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Archives for September 2010

The 32% of GDP question

Stephanie Flanders | 17:39 UK time, Thursday, 30 September 2010

You might expect the international markets to be a bit concerned to hear that Ireland's budget deficit this year will be a record 32% of GDP. But you'd be wrong. Today the interest rate - yield - on Irish government debt went down, and the difference between Ireland's borrowing rate and Germany's also went down, by nearly a quarter of a percentage point.

The implication is that investors are now (slightly) more relaxed about Ireland's fiscal situation than they were yesterday, when its budget deficit for 2010 was 'only' around 11% of GDP. What gives?

One answer is that the news was already "priced in": Irish bond yields have been rising for months on the back of fears about the scale of the banking system's bad debts (see chart 2 below). Another, mentioned earlier, is that the government actually won't need to borrow money from the markets until next year.

10-Year Government Bond Yields

But it's also because that 32% of GDP deficit is, genuinely a one-off. If there were actually a 32% of GDP gap between what the Irish government takes in tax revenues and what it spends on public goods and services, trust me, Irish yields would be a lot higher than 6.75%. But it isn't. That gap is still roughly 12% of GDP (see chart 1 below). That's because the annual cost of running Ireland's government has not changed at all.

Government Budget Balance and Debt

As I have written in the past, Ireland has made enormous efforts to cut borrowing, with swingeing tax rises and spending cuts worth 5% of GDP in 2009 alone. Alas, with GDP still flat or falling, the deficit has remained high. As a result, the finance minister, Brian Lenihan, already knew he would have more bad news for Irish taxpayers in early November, when he announced his new four-year budget plan.

The news will be worse as a result of today's move. But, to be clear, he doesn't have to find tax rises or spending cuts worth an extra 20% of GDP. Assuming there is no equivalent bailout next year, the deficit in 2011 will come in close to the previous target of 10% of GDP.

In fact, Mr Lenihan insists that Ireland will still keep its promise to get borrowing down to 3% of GDP by 2014. Supposedly, it will also stabilise the stock of national debt, as a share of GDP, over the same period, albeit at a rather higher level than previously thought.

This is not going to be easy - or cheap. Ireland's citizens will ultimately pay for the bailout, as they pay the interest on a much higher stock of government debt. If there are more bank bailouts to come and the economy continues to disappoint, investors may yet conclude that the numbers, for Ireland, simply do not add up. But right now, they rather like the fact that Ireland is taking the bank losses on the chin.

The government is not assuming, as the UK and others have, that money injected into troubled banks will eventually be repaid. In Ireland's case, this is probably a realistic assumption. But realism always wins points with international investors - even if the reality in question involves a budget deficit of 32% of GDP.

Ireland: A problem soon to be shared

Stephanie Flanders | 13:59 UK time, Thursday, 30 September 2010

Small countries shouldn't make gigantic bets. That's the lesson that Iceland learned early. When the crisis hit, the country's three largest banks had foreign debts worth more than six times the country's GDP. There was never any prospect of Iceland's taxpayers covering that lot - and they didn't.

Irish euro


In Ireland, the decision was less clear-cut. There was always the possibility - however slim - that the Irish economy would be able to come through the crisis without stiffing the foreign creditors that lent the country the equivalent of five times its annual GDP.

So, Dublin has had a slow-motion crisis rather than an Icelandic bonfire of the creditors - and Ireland's roughly 2 million taxpayers are picking up the tab for tens of billions of misplaced private bets.

If the end result is similar, Ireland's citizens may well wonder whether the battle to preserve Ireland's good name in international markets was really worth all this pain.

But, as the finance minister Brian Lenihan knows well, Ireland has one crucial advantage which Iceland lacked. It is a member of the euro. That means its problems are also the eurozone's. It also means that the European Central Bank (ECB) - and other eurozone governments - will have a big say in where Ireland goes from here.

It's possible that Ireland wouldn't have got into quite such a mess outside the euro. It would have been able to take some air out of the boom - maybe - by raising domestic interest rates. And its banks and businesses would not have been able to borrow quite so cheaply from abroad. But all that is in the past. Since the crisis hit, being in the single currency has been an important crutch.

Anglo Irish has been deemed too big to fail

Anglo Irish has been deemed too big to fail

Ireland would almost certainly have gone the way of Iceland by now, had the markets not assumed that its fellow eurozone governments would ultimately bail it out, and - crucially - Ireland's banks had not been able to borrow unlimited amounts from the ECB. A year ago, Irish banks had borrowed an amount equivalent to 10% of their total assets from the ECB. The share has fallen a little since then (for reference, borrowing by Greek banks is running at about 20% of their total assets), but that more-or-less free liquidity from the central bank has been a crucial safety valve.

Robert Peston has described Ireland's situation in great detail in recent posts. As we have both pointed out, Mr Lenihan has protected himself from any immediate embarrassment in the markets, by pre-funding the deficit until well into 2011. The government is sitting on substantial cash reserves, and today's 6.4bn-euro injection into Anglo-Irish has also been designed in a way to avoid actually putting any cash in right now.

So, once again, this is a slow-motion crisis. But even though the government has done everything to avoid it, Ireland may still be forced to follow in the footsteps in Greece, and head to the eurozone and International Monetary Fund (IMF) for support.

In the case of Greece, European governments would not face up to the problem until it had got significantly worse. Now there is a formal support mechanism in place - the European Financial Stability Facility (EFSF) - you might think the process would be less fraught. But I wouldn't bet on it.

Unlike Greece - which wanted to go to the IMF from the start of 2010 - Ireland still thinks there a chance to avoid it.

Other eurozone governments won't want to seem to be pushing them in that direction. As we know, they were rather hoping that the sheer existence of the EFSF would be enough reassurance to the markets, and it would never actually have to be used.

But that leaves Ireland - and other countries on the eurozone periphery - in a difficult limbo. Ask anyone in the financial markets, and anyone in Brussels - they all expect the crisis in the eurozone to have plenty more rounds.

It also leaves the ECB sitting on a mountain of IOUs from Greek, Portugese and Irish banks, backed by collateral which is probably not very good. (Why give the ECB your best collateral, when it will take pretty much anything you've got?)

The ECB's head, Jean-Claude Trichet, would very much like to get out of the business of providing all of this "unconventional" support. But of course, the member governments would like to put off that day as long as possible. Why? Because once that below-the-radar safety net goes away, the eurozone might have to decide how far they are really willing to go, to ensure that every last penny of every bad bet on a eurozone country gets repaid.

Rocking the boat on the MPC

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Stephanie Flanders | 16:56 UK time, Tuesday, 28 September 2010

Someone gave a deeply subversive speech in the north of England today and it wasn't Ed Miliband. The MPC member, Adam Posen, has raised eyebrows at the Bank with some of his past speeches. But speaking to business people in Hull this afternoon, he lobbed several hand grenades into the debate over UK monetary policy, some of which may take a while to explode.

Bank of England


The first  is the assertion that "we should do more quantitative easing now in the UK," or else risk a Japan-style period of slow growth and high unemployment.

Policymakers, he warned, must not "settle for weak growth out of misplaced fear of inflation".

True, inflation in the UK has been higher than expected, for longer than expected. As he himself has pointed out, not all of this overshoot can be explained. But looking two to three years ahead, he thinks that inflation is more likely to undershoot the Bank's target in a few years' time than again come in too high.

No, he thinks the risks are all on the other side.

"There are, however, very serious risks if we make policy errors by tightening prematurely, or even if we loosen insufficiently. Those risks are not primarily the potential for a double-dip recession or even of temporary measured deflation...The risks that I believe we face now are the far more serious ones of sustained low growth turning into a self-fulfilling prophecy, and/or inducing a political reaction that could undermine our long-run stability and prosperity. Inaction by central banks could ratify decisions both by businesses to lastingly shrink the economy's productive capacity, and by investors to avoid risk and prefer cash. Those tendencies are already present, and insufficient monetary response is likely to worsen them."

Or, as he puts it: "we are a long way from home, and a long, long, way from overheating."

Dr Posen has spent a lot of time in Japan. He's an acknowledged expert on what happened there, and he sees too many parallels between their experience - and the US experience in the 1930s - and our own. He also thinks we're in danger of making their crucial mistake, which was to underestimate, in the wake of a major financial crisis, the economy's potential growth.

Japanese policymakers thought that the crisis had drastically reduced the country's potential output, so they were wary of taking extreme measures to stimulate the economy, out of fear of overheating. As it turned out, the crisis did do permanent damage. But Posen believes the sheer scale of the downturn meant there was a lot more spare capacity - and more room to grow - than the policymakers allowed. The result was a long period of unnecessarily high unemployment and slow growth.

Looking at the UK, he believes that similar risks apply: policymakers will look at the growth we've achieved since the end of the recession and conclude that the economy is not able to grow as fast as we did before, and the Bank will shortly have to think about putting on the brakes.

You might say this was overdoing it. There is one member of the MPC - Andrew Sentance - who supports higher rates now. The OECD has also suggested that the bank should tighten sooner rather than later. But they are the exception. Most think there is still a lot of spare capacity in the UK, and the Bank should keep policy loose for some time to start using it up.

However, that brings me to the second, more subversive, piece of Posen's message: in his view, the Bank can't afford to just hang around waiting for this potential to be used up, because time is money. Or rather, time is lost output and lost jobs.

Why? Because if you're a firm that's trying to hang on to their under-employed workers - and still oiling that unused production line - growth next year is simply not the same thing as growth today. By next year you might have had to lay those people off, or shut down that production line for good. The extra capacity will be gone.

This might seem like common sense. But if you're a central banker, it is dangerous talk. It suggests that monetary policy can have a lasting impact - not just on inflation, but on the real level of output as well. Efforts to raise output above the sustainable level caused a lot of inflationary grief in the 1970s - central bankers have been understandably nervous about it ever since, insisting that they could only affect inflation, not long-term growth.

But, says Posen, these fears "can be taken to unjustified extremes, and there is a risk of our doing so now when the damage could be great by so doing. When the overwhelming bulk of pressures in the economy are disinflationary, and when the level of output and employment are clearly likely to be below potential for an extended period."

In those circumstances - in these circumstances - he thinks it makes sense for central bankers to go the extra mile to get that unused capacity on stream before it disappears forever and our long-term growth fulfils our gloomiest expectations. (It's worth noting that Charlie Bean, the deputy governor, has also expressed sympathy with this idea.)

I have spent a long time outlining Posen's argument, not just because he is an interesting and influential member of the MPC, but because this speech is perhaps the most detailed statement of the case for "QE2" that anyone has provided - on either side of the Atlantic - since the debate was re-opened over the summer.

That discussion has got "legs" in the US from the Federal Reserve's recent statement suggesting they would move in that direction. Indeed, some might say Dr Posen - a US academic previously based in Washington - is raising the debate in the MPC that he would be like to be having inside the Fed. In many ways his argument looks stronger when applied to the US.

Whether or not you agree with him, this is the case for further - substantial - quantitative easing which less dove-ish MPC colleagues will have to answer at next month's meeting.

It is far from clear he will get his way. Bizarrely, in the speech he says that we cannot even assume - on the basis of this speech - that he will be voting for extra QE next month.

The minutes of the September meeting suggested that a majority of members thought the downside risks to growth over the next few years had gone up, while the inflation risks were about the same. It's not an impossible leap from there to further QE, but it is a leap.

Even if he does prevail - you might ask, how do we know it would even work? Posen has two answers to this.

The first is that "fear of being ineffective should not be a deterrent to doing the right thing. When facing a worsening situation, you work with the tools you have."

The second answer is that you try a lot more QE, but if it looks like even that's not going to be enough, you bring on the big guns: fiscal stimulus, directly financed by the central bank. That is the most subversive suggestion of all, and worthy of a post in its own right.

Thumbs up from the IMF

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Stephanie Flanders | 15:16 UK time, Monday, 27 September 2010

It couldn't be better timing for George Osborne. On the day that Labour's old and new guard debate just how outraged to be about the government's deficit plans, the IMF has given them a resounding thumbs up.

IMF staff come over to London every year to give the country an economic health check. Here are the sentences from the concluding report that we can expect Mr Osborne to be returning to in the coming weeks:

"The government's strong and credible multi-year fiscal deficit reduction plan is essential to ensure debt sustainability. The plan greatly reduces the risk of a costly loss of confidence in public finances and supports a balanced recovery. Fiscal tightening will dampen short-term growth but not stop it as other sectors of the economy emerge as drivers of recovery, supported by continued monetary stimulus."

In the body of the report, the staff warm to their theme, and make clear that they consider Mr Osborne's plans an improvement on Alistair Darling's. Specifically, they say, with surprisingly few caveats, that the benefits of the tougher deficit plan:

"outweigh the expected costs in terms of adverse effects on near-term growth. Indeed, market reaction to the adjustment plan has been positive."

In other words, the coalition have taken an economic risk with their approach, but the IMF thinks it's a risk worth taking. Like Mr Osborne, they also believe that the "automatic stabilisers" - the automatic increase in spending, and fall in tax revenues, that occurs with a slowdown in the economy - are an adequate Plan B, assuming that the Bank of England is able to keep rates low. According to the report:

"this provides an important safeguard even as structural consolidation continues."

It is safe to say that Ed Balls will not change his mind on the basis of reading this report. Neither - I suspect - will anyone else appearing on the stage in Manchester this week. But in the public relations battle over the deficit, Mr Osborne's team has won an important, and surprisingly unqualified, endorsement.

Update 1705: You might deduce from the chancellor's response to this report that the UK was previously on the IMF equivalent to the naughty step. That is not quite right. The last time that the staff carried out a similar exercise, in May 2009, their report was quite low-key in its criticism of the government, which was mixed with a fair amount of praise.

It was highly positive about the government's response to the crisis, and accepted that the rise in borrowing had been a more or less inevitable consequence of the crisis.

However, the staff emphasised that confidence in the sustainability of the public finances would be crucial to the government's plans - and that this "would be strengthened" by "targeting a more ambitious medium-term fiscal adjustment path for implementation once the economic recovery is established. The focus of this adjustment profile should be to put public debt on a firmly downward path faster than envisaged in the 2009 Budget."

The report also said that the government should be clearer about what it was going to cut - advice it explicitly chose not to follow when it decided to postpone the comprehensive spending review. The Fund's criticism was repeated in later reports about the global economy.

So yes, the IMF is giving Mr Osborne higher marks than Mr Darling. But it had never suggested that he was sending the UK over a cliff.

A new 'virility pact' for the eurozone?

Stephanie Flanders | 13:22 UK time, Friday, 24 September 2010

Credit where it's due. The European Commission is usually considered a lumbering bureaucratic animal, but in devising a system for preventing future fiscal crises in the Eurozone, it's moving pretty fast. There are only two problems: European governments are unlikely to sign up to the proposals, and the current fiscal crisis still has a long way to run.

You'll remember the dramatic events of early May? (That's the events in the eurozone I'm talking about, not the small matter of a new coalition government in the UK.) Rather late in the day, eurozone governments recognised the need for a massive show of financial force to persuade the doubters that the euro wasn't going to disintegrate and countries weren't going to be allowed to go bust, even though the rules had always said they could.

Olli Rehn, Brussels, 13 September 2010

Olli Rehn, Brussels, 13 September 2010

In the wake of the Greek crisis, the Economic Affairs Commissioner Olli Rehn promised to beef up the old Growth and Stability Pact - dubbed the "virility pact" by Willem Buiter when it first came in - to make sure countries never got into such a mess again. Next Wednesday, we will hear his initial proposals, which sound suitably Germanic. There would be fines in the region of 0.2% of GDP for countries who borrow too much, and also smaller financial penalties for countries that don't try hard enough to improve their competitiveness.

I'm told that competitiveness would be measured by a "persistent current account imbalance". But as this blog has pointed out many times, it takes two to create a current account gap: if one country has a deficit, someone else must have a surplus.

In fact, all the signs are that the new system will have the same asymmetry that we see in the global economy more generally. Countries with deficits are pressured to reform, but the countries with surpluses are under no pressure to change their policies at all.

That is almost certainly the only system that Germany would accept. Because they just don't see anything wrong in having a surplus. In their mind, it's something for other countries to aspire to - not something to be demonised. But it's not a recipe for a stable eurozone economy. Sooner or later, all the old imbalances will appear again.

Happily, the European governments are a long way from agreeing on any new plan, whether Mr Rehn's or anyone else's. This has been evident in the negotiations over the task force on European economic governance being led by the council president, Herman Van Rompuy. (The rule in Brussels is: why have one task force when you can have two?)

The Financial Times outlines today some of the key differences between governments [subscription required]. Suffice to say there is more than enough for governments to battle over in the coming months and years, and more than enough scope - in the debate about whether and how to change the Lisbon Treaty - for headlines here about Britain's sovereignty being under threat.

But strip away the legal niceties - which are anything but nice - and these are the central issues which will determine whether this new system actually works:

First, is it all about sticks and financial punishment - or are there some carrots involved as well, to give countries a stronger incentive to play by the rules? If not, the risk is that the new rules will be no more credible than the old ones, because whenever Europe actually imposed a fine on a country with budget problems, it would always be making a bad situation even worse.

Some have suggested allowing "well-behaved" countries to borrow at cheap rates under the auspices of the new European Financial Stability Fund. There are some problems with this - not least the fact that the fund as currently designed is only supposed to be for emergencies, and it's supposed to disappear in three years. But it's worth debating.

Second, does the system consider only fiscal imbalances, or macroeconomic imbalances more generally? There is some agreement now that questions of competitiveness have to come into the mix, but very little consensus on how on Earth to do it.

For example, It's all very well saying that governments with large current-account deficits need to reduce them, but in market economies with free capital markets and no exchange controls this is easier said than done. It seems a bit harsh to fine governments for a balance of payments position they cannot control.

I'm told that Europe-level surveillance would consider whether governments had made "good faith" efforts to tackle the root cause of such imbalances. But as Thailand - or Spain - will tell you, this isn't a matter of turning a few switches. In both cases, a domestic credit bubble was a large part of the explanation. So, would the new scheme monitor domestic financial regulation and supervision as well - and if so, how? (Yes, this imbalances business is a lot more complicated than it looks.)

Finally, and related to my earlier comments, are the new rules symmetric, or do they only apply to those with current account deficits?

Put it another way: is the end goal of the reform effort a more balanced eurozone economy, or merely one in which every government is instructed to be more like Germany? This will be the question at the heart of these negotiations. It will also be the hardest to resolve.

No more Summers for Obama

Stephanie Flanders | 15:03 UK time, Wednesday, 22 September 2010

It's a good time for Larry Summers to get out of Washington - and a bad time to be driving US economic policy from the White House.

Larry Summers


President Obama's chief economic advisor didn't plan to stay in the job for as long as he has. In effect, the plan was "up or out" - either he would move up, to follow Ben Bernanke as head of the Federal Reserve, or he would get out after a year or so, and go back to Harvard.

The betting has been on the Harvard option ever since the president nominated Mr Bernanke for a second term, a year ago. If Mr Summers had not gone now, he would have lost his tenured position, something even economic superstars like Summers do not take lightly. (Though I suspect he would have found a job.)

So, it's no surprise that he's going after the November mid-term elections. Looking at what may be coming down the track for the administration's economic team, it may also be a relief, because economic policy in Washington is about to get even more ugly.

This isn't the place for a detailed analysis of America's economic position. But here's what anyone with a stake in America's economic future should worry about (in case you're wondering, that means you).

The two big challenges that the US faces are securing the recovery, and tackling the deficit. The debates revolve around how, and whether, policy-makers can balance the two.

Thanks to a Democrat Congress, President Obama was able to pass a massive stimulus programme at the height of the crisis. With a weak recovery, many economists would like to see a bit more spending in the short-term, but also a credible long-term strategy to reassure the markets that US borrowing is under control.

This was a tall order, even with the Democrats formally in control. Now the other side are poised to win control of the House of Representatives - and maybe even the Senate - the tussle is about to get a lot worse.

To be clear - this would not just be bad news for supporters of the president. It could produce some worrying times for the international markets as well. Why? Because they could end up with the worst of all worlds - less support for the economy short term, but little long-term effort on the deficit either. And a lot of uncertainty into the bargain.

For example, one of the top Republican priorities now is to freeze federal discretionary spending at 2008 levels, which would save around $340bn a year. President Obama will fight that, but the new Congress will be more conservative than the current one, and the lack of a budget for this coming fiscal year means he will probably have to do a deal with legislators early in 2011, when the new members take up their seats, to keep the government going.

At the same time, there's a big - and distracting - debate between the White House and Congress about whether to continue the Bush tax cuts for everyone after they run out at the end of this year, or 'only' the top 98%.

Presumably, they will find a way to resolve their short-term differences (though I wouldn't rule out another game of "who can shut down the government" like the one that Newt Gingrich and Bill Clinton had after Gingrich took control of Congress in 1994). But the outcome will almost certainly involve less spending than Mr Obama would like short term, and limited recognition - by either side - that there's a fundamental disconnect between the services US citizens want and the taxes they are willing to pay.

Of course, every country faces this problem - that's why there are a lot more budget deficits than surpluses in the world. But, as the OECD underlined in its latest survey of the US economy this week [9.52MB PDF], America's tax mismatch seems particularly acute (see chart below) - especially when one considers the long-term costs of ageing, as the report does.

Chart showing that the US tax-GDP ratio is low by OECD standards


The OECD joined the long line of economists who say that the US cannot rely on spending cuts alone to stabilise borrowing at a reasonable level - taxes can and should rise. And they see some clear places to start, which could also make the tax system more efficient.

For example, for every $1 that the federal government collects in personal taxes, it gives away 29 cents in tax breaks and deductions - far more than most other advanced economies. (In the UK, it's about 15p for every £1 collected.) Also, consumption taxes in the US amount to only around 4% of GDP. The OECD average is more than 11% of GDP.

To be fair, the Obama administration didn't show much sign of grappling with these issues under a Democratic Congress. There is always the possibility that a Republican victory next month will spur an astonishing outbreak of bipartisan statesmanship in the name of America's long-term fiscal health. But no-one who has been in Washington over the past year or two would consider it very likely.

Where the economic recovery is concerned, there is at least another hand on the tiller - Ben Bernanke's. The Federal Reserve signalled more strongly this week that it would step in if the recovery faltered.

But when it comes to the budget - and, ultimately, the solvency of the world's most important government - Congress and the White House have to agree. Larry Summers probably feels that he and his colleagues spent the last two years under siege. If the mid-terms are as bad for their party as everyone expects, they ain't seen nothing yet.

A Tale of Two Borrowers

Stephanie Flanders | 14:33 UK time, Tuesday, 21 September 2010

Treasury officials are saying that a record UK deficit for August is further evidence that the coalition is right to press ahead with cuts. But they might be on stronger ground pointing to this morning's sovereign debt auction in Ireland.

Whitehall plaque


Today's figures show that the government borrowed £15.9bn last month - the highest August deficit on record. Net debt, relative to GDP, rose to 56.3%. That borrowing figure was about £3bn more than City economists expected, and had some worrying that the Treasury would miss its borrowing targets for this year.

Of course, it is far too early in the fiscal year to draw that kind of conclusion. In fact, before this month, the borrowing figures had come in below expectations in nine of the previous 12 months, with revenues coming in surprisingly strong. These numbers don't change that basic picture - revenues always tend to be weak in August, and so far they are still 9% up on last year, compared to a Treasury forecast of 6.6% growth in 2010-11. If nothing changes, total borrowing this year would still come in several billion below forecast.

The disappointment in August was on the spending side - and entirely accounted for by the fact that a year ago the retail price index (RPI) was negative, and interest spending was freakishly low. (To see how freakish: the Treasury paid out just £1.3bn in debt interest last August, in a year in which the total cost of servicing our debt rose to £32.3bn).

Nick Clegg made much of the rising cost of debt interest in his speech yesterday: "Already we are spending £44bn a year on interest alone. Under Labour's plans, that would have risen to nearly £70bn. A criminal waste of money that shouldn't be lining the pockets of bond traders. It should be paying for police, care workers, hospitals and schools."

It's a strong line of rhetoric - which Labour politicians like Ed Balls will recognise from their time in opposition in the 1990s. He used to say the same thing about Conservative borrowing.

It's worth pointing out that debt interest costs will not be far off £70bn under the coalition's plans either, increasing to £66.5bn in 2015-16. Under Labour's plans, the Office for Budget Responsibility (OBR) reckons it would have reached this level just one year earlier, in 2014-15. That is a lot of money: for reference, total public-sector net investment this year will be just £39bn.

Nick Clegg


But Mr Clegg said that the last government's borrowing had taken the country "to the brink of bankruptcy". That is similar to rhetoric that Chancellor Osborne has used - but it is simply not true.

As it happens, governments can't go bankrupt - they can only default on their debt. But I'm not just being pedantic. The facts are that on the eve of the election, the UK still had an uncontested triple-AAA credit rating, and the market was demanding an interest rate of just 3.9% to lend the government money, compared to 3.7% for US bonds and 3.1% for Germany. (That UK rate might have been higher had investors not been expecting a Tory victory, but the average yield for the previous 12 months was about the same.) Whatever you think about the fiscal mess that the coalition inherited, these are not the characteristics of a country on the "brink" of bankruptcy or default.

No, if you want to get a sense of what that feels like, you have to go to Athens. Or, perhaps, to Dublin, where the government was relieved to raise 1.5bn euros in the sovereign debt markets this morning, but had to pay an implied interest rate on the longer-term debt of just over 6%. In June the yield on a similar bond was 5%.

The growing suspicion in the markets is that sooner or later, Ireland will become the second country to borrow from the new European Financial Stability Facility. That's not the same as admitting bankruptcy. But in today's eurozone, it's the closest that governments will get to admitting they can't cover their debts.

Patrick Honohan


Ministers in Dublin swear this will not happen, and they do have some protection against market storms in the next few months: they have pretty much issued all the new debt the government needs for this year, and they have relatively little existing debt coming up for maturity. In addition, Credit Suisse reckons the government has about 20bn euros in cash reserves squirrelled away which could well come in handy.

But the risk of a full-blown loss of confidence is clearly there, in a country where nominal gross domestic product (GDP) has fallen about 20% since the crisis began and government debt has risen by 60% of GDP.

What's fascinating about the Irish situation is that it has rather little to do with the size of the deficit - or a government failure to take tough action. In fact, as I have written in the past, Ireland was the first country in Europe to announce massive spending cuts and tax rises.

What's worrying investors now isn't the deficit in itself but the huge debts sitting in the financial sector - and how many of them the government will ultimately be forced to honour. At the last count, the government's "contingent liability" in the banking system - the stock of debts that it has guaranteed stood at 153bn euros - nearly 95% of Irish GDP.

So if you're a Liberal Democrat activist who wonders whether Britain really needs to get a handle on its debt - Ireland is indeed a great cautionary tale. The government has lost control of its balance sheet, and in the process lost a great deal of its national autonomy. That might have happened to the UK if we had continued to borrow more than 10% of GDP a year. But Ireland is also a reminder that bringing down public borrowing is only part of the problem - government has to worry about what's going on the private sector as well.

Hedging bets on a eurozone debt crisis

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Stephanie Flanders | 12:52 UK time, Friday, 17 September 2010

Does Europe need more hedge funds? That was one of the more intriguing questions to come out of a one-day seminar on Europe's sovereign debt crisis I attended this week in Brussels.

The event was co-sponsored by the IMF and Bruegel, the respected European think tank, and it was held under the Chatham House Rule, which means I can't tell you who said what. But I can give you a few headlines.

The first is that George Osborne would have loved it. Everyone around the table - around two dozen senior IMF and European finance ministry officials, leading private sector economists and bond market investors - agreed that the mountain of debt sitting on governments' balance sheets was one of the biggest risks facing the global economy today.

Ed Balls would have hated it, for the same reason. No-one questioned the need for governments to rein in borrowing - and there was very little nervousness about the pace of tightening already in train. In fact, the worry was that higher debt ratios would prevent central banks from responding to the next downturn, by putting up pressure on interest rates. Their fear was that countries would get into a negative loop, where high public debt levels produce slower growth, and slower growth makes it that much harder to bring down debt.

And it gets worse: most of the economists at the meeting didn't think it was enough to simply stabilise government debt at a new, higher level, as has happened after most recessions since the war.

Much was made of recent IMF research showing that most European countries had costs coming down the track from ageing - higher pension and health spending - which could make the cost of bailing out the banks in 2008-9 look like a dry cleaning bill.

Related work by Roel Beetsma, an academic economist at the University of Amsterdam, concludes that, on average, EU governments need to run a budget surplus of 1.6% of GDP for the next two generations if baby boomers are going to come close to paying the cost of their extended old age.

Yes, you did read that right: a 1.6% budget surplus for two generations. In case you were wondering, a surplus is when the government takes in more revenues than it spends. We're not very familiar with them in the UK because they have only happened five times in the last 40 years.

This isn't the time to re-open the debate about austerity in the UK - the focus of the seminar was the eurozone, not the UK. But it was interesting that the mood of the room was so hawkish.

You might ask - where do hedge funds come into this? The answer is that the experts at the conference weren't only concerned with the long-term challenge of bringing down Europe's sovereign debt. They were also, understandably, concerned about governments' ability to finance their borrowing right now. And here, non-traditional investors like hedge funds could be more important to the eurozone in the next year or so than ministers realise.

How? Well, in the discussion about the state of play in the financial markets there was an interesting disconnect between the officials and the economists, on the one hand, and the asset managers and bankers who actually buy and sell sovereign debt.

As we know, the interest rate - yield - on government debt for problem countries like Greece, Ireland and Portugal has spiked up again over the last few months, even despite that gargantuan support programme for the eurozone announced in May.

By and large, the officials at the seminar thought this was because investors were worried about the fundamentals in these countries: their long-term growth rate and their basic ability to re-pay. But the players from the "buy-side" of the market suggested a more prosaic explanation.

Yes, they said, of course there are some concerns about Greece, and maybe Ireland's, long-term ability to avoid a debt restructuring. But the high level of the yields right now more than make up for that risk. This is doubly true of the likes of Spain and Portugal, where they judged the fundamental risks of a default to be very small.

The real problem all these peripheral governments are facing, they said, is that the big traditional buyers of government bonds - life insurance companies, pension funds, and the like - have got to the point where they can't or won't buy these assets at any price. (Or at least the foreign institutions won't - domestic institutions in these countries may continue to buy).

Sometimes it's regulation that's hurting demand for bonds: many institutional investors are simply not allowed to invest in assets after the credit rating falls below a certain level. But more often, these participants said, it's about image, and huge risk aversion. Institutions don't want to take the reputational hit of investing in a country that ends up restructuring its debt, even if it's a tiny fraction of their portfolio, and even if they actually make money on the deal.

The upshot is that even if an asset manager has got an elaborate econometric model showing that Portugal, say, is a good investment - if the client says they don't want Portugal, the manager gets out of Portugal. End of discussion. As one person said at the seminar: "it doesn't matter how high the yield is on Greek debt, if I can't sell it, why would I buy it?"

This is where the hedge funds and other non-traditional investors come in. Of course, they may not want to buy this debt either, but they don't have the same regulatory constraint to invest in super-safe assets; and, almost by definition, their clients want them to go for game-changing plays, not follow the herd.

So we could have a nice irony in the coming months. In the aftermath of this crisis, many eurozone governments have focused their rhetoric - and some of their regulatory fire - on hedge funds and short-term speculators. But if these market players are right, it's the traditional, "long-termist" investors that are now pulling out of peripheral European debt markets, causing officials in Lisbon and elsewhere so many sleepless nights.

One thing that everyone at the seminar agreed on is that the funding of European government debt over the next year or so looked pretty tight, with a massive supply of new and maturing debt chasing a limited amount of demand. That means there could be more scary market moments ahead for the likes of Ireland and Portugal.

If this great European sovereign debt train keeps running through 2010 and 2011 without some kind of funding crisis, it might have some evil hedge funds to thank.

Mervyn's message to the unions

Post categories:

Stephanie Flanders | 14:45 UK time, Wednesday, 15 September 2010

"You can (partly) blame me for the recession - but don't blame me for spending cuts."

In effect, that was Mervyn King's message today for the TUC. "Before the crisis", he said, "steady growth with low inflation and high employment was in our grasp. We let it slip - we, that is, in the financial sector and as policy-makers - not your members nor the many businesses and organisations around the country which employ them."

Mervyn King


Perhaps his aides will correct me, but this is the first time I can remember the Bank governor taking some responsibility for the crisis. When he went on to outline the key causes of the crisis, we didn't hear anything that he thought our central bank had done wrong. But it's a nice line. And it was probably wise to start with some humility, given that other parts of his speech were not going appeal to the people assembled in the hall.

"Although a large budget deficit is inevitable for a period after a crisis, it is also clearly unsustainable - our national debt, even relative to GDP, is rising sharply and will continue to do so for several years. It is vital for any government to set out and commit to a clear and credible plan for reducing the deficit. I would be shirking my responsibilities if I did not explain to you the risks of failing to do so."

There was little new in Mr King's argument, but he was even more keen than usual to distance himself from the details of the government's deficit plans, stressing that there was a "perfectly reasonable debate" to be had about the precise speed at which to cut the deficit, and the balance between tax rises and spending cuts. "That is not for me to say; that is for you and the politicians to debate," he said. He did this again in the question and answer, repeatedly dodging questions about spending cuts and their impact on different groups.

This is understandable - and, again, wise, given the audience. But Mr King cannot wash his hands of the coalition's decisions entirely.

For months, leading up to the election, he suggested that Labour had not put forward a "credible plan" for cutting borrowing. Then, days after the election, when the coalition agreement was published, he said publicly that its deficit reduction plan was "strong and powerful", and that £6bn in spending cuts this year were a "sensible" start.

The Governor justified his statement at the time, saying that the coalition had asked him to comment, to reassure the financial markets. That may all be right and true. But it was still a highly political intervention, which many took as further evidence that he had been on Mr Osborne's side of the argument all along. If so, his speech today suggests that he still is.

He states baldly that "monetary policy is the best tool for managing the economy in the short run". There is no reference to the possibility - much discussed by the likes of Paul Krugman - that monetary policy could be a less reliable tool today, in the aftermath of a financial crisis (see my posts last week on the case for and against austerity). He also suggested that the government's plan to reduce the deficit is a "more gradual fiscal tightening than in some other countries". That is factually accurate but a little disingenuous.

In fact, there is no major economy planning to cut its deficit by as much as the coalition over the next five years. Naturally, that is because there is no major economy starting out with a deficit as large as ours. But that doesn't make the government's schedule any more gradual.

True, Greece and Ireland plan to cut their deficits more quickly. But these are countries that have been forced - as Mr King admits - into faster cuts by pressure from the financial markets. Perhaps we would have been forced to do the same thing, if Mr Osborne had not stepped up to the plate. But if so, that is a judgment which Mr King shares with the Chancellor. It is not a statement of fact.

Mr King spoke clearly and passionately about the wrongs of the banks and how the financial sector needs to be fixed. He also mentioned several times that the crisis - and the response to it - had not been fair. Perhaps that is why fewer than expected walked out of the hall.

In the circumstances, he was clearly right to accept the invitation to become only the second Bank of England Governor to address the TUC in nearly 150 years. But I wonder whether they will invite him again.

Spending cuts: A long way to go

Stephanie Flanders | 12:04 UK time, Monday, 13 September 2010

"Put it this way: the first £5bn is a lot easier to find than the last." That was how one very senior minister involved in the spending review responded when I asked him recently how it was going.

In the next few weeks, there will be plenty more leaks - and pseudo-leaks - about where the axe is going to fall. In effect, the chancellor added to them last week, by letting slip that he was looking for an extra £4bn from out-of-work benefits. But, as I said on the Today programme this morning, none of the major Whitehall departments has formally signed off its budget yet, and the chances are they won't have a final number until well into October .

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What's happening now is that literally hundreds of Treasury officials are poring over the draft plans for cuts that departments have sent them - checking every claim, every number, asking them to go back and show how they could cut more, or in ways that better protect the government's priorities.


Mr Osborne has said he wants to move away from the Gordon Brown tradition of Treasury second-guessing every decision in Whitehall. Perhaps. But not before he's used the great army of micro-managers that Mr Brown left behind to downsize most of his predecessors' favourite spending programmes.

How far do they have to go? Well, remember that the chancellor is looking for cuts of £83bn by 2014-15. That compares to the £52bn that Labour was looking for over the same timeframe.

In the June Budget, he told us about £11bn in benefit cuts that would go toward that total - for example, the nearly £2bn to come from housing-benefit bill. There's also the roughly £6bn in so-called "in-year" spending cuts for 2010-11, which are coming through already. And now the chancellor has told us about an extra £4bn coming out of out-of-work benefits.

All of that comes to around £21bn. That's leaves another £60bn to come. Give or take.

You can bet that Mr Osborne now has a good idea where most of that is coming from; and, certainly, many senior ministers now know roughly where the budgets are going to end up (with the important exception of the Department for Work and Pensions). But, to coin a phrase, they are not yet down to their last few billion, and they won't be until after the Conservative party conference.

Austerity plans: Where do you stand?

Stephanie Flanders | 16:10 UK time, Friday, 10 September 2010

Which side is right in the debate over spending cuts and the economy? The truth is that no-one can know. Because the only thing everyone can agree on is that we live in extraordinarily uncertain times.

George Osborne

But the question of how fast to the cut the deficit is one of the most important facing this country today. This week I've summarised the best arguments for each side. You should think about where you stand.

Everyone brings ideological baggage to these questions. If you believe in smaller government, you're more likely to support Mr Osborne. If you tend to favour a big welfare state, you'll probably be more worried by the prospect of steep cuts.

But the more urgent debate I've been focussing on this week isn't really about the proper size of the state. It's about timing - and the size and nature of the economic risks we now face.

In fact, you can be a firm believer in markets and smaller government and still feel that the coalition is taking the dangerous path: Martin Wolf, the FT's chief economic commentator, who has been talking up the risks of austerity for many months.

The best way to work out what you think is to ask yourself three questions.

1) Is this recession more or less like the others that we've seen in the past 50 years - or a once in a lifetime global crisis?

Everyone agrees that this has been a serious crisis. But the recessions of the 1970s and early 80s also felt pretty bad at the time. There are many who think the comparisons between now and the 1930s are overdone.

Yes, there was a moment in the autumn of 2008 when the global financial system could have collapsed. But, say the normalists, all that emergency support by governments took us back from the brink. Now everything's back on course for a normal, or nearly normal, recovery.

This is the view of most mainstream economists, and the hope of most central bankers. But others - the likes of Paul Krugman, or Brad De Long take a darker line. They say countries like the US have not yet turned the corner - in fact, all the pieces are in place for a long, Japanese-style slump.

If you think they're right - that the private sector is too laden with debt to support an economic recovery - you're probably feeling pretty gloomy about the future.

But you still have to answer question number 2:

2) Even if we're looking at a long and painful road out of this - what do you think government can do to help?

Krugman and others call for more fiscal stimulus to insure against a double-dip recession in the US. In a large, relatively closed economy like the US, that could make a difference. But many economists think fiscal pump-priming is less effective in a small open economy like the UK, because a lot of the extra demand - if there is any - will leak overseas.

As we know, Mr Osborne agrees. He thinks that monetary policy is the only reliable way to support our economy. And the only reliable way to encourage the Bank to keep rates low is by cutting public borrowing. He thinks that's especially true when public borrowing is as high as it is today - and many in the city agree.

After a financial crisis, it's probably more difficult for low interest rates to spur lending and economic growth. For some, that's reason to go back to fiscal policy (see my post on The case against Mr Osborne's austerity). But you could also conclude that the world has changed and we just have to make the best of things.

Carmen and Vincent Reinhart - distinguished experts in the impact of financial crises - argue in their latest paper [687.18KB PDF] that part of the reason financial crises are so costly is that policy makers don't realise that the path they were on before the crisis is gone for good.

3) How do you weigh the short-term risk of a weak recovery - or even a return to recession - against the long-term cost of excess borrowing? And how far do you trust politicians to get the balance right?

Maybe you think today is all that matters - that another downturn would be so disastrous, the job of preventing one trumps everything else.

On the other hand, even supporters of the spend now, cut later school accept that it does have costs long-term. Public debt will be higher. Probably interest rates too. If governments overdo it insuring themselves against a double-dip, you could get high inflation - and a loss of financial market confidence - as well.

You might think those long-term risks are more important than the risk of a weak recovery. Or maybe you just don't believe politicians when they tell you they have to borrow more today - in order to borrow less tomorrow. Both will make you more likely to side with the coalition.

So, to sum up:

You will worry most about the coalition's policies if you think that this is a once-in-a -lifetime crisis; that government spending can help avert disaster; that the short-term risk to the recovery trumps everything else; and that policy makers can be trusted to cut borrowing as soon as the danger is past.

You'll be most supportive of Mr Osborne if you think that this economic cycle will be similar to the past; that more borrowing can't do much to support growth; that it's the long-term risk of inflation and a loss of market confidence that we should be focussed on; and that politicians have a hard time keeping their promises.

So now maybe you know where you stand.

But like it or not, it's the government's approach that is now going to be tested - in that sense, we should all be hoping that it is right.

A (lightning) rod for Mr Osborne's back

Stephanie Flanders | 13:19 UK time, Thursday, 9 September 2010

It's no surprise that Robert Chote is going to be head of the Office for Budget Responsibility. He was an easy choice. But the job is anything but.

Robert Chote

As I've discussed before, the OBR is an odd hybrid. To make its forecasts, the government's new independent forecaster and budget watchdog needs to know all there is to know about Mr Osborne's decision-making - yet somehow remain aloof. As I've put it before: it needs to smoke the same stuff as the Treasury, but not inhale.

That will be a little easier when the OBR is based outside the Treasury, as it will be under Mr Chote. But he won't be far away, because most of the data and modelling that goes into each OBR report will still need to come from the Treasury.

By creating the OBR, the chancellor always says he has created a rod for his own back. There is a lot of truth to that: once Mr Chote is confirmed by the Treasury Select Committee, he will be more or less impregnable. Whatever he says, the government will have to accept. And no-one is going to criticise the OBR for being too independent (or not publicly, anyway).

There will be an interesting test of Mr Chote's willingness to rock the boat in the next few months, in the OBR's assessment of the spending review, and its revised forecasts for borrowing, due later in the year (there will be no pre-Budget report, but there will be some form of autumn statement, audited by the OBR).

In drawing up his new forecasts, the new head of the OBR will have to decide whether he agrees with his predecessors about the size of the structural hole in Britain's budget - and, crucially, the impact the government's plans will have on the economic recovery, and jobs.

Of course, there was no formal requirement for applicants to agree with Sir Alan Budd. But - I am reliably informed - officials did suggest informally that it would be "inconvenient" if his replacement took a radically different view.

I have no reason to believe that Mr Chote will go back on what the OBR has said before. Given the transparency of the OBR, he would need to show very good reasons for doing so. But there is very little that Mr Osborne could do if Mr Chote did decide to go off piste - however politically awkward it might be.

So Mr Osborne has lost some power with this new institution - but with it, he is also getting rid of an enormous amount of flack.

Why? Because even an independent economic forecaster gets things wrong, most of the time. Look at how most City forecasts turn out. And now, whenever the deficit turns out larger - or smaller - than expected, or a growth forecasts turns out to hopelessly optimistic, we will have no-one to blame but the OBR. No matter that it has based its judgements on the same dodgy models that the Treasury has always used.

Robert Chote knows more about the public finances than anyone outside the Treasury - and probably many inside it. But we know for sure that most of his forecasts will turn out to be wrong - especially the longer term ones.

And when they do, Mr Osborne will be the first chancellor in history who will be able to say: "it wasn't me guv, it was that man Chote".

Yes, the OBR may be a rod for Mr Osborne's back, but it will also be conducting a lot of lightning on his behalf. 

PS. Sharp-witted readers have noticed that I was due to write more on austerity today. That was waylaid by the OBR announcement, but expect it tomorrow.  

The case against Mr Osborne's austerity

Stephanie Flanders | 13:05 UK time, Wednesday, 8 September 2010

Spending cuts will be this government's "poll tax", according to the TUC chief Brendan Barber in an interview with the FT [registration required].

George Osborne

Yesterday I laid out George Osborne's best arguments for pressing ahead with the steepest cuts in public spending in more than 50 years. Today, I bring you the case against - taking each of yesterday's points in turn.

First, the anti-austerity school would say, Mr Osborne is wrong to say there is no alternative to his plans. Britain may have a high deficit, but borrowing is already falling, without any help from new spending cuts. In fact, the monthly borrowing numbers have come in below expectations in nine of the last 12 months.

There aren't many economists who support a big new stimulus programme in the UK, but - as this blog noted last week - research by the IMF suggests the UK could have more room to run up debt than many other major economies.

Mr Osborne says the fall in long-term interest rates - government bond yields - since the election shows the benefits of his tougher approach. But investors were choosing the UK over the likes of Spain and Portugal, long before the election.

When bond yields in those countries went up, yields in the UK, Germany and the US have tended to all fall. That has been true since the start of the year.

At less than 3%, UK 10 year bond yields are close to historic lows. We see the same low rates in the US, which has not said how it will cut its massive deficit.

Some say it's a "bond market bubble". Perhaps. But it is difficult to argue that investors are focussed on the size of deficits - or fears of inflation. Those rates suggest, rather, they are betting on a very long period sub-par growth.

The economic data are all over the place: we can't say for sure we're heading for a double-dip. But nor can you take much comfort from the "consensus forecast" for growth next year. In January 2008, only one of the dozens of independent forecasts monitored by the Treasury was expecting any fall in GDP in 2009. And that was months after the credit crunch had begun.

In the wake of this crisis, no-one believes we are looking at the kind of 3-4% growth we had coming out of the past few recessions. That means there will be less room for spending cuts to be lost in the mix: the NIESR estimates that the June Budget will cut growth by 0.4 percentage points in 2011 alone.

Second, the austerity school say that the central banks can always come to the rescue. But, as the Economist recently argued, Ben Bernanke and Mervyn King can't do everything - especially when official interest rates are already at all-time lows, and they have already hugely expanded their balance sheets to help the economy.

At a time when companies and households want to run down their debts and increase their savings, it's difficult for the central bank to force them to borrow.

Third, Mr Osborne says the evidence shows that cutting deficits by slashing spending can be expansionary. But it turns out that nearly all of the countries that feature in these studies [311.35KB PDF] were already experiencing strong recoveries when they started to cut.

There is simply no historical precedent for budget cuts on this scale - across so many countries - in the wake of a financial crisis which may subdue growth. Simple arithmetic says they can't all export their way out of recession.

The Irish example shows the opposite: its government was the first to embrace fiscal austerity, for all the reasons put forward by the coalition. But their borrowing rates have gone up again in the past few months, because investors simply don't think they can grow their way out.

Finally, the government says we need to shrink the public sector - to allow the private sector to climb out from under the dead hand of the state. That's a reasonable philosophical position to take. But this isn't - at bottom - an argument about the proper size and function of the state. It's an argument about how to insure against a disastrous economic slump.

Everyone can agree that it would best for the economy if the private sector took the lead, especially through rising investment and exports. The question is whether this is likely, at a time when most businesses and households want to save, not invest.

In those circumstances, Keynes taught us that the government becomes "borrower of last resort" - whether it likes it or not. That is Britain's true Plan B. If Mr Osborne's spending cuts do push the economy back into recession, tax revenues will fall and other spending will go up - meaning the deficit stays high.

If the government is going to have to prop up the recovery for longer than hoped, surely it is better to choose to do it, through higher public investment, than simply foot the bill for rising unemployment? That is very real risk if the government sticks to its approach.

So much for the case against austerity. Tomorrow: how to decide which side you are on.

The case for Mr Osborne's austerity

Stephanie Flanders | 08:45 UK time, Tuesday, 7 September 2010

George Osborne has already shown he is a courageous chancellor. But is he also mad? In essence, the fate of Britain's recovery over the next few years depends on the answer to that question.

George Osborne with the Budget box

Thanks to Mr Osborne, Britain now has the earliest, most aggressive programme to cut government borrowing in the G7, despite widespread fears about the strength of the UK and global recovery.

But, in a major speech last month, the chancellor took credit for having put Britain's budget on a different path. If he's had any second thoughts, he wasn't letting on.

Ten days later we had a fierce response from the opposing camp - a speech by Ed Balls in which he accused the government of "ripping out the foundations [of the recovery] just as the hurricane is about to hit."

Though all agree that Britain's budget deficit must come down, there is an unusually - some would say, disturbingly - wide range of views on when this should start, and how fast it should proceed. Even more unusual, some of our leading politicians occupy the farther edges of that debate.

Ed Balls doesn't just want to delay cuts - he wants to spend more in the next year or so. Martin Wolf, the FT's chief economic commentator seems to agree with him [registration required], but you won't find many in the city who do.

On his side, the chancellor has the support of Mervyn King. The likes of the IMF and the OECD have also broadly endorsed the coalition's approach. But jitters about the global economy - especially the US - mean that his June Budget looks more extreme now than it did a few months ago. The City still generally supports cuts, but it's difficult now to think of a serious contributor to this debate who thinks he should be cutting more quickly than Mr Osborne has proposed (though I'm confident that writing that sentence will flush some out).

Which side is right? That's for you to decide - and history to judge. But as part of the BBC's series on the spending review, Stephanomics is providing a cut-out and keep guide to the debate.

Let me start here with what Mr Osborne would say to convince you that he's right.

First, he would say, this isn't about what's desirable. It's about what's possible, given the massive deficit that the last government left Britain with. It might be nice to cut taxes - or raise spending - to help the recovery. But in my view, that option simply isn't open to UK.

If the government hasn't announced a tougher approach to the deficit, Britain would have seen its international bond yields go up in the past few months - as they have in the likes of Portugal and Spain. Instead we have had new falls in interest rates - which means lower borrowing costs for the taxpayer and for business. People now talk of the UK as a "safe haven" for international bond investors. But that wasn't the perception at the end of last year.

It's true that there's a lot of uncertainty about how the economy will go. But if you look at the underlying pace of growth over the past few quarters it's not very different from past upturns. Few expect the surprising 1.2% growth in the second quarter to continue, but even if the economy slowed to half that pace over the summer, as many expect, 0.6% growth would be more or less Britain's trend rate of growth, and broadly in line with what the city expected a months ago.

There's been a lot of hand-wringing about the impact of our cuts, but last time I looked, the average private forecast was for growth of 1.9% in 2011 in the UK, and the IMF is expecting the world economy to grow by more than 4% in 2010 and 2011. That's not as high as it might be, but it's not a double-dip.

Second, people say we don't have a Plan B. But the Bank of England is Plan B - it can and will act if the economy seems to be weakening. The same can be said of the Federal Reserve. Its chairman, Ben Bernanke, recently spoke in detail of the options available to the US central bank if deflation and/or recession became a serious risk.

Third, yes, there are risks to what we are doing, but you have to consider the risks of the alternative. By supporting market confidence, the academic evidence suggests that efforts to cut borrowing which focus on spending cuts don't undermine growth - in fact they are often expansionary, even in the short term. We might have seen that already in the fall in bond yields since the election.

Dark talk of a deflationary cycle in the US at least has some basis in fact, with inflation there running at less than 1%. Here it's 3.1%, having been above the Bank of England's target for most of the past two years. In fact, the UK is one of the only major advanced economies that now has higher inflation rate than at the start of 2008. It's expected to remain relatively high, well into next year - just as the Bank of England starts to think about how they will mop up the £200bn they've pumped into the economy by buying government bonds. This is not the time to raise suspicions that the UK would rather inflate away its borrowing than bring the deficit down the hard way.

Finally, remember the starting point. When this government took office, public spending was fast approaching 50% of GDP, a level of spending not seen since the mid 1970s. Under Labour, there were large parts of the country where two-thirds of jobs created since 2001 came from the state. There aren't many serious economists who think it would be good for the long-term health of our economy to let the state take an ever larger role.

Of course, the likes of Ed Balls say they will bring borrowing (and spending) down in a few years, when the risks have passed. But that's what they always say. When he was chancellor, Gordon Brown was always promising to balance the books in a few years' time, at the same time as explaining why that year's borrowing had overshot.

The public knows that it's time to get real. That's why every recent poll - including one recently published by the BBC - shows two-thirds of the public in favour of cuts.

So much for Mr Osborne. In my next post - a summary of the arguments against.

UK economy: Some good news from the IMF

Stephanie Flanders | 12:58 UK time, Friday, 3 September 2010

Partly thanks to Ed Balls, the debate over the scale and timing of spending cuts in the UK is still very much alive. Next week I'll be taking a look at the arguments in detail, as part of the BBC's special season on the spending review.

But in the meantime, anyone who agrees with Mr Balls that the government is overstating the risk posed by the deficit may be surprised to hear they got some support this week from the IMF.

Not that many people noticed. Most of the (modest) news coverage of the new research released by the fund late on Wednesday focused on the prediction that Britain's debt stock would rise to 90% in 2015, compared to a government forecast that debt will peak at around 70% of GDP in 2013-4.

That sounds scary. But it's worth noting that the fund then expects the average debt ratio for the advanced economies to be 86%. The forecast for the US is nearly 110% of GDP and France nearly 95%.

More important, the 90% figure is an old forecast, dating back to the IMF's regular round-up of global prospects in April. Since then we've had a lot of tax revenues come into the Treasury that it didn't expect in April. Oh yes, and we had a general election, which brought in a new government and some much tougher spending plans.

The interesting nuggets in these new academic papers - once you've managed to wade through them - aren't so much the forecasts for the UK but the comparison with other countries, notably the US.

One paper tries to measure "fiscal space" - how much room countries have to run up more debt, before the markets lose confidence in them, and their borrowing goes onto an explosive path. Predictably, the authors conclude that Greece, Spain, Italy, Japan and Portugal have little or no room for fiscal manoeuvre. The executive summary asserts that Ireland, Spain, the UK and the US are also "constrained" in the amount of debt they can run up over the next few years.

Again, that sounds bad. Until you actually look at the research. It turns out that, yes, Greece, Japan and Italy are on very thin ice. According to the authors' modelling, there's only a 6% chance that Greece can take on significantly more debt in the next few years, without something very bad happening. There's a less than one in five chance that Italy has any room to borrow more.

But it turns out that the UK is in much better shape. What the authors mean when they say we're "constrained" is that they think there's very little chance that the UK or the US could afford to raise their debt stock by another 100% of GDP from where we are now. But that's quite a lot of fiscal space to play with, even taking into account the rising cost of health care and pensions, which the IMF is understandably concerned about. After all, the "unprecedented in peacetime" rise in debt in the past few years has been on the order of 35% of GDP - not 100%.

In fact, the study concludes that there's a more than 75% chance that the UK has room to increase its debt stock by another 50% of GDP before getting into a vicious debt spiral. Yes, you read that right - it thinks there's a good chance our debt could go to 140% of GDP without us getting into an explosive debt spiral (though by that time I suspect we would have long ago lost our AAA rating). In this we are in better shape than the US, where there's only a 50/50 chance they could sustainably raise their debt stock by that much.

Of course, all of this is built on a lot of speculative assumptions about interest rates and the likely future behaviour of governments and markets. No-one's suggesting that the chancellor - or a would-be chancellor - should put these estimates to the test. But, if nothing else, it shows how far even the IMF thinks we are from some of the doomsday scenarios you hear on the subject of government debt.

One of the other papers makes the point in a more straightforward way. It's called "Default in Today's Advanced Economics: Unnecessary, Undesirable and Unlikely" (the clue's in the title).

It says that the risk of a sovereign debt restructuring - or default - is being "significantly overestimated" by the markets, largely because people are overstating the benefits that countries like Portugal or Ireland would actually get from a restructuring.

Why? Because people are forgetting that the big burden these countries face isn't the cost of servicing the borrowing, but the borrowing itself. Of the 10 advanced economies with the biggest deficit problems, interest payments on debt now average around 3% of GDP. The real problem is the continuing gap between spending and revenues, even before they start thinking about servicing their debt (what economists call the "primary deficit").

The average primary deficit in these economies is more than 7% of GDP. As I've mentioned before, in the context of Greece, if a country has a large primary deficit it makes less sense to default or restructure the debt, because even if they stop paying any interest at all on your debt, they will still have to find a way to cover the ongoing gap between your core spending and tax revenues. And if you've just reneged on your promises you're not going to find the market very willing to plug the hole.

The authors take a long hard look at the debt and interest rate dynamics facing different countries over the next few years. Once again, the surprising news is that Britain comes out relatively well.

True, our primary deficit - before interest payments - is up there with the worst of them: 8.8% of GDP, compared to that average figure of 7%. But when it comes to bringing it down, it turns out we have some powerful forces operating in our favour.

For example, unlike nearly every other advanced economy, the IMF expects the interest rate we pay on our debt to be lower than our rate of economic growth over the next few years. When it comes to government debt ratios, that is very important: it means we don't actually have to deliver a primary surplus - a surplus before interest servicing costs - in order to stabilise our debt.

In fact, the IMF thinks the UK could run a deficit, before interest costs, of 0.7% of GDP between 2011 and 2015 and still stabilise the debt. On average, the other advanced economies in this study have to run a primary surplus of 1 % of GDP to achieve the same thing. (It's a reflection of Greece's plight that it needs a primary surplus of 5.5 % of GDP to stop its debt ratio going up.)

Finally, the authors highlight the other big advantage that the UK has, which I've been banging on about for ages: the much longer maturity of our debt. Robert Peston underlined this a few months ago when he looked at how much different governments would need to raise in the financial markets over the next year or so. The IMF paper produces broadly similar numbers.

IMF table showing advanced economies' gross financing needs 2010-2011

For example, in 2011, it calculates that Britain will need to raise about 13% of GDP on the markets (that's to cover both new borrowing and the old debt that needs to be rolled over). As you see, the figure for Japan is nearly 41% of GDP and the average for the advanced economies is just under 20% of GDP. And remember, these calculations don't take account of the good news on revenues since the spring, or the new government's tougher borrowing plans.

None of this is to say the IMF thinks it's fine we have a 10% of GDP deficit. Indeed, the authors explicitly praise some of the steps the government has taken to take control of the budget.

Certainly, there's no argument in these papers for an increase in spending along the lines suggested by Mr Balls. Quite the reverse.

But when you take a broader - global perspective - of Britain's budget troubles, it does start to make more sense why the international financial markets continue to see Britain's sovereign debt market as a safe haven, alongside Germany and the US. As bond yields for Portugal and the rest have ballooned over the last few months, UK gilt yields have gone down.

As the papers show, budgets everywhere are in a pretty bad state. We're not the best of a bad lot - the likes of Australia and Canada can take that prize. But we're by no means the worst. And when it comes to digging our way out, we have some important advantages that others lack.

People power

Stephanie Flanders | 13:14 UK time, Wednesday, 1 September 2010

There's been a striking change of mood in global financial markets since I left for my summer break: now it's the US that everyone is gloomy about, and views of the eurozone's recovery are more upbeat.

But there are two reasons to think that the smart money will sooner or later return to the US.

The first reason is simple - and fairly immediate. As this chart, from Capital Economics, suggests, the business cycle in the eurozone often operates a few steps behind the US.

Chart showing euro zone and US GDP

Source: Capital Economics

Add that historical pattern to the slightly more disappointing business surveys and other data coming out from the Continental economies in recent weeks, and you can see why some think the clouds which hung over the US in the summer will be crossing the Atlantic pretty soon.

That seems all the more likely, when you consider that the eurozone economies have depended on the rest of the world for much of their growth. Of the 1.7% rise in eurozone GDP since the trough of the recession in 2009, as much as 0.8 percentage points is due to net trade. Whereas trade has played a negative role in America's recovery so far.

The less polite way to put that would be that the US, thanks to its continuing appetite for imports, has once again been acting as a locomotive for global growth - albeit one with less horsepower than in the past.

Most of the eurozone economies have been growing at the rest of the world's expense: taking more demand from the rest of the world economy than they put in.

The only exception is France: it has grown more slowly than Germany this year, but more of its growth has come from domestic demand: in the second quarter, imports grew by 4.2% versus 2.7% growth in exports.

So, where the US economy goes, you can probably expect the eurozone to follow. But there's another, more fundamental reason to be less hopeful about Europe's long-term prospects than America's, which European politicians are only too familiar with.

It all comes down to demographics - or people power. Put simply: America is going to have plenty of people to help grow its economy over the next few decades; the eurozone, not so much.

Michael Saunders, economist at Citi, put together the numbers in a recent report.

It's not exactly a revelation that Europe's population is aging, and its labour force is growing more slowly than America's. That's been true for a while: indeed, Germany's working age population has been falling for some time. But, as he shows, the demographics in certain countries are about to got a lot worse. The news is especially bad for Spain, which you might think had troubles enough.

As we know, the Spanish economy took off after joining the eurozone, growing by 3.7% a year, on average, between 1999 and 2007. We now know that a lot of that growth was built on an unsustainable credit and property boom.

What you may not know is that the growth was also fuelled by rising labour force, itself due to massive immigration. Total GDP may have grown by 3.7 %, but GDP per head only grew by 2.4%.

Mr Saunders reckons that the rise in the labour force pushed up growth by about 1% a year over this period, with greater participation in the labour market by existing workers adding another 1% a year. Both factors are now going into reverse: with a dearth of jobs, the migrant workers are going home, and labour force participation is going down.

As recently as 2008, the Spanish government was expecting the working age population to rise by 5% between 2008 and 2018. Now it thinks it will fall by more than 2% over that time, and many say that is optimistic.

There's been a similar dynamic operating in Ireland, which saw even more dramatic growth in its labour force before the crisis. Unlike France, Germany and Italy, Ireland's working age population is going to carry on growing in the next few years, but much slower than before.

Other things equal, the research suggests that declining "labour input" - also known as a declining number of willing workers - is going to cut Spain's potential growth rate by about 1.5% a year between now and 2020, and cut Ireland's trend rate of growth by about 1% a year.

Italy is also going to suffer. France and Germany will get none of their growth from rising labour inputs - but that was also true for much of the boom.

The net result, across the eurozone, could be to knock 0.25-0.50% off the eurozone's long run trend rate of growth. That might not sound like much, but when you're looking at growth of less than 2% a year, every little helps.

As the chart shows, the story is very different indeed in the US. There, as ever, sheer people power is going to be adding to the country's potential growth, almost regardless of what happens to the rest of the economy.

Chart showing euro area and US working age

Faster labour force growth can't solve all of America's problems, and it certainly can't guarantee a higher national standard of living. GDP per head might stagnate, even as overall GDP continues to rise. But by making nominal GDP grow faster relative to government borrowing, it makes the long-term debt dynamics for the US a lot easier than Europe's.

In the short term, it also makes it easier to shoulder the cost of all those baby boomers growing old. And, of course, it adds to the impression that the US is still a young country, whereas most of Europe is growing old.

Demographics aren't everything. There are plenty of other reasons why one country may grow father than another. But their very different demographic fortunes do provide another reason why investors may end up choosing America over Europe.

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