be allowed to renege on its debts. As long as that remains true, Greece is a lot stronger than it looks.

One-way bet?

Post categories:

Stephanie Flanders | 14:20 UK time, Monday, 1 March 2010

As the Conservative lead tumbles, so falls the pound, and the price of UK government debt. Apparently, traders are worried that the election will come and go, and we won't know who's in charge of No 10.

The door of 10 Downing StBut, when you think about it, the markets might have good reasons to sell the pound, even if Labour or the Conservatives win a clear victory.

How so? Well, consider, first, the other reasons why the markets might be down on the pound. (Yes, I do know that explaining daily exchange rate movements is a fruitless exercise, but I've started now so I guess I have to finish.)

There were some pretty dovish remarks last week from the governor of the Bank of England and some of his colleagues on the Monetary Policy Committee - that could lead traders to think interest rates will stay low for even longer than previously thought.

Other things equal, if rates are expected to be lower than before, then that will push down the pound.

Thursday's dire investment figures for the final three months of 2009, and the news on Friday that investment and exports had played no part in the recovery so far, could also leave investors worried about the health of the economy from now on. That's why sterling did badly at the end of last week.

But it does seem that politics and the deficit are at the centre of today's moves. After all, some of the latest economic news - like this morning's manufacturing purchasing managers' index - was quite good.

The line is that markets fear uncertainty. And a hung parliament, in a country that is not accustomed to them, sounds like a very uncertain prospect indeed.

As a factual matter, you could say this fear is ungrounded. It turns out that seven of the 10 most ambitious programmes of budget cuts in the Organisation for Economic Co-operation and Development in the last 40 years have been achieved by coalition governments.

There is also the fact that Britain's third largest party - which could be the kingmaker in a hung Parliament - has a respected economics spokesman, Vince Cable, who is somewhat more hawkish on the deficit than the chancellor.

However, if you are a sterling trader, none of that really matters.

Even if a minority Conservative government, or a coalition, could probably pass a tough emergency budget, the important point is that you can't count on it. The shadow of uncertainty could hang over the UK for weeks.

But here's the funny thing. Imagine this weekend had brought news of a massive widening of the gap between the Conservatives and everyone else - to the point where a Tory election victory looked all but in the bag.

What would that same trader have done then? It's quite possible he would have sold the pound as well.

Why? Because if he knows anything about George Osborne it is that he would run a tighter fiscal policy than Labour, and he would start that tightening right away. Other things equal, that should push down the pound.

As the shadow chancellor explained very clearly in his Mais Lecture last week, more rapid budget cuts need not endanger the UK's recovery. And the main reason he doesn't think so is that it would, other things equal, mean lower short and long-term interest rates, and a lower - sorry, more competitive - pound.

Mr Osborne didn't exactly say: "vote for us, vote for a lower pound". But last year his staff were keen to point journalists in the direction of an article by a Goldman Sachs economist, Ben Broadbent (see my post from 14 September), making the argument that tighter fiscal policy need not hurt UK growth.

The central part of that analysis was that exports would take the place of the lost government spending, because budget cuts and relatively looser monetary policy would lower the value of the pound.

This argument may or may not be right. But, as I say, the Conservatives were quite happy to cite it in support of their policies.

We have to assume they would not be unhappy with a lower pound. Indeed, if the pound fell on the back of an Osborne emergency budget, you have to imagine they would welcome it.

And what about Labour? What if traders had woken up this morning and found Gordon Brown 10 points ahead?

Well, on the basis of the previous argument, you might expect me to say the pound to go up. After all - wouldn't a "loose" Labour government drive up long-term bond yields (ie long-term interest rates) - and encourage the Bank of England to tighten sooner as well? And wouldn't these higher interest rates spell a higher pound?

Well, maybe. If you're an academic economist. But it might not be the first instinct of many investors in the markets, many of whom have gone back to associating Labour with economic instability and possibly higher inflation as well.

In fact, you might expect them to sell on a big Labour lead as well. After all, Labour needs a recovery built on exports as well. And even with the dramatic depreciation we've already had, there's not much sign of those exports coming through.

Chart showing sterling exchange rates

So, there might have been political and economic reasons to sell the pound - whatever today's polls had said. For today at least, that is what is known in the trade as a one-way bet.

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