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Archives for October 2010

Good news on GDP

Stephanie Flanders | 10:40 UK time, Tuesday, 26 October 2010

They say you can see evidence of a stifled recovery everywhere.  Everywhere, that is, except the official statistics. Today's 0.8% quarterly growth figure is the strongest third quarter figure in a decade.

The GDP numbers are going to jump around a lot over the next year or so - they always do. But if you look through the quarterly ups and downs, today's preliminary estimate suggests that the UK economy is now 2.8% bigger now than it was a year ago. They also suggest that the UK has been growing, on average, at an annualised rate of roughly 3.2% since the start of 2010.

Cranes over west London


Beneath that headline average, the strongest sectors have been construction, distribution, hotels and restaurants, and business and financial services. If the figures are right, output in the construction industry is now 11% higher than it was a year ago; the distribution sector is up 3.2%; and business and financial services have grown by 2.9%.

Interestingly, government and other public services have grown by just 1.1% over the past year, though remember that this does not cover all of the ways that government supports the economy. For example, as I've discussed in the past, public investment money often takes a year or more to feed through into output.

So, there's no doubt that the figures tell us good news about the recent past. What about the future?

The government would say it shows that fears of a stifled recovery are greatly overdone. The opposition - the so-called "deficit-deniers" - would say it shows that spending cuts have yet to bite. Who is right?

The honest answer is that we don't know. But, on the government's side, remember that the primary government deficit - the gap between spending and revenues, before debt interest, has fallen by more than 3% of GDP in the past 12 months (see my post of 13 October for the precise details). By that measure, fiscal policy has tightened more in the past 12 months than in any single year of the government's plan. But somehow, the economy has managed to grow by 2.8%, roughly its long-term trend rate.

You might hope to grow a bit faster than that after such a deep recession. But in past recoveries, it has usually taken some time for the recovery to build up solid momentum. This is unlikely to be an exception.

The lurking fear, in these numbers, can only be that the UK is behind the curve. After all, growth was strong in the early part of the US recovery, as well, only to slip back sharply in the summer. Given the importance of the US market for many UK exporters - and signs of weakening consumer confidence here at home - you still have to wonder whether this level of momentum can be sustained.

That will be one question that the Bank of England's MPC will focus on when it meets next month, with a new set of quarterly set of forecasts. The other question will be whether we are raising our expectations of inflation, as a result of the official CPI measure staying so long above its target rate.

Before today, there was perhaps a 50-60% chance that a majority on the committee would support more quantitative easing. I suspect that probability has now fallen. But with most economists still forecasting sub-par growth in 2011, I wouldn't rule it out - if not next month, then early next year.

There is still plenty to worry about in this recovery: much of it beyond our shores, and beyond the government or the Bank of England's control. But for today at least, I think we're allowed to join the cabinet in a sigh of relief.

Update, 1503: Simon Ward, from Henderson Global Investors, has just sent round a useful graph comparing this recovery with past upturns. Relative to the previous peak, it shows that our national output is now slightly higher than it was at the equivalent stage in the recovery in early 80s. The bottom line is similar: you can't call this a strong recovery, but it's not the weakest we've ever seen either.

Graph showing UK GDP recessions/recoveries


Gilt yields have risen sharply on the news, bearing out what I said in Friday's post about last week's fall in yields. Right now, bond investors are more concerned with Britain's growth prospects than with the size of the government deficit.

On that subject, the Treasury is predictably cock-a-hoop that the ratings agency, Standard and Poor's, has revised its outlook for the UK to Stable from Negative, and affirmed the country's top credit rating.

The chancellor has repeatedly said that Britain was "close to bankruptcy" when the coalition came to office. Despite that, it's interesting to note that S & P was the only major ratings agency to ever formally put the UK's triple A rating on negative watch, last October. Now that medium-sized shadow has been lifted, Mr Osborne can talk, once again, of having brought Britain "back from the brink".

I hesitate to cast any droplets on the chancellor's parade, but note that he is saying the government's spending cuts have transformed the country's creditworthiness, yet will not make a noticeable dent on the recovery. If true, that would be a pretty impressive trick to pull off. Indeed, some economists might wonder whether it were actually possible.

When people raise fears about the impact of deficit cuts on the recovery, Mr Osborne likes to say that the government's plans are not that different from Labour's: a matter of a mere £6bn a year in extra spending cuts, on average, between 2010-11 and 2014-15, roughly 0.4% of GDP (or just over 1% of spending).

Yet, on the government's own telling, that modest amount of additional tightening has somehow been enough to take us from the "verge of bankruptcy" to having some of the safest sovereign debt in Europe.

If you claimed to have achieved that kind of turnaround in a company's fortunes, on the back of extra cost savings of just over 1% a year, people might wonder whether the talk of bankruptcy had been ever so slightly overdone.

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Fairness and the recovery: Two verdicts for Mr Osborne

Stephanie Flanders | 16:40 UK time, Friday, 22 October 2010

It may be Tony Blair's great legacy to British politics that we've spent the past few days debating whether the government's budget cuts are fair, not whether they will smother Britain's economic recovery.

George Osborne


The yield on a five-year government bond or gilt this week fell below 1.5%, well below Germany's. That has not happened in the past because (a) British inflation tends to be higher than Germany's and (b) Germany's debt is perceived to be safer than Britain's.

The British 10-year yield is still above Germany's, for both reasons. Inflation in Britain is running at more than 3% and is expected to stay there for a while. Germany's inflation is only 1.3%. Usually that would suggest that British interest rates are more likely to rise in the UK in the future than in Germany.

The gap between them over the shorter time period has disappeared, not because investors have decided that British sovereign debt is safer, but because they reckon the British economy is going to need all the help from the Bank of England that it can get.

So much for the markets' verdict on this week. What about that question of fairness? Is the IFS right? Or the government?

Here's where I think we've ended up.

First, both agree that the tax and spending changes the government has introduced since June have been regressive, in the traditional sense that the bottom fifth of the population take a greater hit, relative to income, than the top.

The government thinks that they should get credit for choosing to go ahead with Labour's tax increases on the rich, some of which -  like the National Insurance rise - will require new legislation. It also thinks it's impossible to model the impact of several benefit changes accurate - including, unfortunately, the big change to housing benefit. The IFS disagrees with that last point.

If you buy the government's line, the changes are not regressive in the narrow sense that the top 2% of earners pay the most as a share of their income. But they are still regressive across the vast majority of the income scale.

Second, both sides agree that tax and benefit changes cannot be the end of the story,  when nearly half of the reduction in the structural borrowing by 2014-15 will come through cuts in public services.

This is where things get fiendishly complicated. But let me cut to the chase: it comes down to whether you measure the impact of spending cuts on individuals as a share of their income, or as a share of their income, plus the overall benefits they receive from the state.

Here's a stylized example, using numbers that are roughly similar to the real ones, but generously rounded for simplicity.

Say the average household in the bottom fifth has an income of around £200 per week. The government reckons that government services are so important to them, these benefits in kind are worth another £200 a week. The state plays a much smaller role in the life of the average household in the top fifth of the income distribution: they get benefits of kind of about £100 a week, to add to their weekly net income of £1,000.

The Treasury has looked at around two-thirds of departmental spending, and taken a best guess of how these different households will be affected by the cuts, including Health, Education, Communities and Local Government, Work and Pensions, and Transport. (Unlike the benefit analysis, the IFS has not said that there any glaring omissions from the Treasury's list.)

Their conclusion? The poorest will lose government services worth about seven per week, whereas the richest fifth have lost services worth about £10 a week.

This is what lets the IFS conclude that the government's programme looks even more regressive, once spending cuts are added to the mix. That £7 is obviously worth a lot more to the poor family than the rich one.  In my (roughly right) example, its worth just over 3 per cent of their net income, while the £10 hit to the top fifth is only 1%.

For the IFS, that is more or less the end of the story. But Mr Osborne and Nick Clegg - think it is relevant that the poorer family are getting a lot more from the state to start off with. That £7 represents roughly 3% of their benefits in kind from the government whereas the £10 hit to richer households reduces their in-kind benefits by fully 10%.

If you think this sounds fishy, the Treasury doesn't provide all the details of the calculation, but I think the idea is that the bits of the state that have been hardest hit - like Higher Education - are often the parts that richer households use the most. Most of the subsidy for the poorest students has been protected.

That is why the Treasury thinks the spending cuts will be fairly evenly spread in their impact, with the poorest taking a smaller hit than the rich, relative to their total income and benefits in kind from the state - though they still need Labour's tax rises to say that the top fifth are hurting the most.

Is that a reasonable definition of fairness? I guess it depends on whether you think everything really is relative - or whether the absolute starting point also matters, when you're considering how badly a family will be hit.

If you take 3% of a family's total income and public services way from them, do you need to know how rich they are to judge whether the cut is fair? The government says you don't: a 3% hit is a 3% hit.

Polly Toynbee - and other campaigners for the poor think it is relevant, because the rich family has the means to get that service another way. If they lose their right to free child care they can go out and pay for it. The poor family probably can't.

What is fair? I leave that up to you. But perhaps it's another tribute to the Blair years that we have had weeks of political debate centred around a concept that is almost impossible to pin down.

IFS analysis of tax and benefit changes

Stephanie Flanders | 14:06 UK time, Thursday, 21 October 2010

The Institute For Fiscal Studies (IFS) says that the entire package of tax and benefit changes coming into force by 2014-15 is clearly regressive, including the tax increases put in train by Labour.

IFS report


The Treasury analysis for the spending review document, which suggests otherwise, excludes a third of the benefit changes planned by the government and does not go up to 2014-15. The changes excluded by this are clearly regressive - they have the greatest effect, relative to income, on people at the lower end of the income scale.

The IFS also notes the inconsistency in the Treasury analysis - that it should make the heroic assumptions necessary to model the effect of, for example, the pupil premium across households, while making no effort to calculate the effect of removing council tax benefit and cutting housing benefit. The IFS says both are difficult to do and sensitive to the assumptions used - but benefit changes are much easier.

Update 14:41: To get a sense of the numbers involved - if you rank households by income, the poorest 10% of households will lose an average of roughly £550, or just over 5.5% of their net income, versus a roughly 4.5% loss for the top 10%.

The IFS does not like focussing on the bottom 10% because a lot of people in this group are students or have intermittent income and are not "poor" in the sense we usually mean. So, it is more comfortable talking about the changes being clearly regressive "across 90% of the income scale", because the top 10% (largely the top 2%) are paying more than most other groups.

However, if you rank households by spending rather than income, which the Treasury also does in some of its tables, the bottom 30% of households are all contributing more to the deficit reduction effort, as a share of their spending, than the top 10%.

Taking into account all tax and benefit changes up to 2014-15, the average loss across the bottom 30% is roughly 6% of their spending, versus just over 3% for the top 10%.

More generally: the IFS notes that the benefit changes have actually increased, slightly, the money going to pensioners. By far the biggest losers from the coalition's benefit changes will be families with children.

As I discussed in a post in August, it is an interesting irony of the coalition's approach that a plan which is supposed to be "saving our children from the burden of rising national debt" is being paid for, in large part, by families and children.

The baby boomers who benefited so much from the boom, and will start to retire next year, are being relatively protected from the costs of paying for the bust.

All in it together?

Stephanie Flanders | 13:50 UK time, Wednesday, 20 October 2010

"Today is the day that Britain steps back from the brink," was the chancellor's opening promise today. That is one yardstick by which today's decisions have to be judged: have they supported our economic future or put it at risk? The other measure of this review - as the government has itself insisted - must be whether the cuts that George Osborne has announced are fair.

Spending review book


On the first, he said that Britain was now "out of the danger zone". Certainly, the UK is not now on the list of governments whose deficit-cutting credentials are in doubt. Quite the opposite.

But the interest rate on government bonds - which fell slightly today - is only one measure of the contribution that these spending cuts will make to the recovery. The other is whether the chancellor has done his best to pick cuts that will do least economic harm.

The chancellor said he had done this. For example, by adding £2bn to the capital investment plans he outlined in June, and by protecting the science budget, relatively speaking. The City won't mind that: with the government now borrowing at record low interest rates - barely 1%, in real terms - many large-scale public investments probably represent good value for money (see my piece on the Ten last week). But he can't get around the fact that public investment in real terms is still going to fall by around 30% by 2014-15.

Don't forget that around £2bn of the £5bn in cuts for 2010-11 announced soon after the election were investment projects. I have to confirm this when I see the document, but, at first glance, this extra £2bn merely puts that investment back on the books - a few years later than it would have happened if the old plans had gone through.

The OBR reckons that every 1% of GDP fall in public investment translates into a 1% hit on national output - far more than any other form of cut (or tax rise). That is one reason why the IMF suggested, in its otherwise supportive report on the UK a few weeks ago, that the government should be looking to take more from the welfare budget, especially benefits that go to people in the upper half of the income scale.

Have they done that? Yes and no. Taking child benefit from higher-rate tax-payers is going to raise a bit more than he thought - £2.5bn. But clearly the government were so spooked by the response to that change that they decided they couldn't do any more to middle class benefits.

There will be an extra £7bn from the means-tested part of the welfare budget. This will overwhelmingly affect families in the lower half of the income distribution. I cannot see how to avoid that conclusion - even with the increase in the child element of the working tax credit, which enables the government to say that child poverty is not directly increased by these changes.

But better-off pensioners can relax. Here's the key part of the speech: "we also keep the universal benefits for pensioners, in recognition of the fact that many have worked hard and saved throughout their lives. Free eye tests; free prescription charges; free bus passes; free TV licenses for the over-75s; and Winter Fuel Payments will remain exactly as budgeted for by the previous government - as promised."

True, the state retirement age is going up - but even that rise (which will be much welcomed by economists) is regressive. Poorer people start working earlier in their lives, often need to retire sooner because they do physically demanding jobs, and do not live as long as the better off. We found out this week that the gap in life expectancy between the richest and parts of the UK has risen to 13 years. The gap between the North and the South is at least seven years.

That is where judging the economic impact of these cuts overlaps with the assessment of its fairness.

We have been promised - for the first time - a Treasury assessment of the distributional impact of today's spending and benefit decisions. Since the document has not been released, I don't know what is included in that calculation - and what is left out. But, at first glance, the cuts to the welfare benefit are regressive, in the most basic sense of costing families in the lower half of the income distribution more, as a share of their income (and often in cash terms as well) than families in the upper half.

That could have an economic downside. As the IMF noted in that same report, poorer families, are more cash-constrained (you don't need an economist to tell you that. A lack of cash is rather what it means to be poor). If you cut their benefits they tend to cut their spending more than richer households do. They do not necessarily have the same capacity to complain.

But here is what seems to me to be the ticking time bomb in the government's plans - which will have economic implications as well as political ones. That is the likely impact on the demand and supply for housing.

With the housing benefit cuts, the cuts in social investment, and the re-definition of "affordable" housing to include rent that is 80% of the going market rate, the government is surely ensuring a massive rise in the demand for social housing, and only a modest increase in supply. When you consider that local authorities have also been told that they do not have to stick with the targets for private house building which were imposed on them by the previous government, this is a big gamble with the bottom end of the UK housing market.

The chancellor says, rightly, that the old system of social housing was not working. He has some bold ideas for creating a better one. But they will take time to work - if they actually do. In the meantime, you have to wonder where a lot of lower-income households in the South East are going to live.

Update, 14:30: Now we have the Spending Review document [2.03MB PDF], I can tell you that the chancellor has indeed found an extra £10.5bn from non-departmental spending to ease the burden on departments - in addition to the £11bn in welfare cuts announced in June.

£3.5bn of that has come from non-welfare changes, like the rise in public sector pension contributions. Around £7bn comes from welfare, only £2.5bn from the universal benefit change - removing child benefit from the better off.

I am now wading through the promised distributional analysis of today's changes - and all the cuts announced by Labour and the coalition in the past few years which have yet to come into force.

The headline from Chart B5 (below) is that today's welfare changes are indeed regressive. The biggest losers, as a share of their income, are the bottom fifth of the income distribution. As the document points out, many in this part of the income distribution are not "poor" - many, for example, are students, or self-employed with intermittent income. But the bottom 30% of the income distribution each lose more from these changes than anyone else.

Chart showing impact of Spending Review and Budget measures (including pre-announcements) as a per cent of net income by income distribution (2012-13)

Overall, the chart shows that the benefit and tax changes coming down the track hit the richest tenth of households worst. But, as the IFS has shown, that is only because of the decision to retain part of Labour's National Insurance rise and the new 50p rate. Without those, the IFS has concluded that the extra tax rises and benefit changes announced by the coalition have been regressive. That is all the more true after today's announcements.

There is a very complicated table (see below) that claims to take account of the impact of departmental spending cuts as well - this reaches the same conclusion. The richest fifth are worst hit, but only because of the tax increases which the coalition inherited.


Overall, this table shows that the top fifth are paying most as a share of their income, but once again, this is only due to the tax increases coming in the next few years. The bottom 20% don't fare worst, but the IFS has pointed out, the Treasury is still not including in its analysis several benefit changes which probably most affect the poor. By the Treasury's own calculation, the spending and benefit changes which, famously, make up 80% of the coalition's deficit plan will hit the lower 60% of the income scale harder than the top 40%.

It would have been almost impossible for the government to avoid this outcome: to cut the deficit, they need to cut government spending, and the lower half of the population is much more dependent on the things that government provides than the top half. But, looking at the universal benefits that this spending review has left intact, many economists would say that they have not tried as they might have done to even the score.

Spending cuts: Molehill and mountain

Stephanie Flanders | 11:49 UK time, Tuesday, 19 October 2010

Are we all making too much fuss about the Spending Review? Nick Clegg thinks so. He likes to point out that, even with all the cuts we will see unveiled tomorrow by the chancellor, total public spending in 2014-15 will only be back to where it was, as a share of the economy, in 2006-7. At the end of the Parliament, the government will be spending £41bn more, in cash terms, than it is today.

That doesn't sound so bad. How, you might ask, can it possibly take the deepest and most prolonged spending cuts since World War II, simply to take government spending back to where it was four years ago?

The answer, as a certain meerkat would say, is "simples". All you need is the largest, most sustained increase in public spending for over 50 years, the deepest recession in more than 70 years, and the first decline in Britain's nominal GDP since records began.

Take a look at this chart, which shows total government spending in real terms since 1955. There are two lessons to take from it. One is that the pressure on government spending since WWII has been relentlessly upward. You could do the same chart for almost any developed economy in the second half of the 21st Century. As we get richer, we demand more of the kinds of things that government provides, and the cost of those things often rises faster than the economy.

Chart showing real total managed expenditure (£bn)


It takes a very determined government - taking some very tough decisions - to fight that upward pressure for any length of time. You'll note that the Thatcher era barely registers on the chart.

(Before you ask, yes, I do realise that a chart of real GDP since 1955 would look similar to this. Spending as share of the economy tended to rise until the 80s. It then bounced around the low 40s until the end of the century.  I wanted to use this chart to show how the government's plans related to the long-term trend.) 

The second lesson is that, even by post-war standards, the increase in public spending from 1999-2000 until 2009-10 was exceptional. Spending rose by 53% in real terms over this period. In effect, the coalition is "only" planning to unwind half of that increase, to take the growth in spending back to its long-term trend. But that doesn't mean it will be easy.

Why did spending rise so fast? About half of it was due to the recession (see below). But, as Tim Morgan points out in a paper for the Centre for Policy Studies, spending in 2006-7 was already 26% higher, in real terms, than it had been in 1999-2000. That was Labour's promised investment in public services.

Maybe public services did not feel 26% better. But all that means is that it was spent inefficiently, and/or prices and wages in the public sector rose much faster than the economy overall (which they surely did). The money definitely went out the door.

Then the recession came, with a real decline in GDP of 6% between the spring of 2008 and the autumn of 2009. We have had recessions before, of course, but few that deep, and none, in modern times, that was accompanied by an annual decline in the cash value of GDP.

As a general rule, cash GDP rises by at least 5% a year, meaning that spending can rise by that amount, in cash terms, without rising as a share of the economy. Even in a bad recession, the cash value of output usually goes up a few percent, because prices are rising, even as amount of stuff we produce as a nationa has gone down.

The unprecedented 3.6% fall that occurred in 2009 meant that spending would have jumped as a share of GDP, even if the nominal amount of spending had remained unchanged.

As we know, spending did not remain unchanged. It grew as the natural consequence of the recession, and also because of the stimulus programme (though that had a fairly small part in the drama.) Spending by departments also took off in real terms, because the government chose not to row back on nominal spending totals which had anticipated a much higher rate of economy-wide inflation. So spending rose sharply both in real terms and as a share of the economy.

As Alan Johnson pointed out yesterday, George Osborne and David Cameron largely went along with this spending. They only sounded the alarm on spending toward the end of 2008, and then only to reject the stimulus.

So, we are only going back to 2006-7, but an awful lot has happened between then and now. And the government will find that it cannot spend its 40.9% of GDP in 2014-15 that Labour spent it on in 2006-7.

If things go according to plan, by 2014-15 departmental spending will account for 20% of GDP, or just under half of total spending. Back in 2006-7, it accounted for 24% of GDP, and nearly 60% of the spending total.

Thanks to the promise of a real terms increase for the NHS - health will take up a much larger part of that departmental total. In 2006-7 one pound of every four spent by departments was spent by the NHS. On current plans, I reckon that by 2014-15 it will be accounting for one in every three pounds spent.

What else will we be spending on? Well, there will be more spent on central government debt interest, but perhaps not as much as you might think: about 3.5% of GDP versus 2.1% in 2006-7. There will be around 0.6% of GDP more spent on social security and tax credits (though this will change on Wednesday, as the chancellor takes more cuts from there to give to departments). Absent big reforms tomorrow, we will also be spending more on state and public pensions.

Which brings me back to where I began. If the government follows through on this spending review, public spending in 2014-15 will be 4% lower, in real terms than it is today - but account for roughly the same share of the economy as it was spending in 2005-6.

Labour is right to stress that economic growth will be crucial to how tough these spending cuts feel - and, indeed, whether cuts of this magnitude are even necessary. If the economy grows faster than the coalition expects, they could take spending back to its 2006-7 level with less pain for the benefits system and individual departments. If growth falters, then the task will be harder still.

But, the coalition is right that this is not about turning Britain into Hong Kong. It is about reversing a small-ish part of the relentless upward march in government spending since WWII. The fact that it should take such a gargantuan effort to achieve even this merely demonstrates quite how relentless that upward march can be, in a rich but now ageing modern economy.

Alan Johnson and his deficit thoughts

Stephanie Flanders | 18:09 UK time, Monday, 18 October 2010

Alan Johnson doesn't need a detailed plan to cut the deficit. When you're several years from a general election, it's the government's job to provide details, and the opposition's to respond.

That is probably just as well, because on the basis of his speech today, Mr Johnson doesn't have a plan. Instead he has a series of thoughts about the economy and the deficit, which do not necessarily add up to a coherent whole.

Thought number one, as Nick Robinson has said, is "Tiaa": There Is An Alternative to the government's approach. This argument goes: we do not need to cut borrowing as fast as the coalition suggests - indeed, it may not even be possible to do so, given the possible downside effect on economic growth.

Alan Johnson


That is, of course, the big debate - which has been thrashed out many times at this blog - see, for example, The case for Mr Osborne's austerity, The case against Mr Osborne's austerity and Austerity plans: Where do you stand?.

But note one key part of his argument is that the government's plan "has more to do with the date of the next general election than the economic cycle".

That is true. If there were no such thing as elections, there would be no obvious reason to eliminate the structural deficit in four years, rather than six. But this is a Parliamentary democracy, and that makes the electoral cycle highly relevant to investors when they assess whether a country's plans to cut borrowing are credible.

Rightly or wrongly, supporters of the government's approach think that investors only look at what governments commit themselves to doing before the next election. They do not think much of commitments to cut after that, when somebody else may be in control.

In the chancellor's view, he had to prove he was serious about cutting the deficit, or else risk a loss of confidence in Britain's public finances and a big rise in UK borrowing costs. The best way to show he was serious was to promise to get the hard work done before the next election.

So yes: there were political reasons to let the Parliamentary term set the timetable for cuts. The government would like to have room for some good news - probably tax cuts - in time for the next election. But its focus on the markets gives it an economic reason to do so as well.

Thought number two: it would be good for the recovery to cut public investment less than the coalition currently plans. That is a perfectly intelligent position, which many business groups would agree with - see my piece below.

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As Mr Johnson points out, the Office for Budget Responsibility (OBR) estimates that cuts in capital investment hit the economy much harder than either cuts in current spending or tax rises. It reckons that a 1%-of-GDP fall in public investment will cut national income by 1% as well, but if you save that money by raising taxes, the hit to the economy in the short term would be only 0.3%, or slightly more in the case of VAT. A 1%-of-GDP fall in current spending would hit national income by around 0.6% - see the table on page 95 of the June Budget document.

Given this background, the shadow chancellor is naturally shocked to discover that the government plans to cut capital spending by 33% in real terms by 2014-15. As it happens, Alistair Darling planned to cut it by about 31%. Presumably he's shocked by that as well.

He wants to cut by half that amount - that is, around 17%. According to the government, that would cost about £10bn. He says around £5bn of that would come from taxing the banks, which would be on top of the roughly £2.5bn a year that the coalition is hoping to raise from the same source.

Thought number three: Labour will not oppose all of the benefit cuts proposed by the coalition, but Mr Johnson doesn't see many that he likes. There's a thumbs-up for reforming the Disability Living Allowance ("provided it is done properly"). That raises just over £1bn. He also says, oddly, that he would endorse a short-term move to uprate benefits in line with the consumer prices index (CPI) instead of the retail price index (RPI), but only "ensuring that benefits do not fall behind earnings in the next few years".

I say "oddly" because the decision to uprate in line with CPI almost guarantees that benefits rise more slowly than earnings. That's why it saves so much money. The index of average earnings across the economy rose 38% between 2000 and 2009. Over that period, the RPI rose 43 % - slightly faster. The CPI rose by 19%.

The speech is being read as an endorsement of the change to CPI, at least for the next few years. Perhaps that is because earnings are expected to grow more slowly over this period than they have in the past. That is quite possible. But it's a big caveat to add if you want to pocket the nearly £4bn a year in savings that this proposal would bring.

Finally, there is thought number four: Labour would stick to Mr Darling's plan to halve the deficit by 2013-14, but with departmental spending cuts of 8% over four years, not 14% - or 10%, as per Mr Darling. And there will be no increases in personal taxes "beyond those already announced".

Is that possible? Start by thinking about what that deficit target would mean. The latest OBR estimate for borrowing in 2009-10 is 11% of GDP, so Labour would need to bring that down to 5.5% of GDP by 2013-14, compared to the 3.5% now forecast by the government. That gives the shadow chancellor roughly 2% of GDP to play with - or about £30bn in spending cuts over the next four years that he does not need to find.

Mr Johnson reckons that cutting departments by 8% instead of 14% means cutting public services by £27bn less than the government, of which £10bn would come through more generous plans for capital investment. It is difficult to make this comparison, because the 14% applies to 2014-15, not 2013-14. For what it's worth, I get £25bn, but we're in the same ballpark.

However, he still has to give us a sense of where that 8% - or roughly £30bn - in spending cuts that he would support would come from. Especially when Labour has rejected the £6bn in spending cuts that the coalition has found for 2010-11, and rejected at least £6bn of the £11bn the government is looking to raise from the benefit system by 2014-15.

Mr Johnson says that Mr Darling had already explained where £20bn in spending cuts would come from, in the March Budget. He didn't. He provided around £10bn in concrete reductions, including a freeze in public-sector pay. The rest were "efficiency savings" which, as the Institute for Fiscal Studies commented at the time, did not mean anything until the implications were spelled out for individual budgets.

If he is going to "spend" most of the room that a looser deficit target brings him, the shadow chancellor has also to explain how he is going to avoid the government's £12bn VAT hike with only a £5bn increase in bank taxes and "no personal tax increases other than those already announced."

But that would be an alternative Budget. As I said at the start, a shadow chancellor doesn't need one this far from an election, and just two days before the government's own spending review is announced.

The big message of today's speech is that Labour would cut the deficit more slowly than the government, and that would give it room to cut spending by around £30bn less than the government plans between now and 2014-15 - if Labour is right that it could loosen borrowing by that much and not send the government's cost of borrowing through the roof.

For my money, the hidden message is that if Mr Johnson did have to come up with an alternative Budget, at short notice, he would find it difficult to do so without swallowing some or all of that "terrible" rise in VAT.

Ben Bernanke's war

Stephanie Flanders | 17:16 UK time, Friday, 15 October 2010

Ben Bernanke declared war today - not on China, but on the possibility of deflation. he knows that a vicious cycle of slow growth, stagnant or falling prices and high unemployment poses a much greater threat to America's way of life than China's silly exchange rate.

Ben Bernanke


But like it or not, the exchange rate will be caught up in the Fed's response.

In the 1930s, the deflationary trap was the gold standard. Britain left it first, and was vilified for doing so - but it was also the first major economy to recover.

The verdict of economic historians has been that it would have been better for the world if other countries had followed Britain sooner.

Now we have no gold standard (though the euro might be playing a similar role for the eurozone). But we do have a collection of countries, most of them Asian, who have created a modern version of it, by pegging their currencies to the dollar.

America can't abandon its own currency. But it can make things as uncomfortable as possible for those that choose to stick with it. Ben Bernanke may not have planned it that way, but that is exactly what the Fed's policy will do.

Let me say something about what that policy will actually be.

The message of today's speech is that chairman Bernanke thinks that US inflation is dangerously low, that unemployment is dangerously high, and that growth can and should be much faster than it is now.

You don't have to be the world's most powerful academic economist to grasp these three features of the US economy. The September inflation numbers, also out today, make clear just how serious the threat of deflation is: the annual core inflation rate last month fell to 0.8%, the lowest rate since 1961.

Also note that Ben Bernanke doesn't buy the idea - common among some US economists - that a large part of the recent rise in US unemployment is structural, meaning growth will not bring it down.

Here's the key sentence in the speech, which Paul Krugman and other US Keynesians will like:

"Overall, my assessment is that the bulk of the increase in unemployment since the recession began is attributable to the sharp contraction in economic activity that occurred in the wake of the financial crisis and the continuing shortfall of aggregate demand since then, rather than to structural factors."

But if you're the Fed chairman and your mandate is to achieve price stability and full employment, you can't just observe these facts. You also need a plan to fix them.

In effect, the speech lays out a four point plan. First, tell investors that you have a roughly 2% inflation target. Second, tell them you are perfectly willing to buy a lot more bonds to push down long-term interest rates and increase nominal spending, and you think it will work.

Third, tell them that they're still underestimating your commitment to push up inflation, and you expect to keep rates low for longer than they think. Fourth, actually go out and buy a lot more bonds and hope for the best.

Arguably, with this speech the Fed is now up to point three of the plan (though part of its strength will lie in repetition). Apparently, the fourth, "QE 2", is only a matter of time.

Naturally, the speech doesn't have details on the likely scale of the Fed's asset purchases, or what, exactly, they would buy. But Bernanke does cite the Bank of England's gilt purchases approvingly.

True, the chairman says there is a big downside to such extraordinary measures, because markets will worry about the exit path. But in his next breath he asserts that, with the new tools at the Fed's disposal - primarily the capacity to mop up excess bank reserves - this problem has now been solved. Some will doubt that this is true. But it's noteworthy that he thinks it is.

Not all the Fed governors agree on the need for more QE. As in the UK, some have been making the case in recent weeks - while others have talked up the risks. But one has to imagine, on the basis of this speech, that Bernanke believes he has a majority on his side.

Some have talked of a linkage between Fed policy and the Chinese exchange rate: if the Fed agrees not to do more QE, then the Chinese will shift the exchange rate. That is not going to happen, and it shows a misunderstanding of the Fed's own view of what it is doing.

Ben Bernanke's goal is faster US growth, higher inflation and lower unemployment. A rebalancing of the global economy - and as a small step toward that, a change in the Chinese currency - can play a welcome contribution to that goal, and will also be a sign of the Fed's success. But it's a secondary objective. America's recovery comes first. Whether the rest of the world likes it or not.

America: First time among equals

Stephanie Flanders | 10:50 UK time, Friday, 15 October 2010

It's not a fair fight, the currency war between the US and China - but it's more evenly matched than most of us has ever seen. And as we saw in yesterday's sharp fall in the dollar, it has the potential to cause the rest of the world a lot of trouble.

Chinese yen being counted out beside US dollars


Whether in the economic arena or the political one - it's been a long time since the US could pick on someone its own size. When it comes to a currency war, China's peculiar economic system lets it come pretty close.

The US spends as much on national defence every year as the rest of the G20 combined. That speaks to its unique geopolitical standing. Its economic firepower stems not just from its position as the world's largest economy but the "exorbitant privilege" of having the world's reserve currency.

As Martin Wolf argued in yesterday's FT [registration required], that means America will win this currency war - because it has a limitless capacity to print dollars. But China also has some unique weapons at its disposal - which America would not have, if the shoe were ever on the other foot. It can withstand the dollar onslaught for a lot longer than anyone else.

Why? Because there is no other country with a large economy - but a communist financial system. True, foreign banks have come to China in the past decade. True, they now have a new financial regulatory and supervisory authority that looks a bit like the FSA. But that is where the similarities end. Most banks are state-owned and all of them are still very much state-controlled.

This means that China can resist more upward pressure on its exchange rate, for a longer period of time, than any other government in the world, because it has a greater capacity to neutralise the impact on the domestic economy.

Sorry, this is complicated. But trust me, it's important.

In a normal Western financial system, governments can't hope to absorb large inflows of capital and hold down their currency and keep control of domestic interest rates. If they intervene to prop up the dollar (and keep their own currency cheap), that raises their foreign reserves, which in turn would usually push up the domestic monetary supply and create inflation. They can raise interest rates to tackle that problem, but that tends to make the inflow problem even worse, by making the country that much more attractive to foreign investors.

That is basically the dilemma being faced by Brazil, some of Central and Eastern Europe, and most of the emerging Asian economies. Thanks to loose monetary policy in the US and elsewhere, investors are flooding their economies with cash, in search of higher returns.

As I mentioned last week, this could do a lot of damage to their economies. In that sense, they are already victims in this battle to re-balance the global economy: some more innocent than others.

In Brazil, which has a flexible exchange rate, the government has put a tax on capital inflows, with only modest success. Where exchange rates are controlled (primarily Asia), there's been massive intervention to stop the currency going up - some of it even larger, as a share of their economy, than China's.

All of them try to "sterilize" those interventions, selling assets into the market to mop up the cash and prevent it turning into inflation. But there's a limit to what they can do. In a normally functioning financial system, building up hundreds of billions of dollars of reserves will massively distort asset prices and financial activity in the domestic economy, even if you prevent the immediate hit to inflation.

Which brings me to China and its repressed financial system. America would be quite happy for China's inflation rate to go up instead of its exchange rate: domestic inflation ought to make Chinese exports less competitive in the US, just as a change in the nominal exchange rate would.

But of course, that's exactly what the Chinese don't want. So, like most countries that intervene in exchange market, it tries to sterilize those flows. Here is where the repressed financial system comes in handy: not only can it require the banks to buy an enormous amount of low-interest government bonds, but it can also instruct them to hold a lot more cash in reserve at the central bank.

According to Nick Lardy, a renowned expert on the Chinese financial system at the Petersen Institute for International Economics, in the first half of 2008 alone, a three-percentage point increase in this reserve ratio forced banks to deposit an extra RMB1.3 trillion with the central bank. From 2002 to 2008, the authorities raised the reserve ratio 21 times, taking the rate from six to 17.5% (eat your heart out, Basel III).

Of course, the banks don't like this. But they don't get a choice. They can also comfort themselves with the knowledge that the money they're losing on all these forced investments in low-yield investments is at least partly offset by the profits they make on their domestic deposit accounts, which all receive interest rates far below the rate of inflation.

That low rate of return on savings is the government's doing as well, and for economists, it is the hallmark of a repressed financial system. It's a massive "stealth tax" on household savings, the proceeds of which accrue to banks, the government and, in China's case, exporters.

As Nick Lardy and others have argued, this is not safe or sustainable for China's economy. It pushes savings into the black economy, and adds to the problem of global imbalances because Chinese households are not benefiting as much as they should be from the nation's growth, and they have to save a lot more to feel secure.

But when it comes to China, we know that the unsustainable can continue for a very long time. We found out this week that China's foreign exchange reserves had risen by $194bn in the three months to September - one of the biggest increases on record (see chart below). At least $100bn of that was due to purchases of foreign exchange. (For reference, then the Bank of Japan intervened, to such acclaim, last month it spent about $25bn.)

Chart showing


As we saw yesterday, the longer this war continues, the greater the collateral damage will be for other economies, caught in the crossfire. And the more it will come home to the US administration that we really are living in a new world.

Working the numbers

Stephanie Flanders | 12:55 UK time, Wednesday, 13 October 2010

Today's labour market figures for August and September show a disappointing second monthly rise in the claimant count.

Job centre


That has some analysts suggesting that the "trend has turned" - in other words, that unemployment has stopped falling and may even now start to rise.

It is too soon to make that call, though it is hard to believe we will see further large falls in the unemployment total in the next few months.

However, we shouldn't forget that the labour market news for most of this year has been surprisingly good. Private sector employment has grown at a decent clip for the past six months, and that increase seems to have continued in August and September.

These latest figures show that total employment rose by 178,000 in the three months to August (though, as usual, part-time work made up most of that growth).

That's all very well, you might be thinking, but wasn't that the calm before the storm - a time when the private sector is recovering, but the cuts to public sector employment have yet to hit home?

I've produced that line plenty of times in the past few months. It is probably even true (phew).

But it's worth remembering that the economy has been experiencing plenty of fiscal tightening during this period - tightening that has very little to do with George Osborne.

The primary fiscal deficit - the amount the government has to borrow, excluding the amount it pays on debt interest - is a good measure of whether the government is in expansionary or tightening mode.

Using three month rolling averages, economists at Goldman Sachs have calculate that this measure of borrowing is now 3% of GDP lower than it was 12 months ago. Think the return of VAT to 17.5%, the bank bonus tax, and the new 50p rate.

Some of that fall in the primary deficit is simply due to the fact that inflation has pushed the denominator (nominal GDP) up more than expected. But more than two-thirds of the change seems to be structural. If true, that would suggest that fiscal policy has tightened more in the past year than the coalition is planning to tighten in any single year of its plan.

Of course, this will not be the worst year for public sector job cuts. But 2011 probably won't be either. Given the time lags involved in laying off public sector workers, the Office for Budget Responsibility (OBR) is expecting the biggest job cuts to come after 2012.

Overall, the OBR is forecasting that public sector employment will fall by about 500,000 between 2010-2011 and 2014-15, from 5.5 million to about five million. That is a big number. But go back to third quarter of 1991. At that time, public sector employment was just over six million and the economy was still technically in recession.

Over the next four years the public sector lost a whopping 650,000 - rather more than the OBR is expecting now. The total fall between 1991 and 1997 was 850,000. Yet employment overall went up, and we did not feel like we were seeing the end of government as we knew it.

Will this time feel very different? We don't know. But if it does, the explanation will be slower growth.  Over the next four years, the OBR forecasts that the economy will grow by 2.6% a year, on average. Private forecasters tend to be more pessimistic. Between 1992 and 1996, growth averaged 3.1% a year - after a much shallower recession than we have just experienced.

The lesson, as ever, is that it is all about the growth, stupid. If Britain has more room to grow than the gloomier economists now expect, the private sector will be able to create more than enough jobs to offset the losses coming for the public sector.

Even that "good" outcome will of course be hugely destabilising for the people concerned and quite likely will cost them financially as well. But the alternative, slow growth path, would be many times worse. Once again, in this debate about growth, there is everything to play for.

Threat of a global currency war

Stephanie Flanders | 08:07 UK time, Wednesday, 13 October 2010

It may not really be a currency war, but even I was surprised by the aggressive language being used by senior American and Chinese officials in Washington last week. Not to mention the head of the IMF. It's been a long time since economic relations between the major powers have been this bad-tempered.

I reported from the "frontline" last Thursday, but here's an "idiot's guide" to the debate over global currencies, which I've just done for the World Service.

Coming out of the financial crisis, every country wants to grow as fast it can. That's not the problem. The problem is how.

The United States and Britain have the largest budget deficits in the G20 - which means they're looking at years of cuts. They're looking for exports to pick up the slack, and the best way to boost exports is through a weaker currency.

The problem is that the eurozone wants the same thing. So does Japan. And so does China - even though America and the eurozone think it's time that the Chinese consumer stepped up to the plate.

It sounds like a global price war, with each country fighting to under-bid the other. But when companies have price wars - don't we consumers usually win?

The trouble is that exchange rates aren't the same as prices - if the dollar is going down, then other currencies have to go up. And governments aren't companies: if they don't like where their currency is going they can intervene. The rest of the world is left fighting the price war on its own.

That is exactly what China and other Asian exporting countries have been doing for the last few years - they've spent hundreds of billions of dollars fixing the market to keep their exports cheap. More than a trillion, in the case of China, which now sits on a mountain of dollar reserves.

At the start of the summer, China promised to let its exchange rate go up - but since then it has strengthened against the dollar by just 2%. The yuan has fallen about 10% against the euro and the yen. You can see why the US and other governments gathered in Washington last week were less than thrilled.

China says the focus on the exchange rate misses the point - policy-makers should focus on the why the US saves too little as a nation, and Asian economies save too much. Long term, that IS what re-balancing the global economy must be about.

But, as the director of the International Monetary Fund said last week, you can't go many steps along that road without a substantial change in exchange rates.

That's why you should worry about where talk of currency wars will lead. Because if the world's leaders cannot agree on the role that currencies will play in this global economy - they're not going to agree on very much else.

Nobel hide and seek

Stephanie Flanders | 17:44 UK time, Monday, 11 October 2010

If you lose your job it could be a while before you find another. You might not think this insight was worth a Nobel prize, or the career of three whole academics.

Christopher Pissarides, Peter Diamond and Dale Mortensen


Christopher Pissarides, Peter Diamond and Dale Mortensen went a bit further than that in developing the economic theory of search. Especially in the case of Peter Diamond, their path-breaking ideas also extend well beyond this one area. They are worthy - and timely - recipients of this year's Nobel economic prize.

Forty years ago, most of the economic textbooks assumed there was a fairly seamless transition from job to job. They couldn't explain why you could have long periods where there were plenty of jobs going begging - but also a lot of people out of work.

This year's prize winners gave economists and policy-makers a better way to think about the real-world search for a job - and plenty of other kinds of searches as well. For example, some of their ideas could also be applied to the property market - and why it's often difficult for home buyers and sellers to get together.

Search theory has provided plenty of ammunition to pro-market reformers over the years: among other things, the theory teaches that when it comes to unemployment benefit, you can have too much of a good thing. Generous benefits with no time limit give people less incentive to take the first job offer - so they end up spending longer out of work, even if the job they end up with is no better than the first.

But there are also lessons here for the true believers in free markets. In effect, these theories teach that the world is a complicated place and you can't expect the market to always find people jobs on its own. There are still some free market fundamentalists - of the real business cycle school - who claim that most unemployment in voluntary. As their critics joke, for these theorists it's not been the Great Recession - but the Great Vacation. You won't find much in the theory of search to back this up.

British economists have always had a strong interest in what made the labour market tick. They've also tended to be more institutionalist in outlook, concerned more with the real world operation of real world markets and institutions, even when competitors in the US were climbing the summits of high econometric theories.

Now the world, and the profession, has come back down to earth, it's perhaps no surprise that labour market economists should get this year's award - and that there should be a British passport holder in the mix.

Though born in Cyprus, nearly all of Chris Pissarides' career has been in the UK. But clever though he is, Mr Pissarides probably hasn't got a theory to explain why he's the third UK citizen to receive a Nobel in barely a week.

Child benefit saga: Lessons to be learned

Stephanie Flanders | 11:45 UK time, Wednesday, 6 October 2010

What are the lessons of this week's child benefit saga? I can see three, which the government will be learning and re-learning over the coming weeks and months.

George Osborne


Lesson one: people often don't see much distinction between the money they've earned and the money they get in benefits. If you cut the latter, you can expect everyone affected to treat it the same as a tax rise. You can also expect the families who are not affected to worry that you'll be coming for their benefit next. Most consider it an entitlement, not a gift.

Lesson two: voters, particularly middle class voters, have strong and often mutually inconsistent views on the subject of women, children and work, and different views about what constitutes a "family-friendly" tax and benefit system.

For some, it means subsidised childcare to make it easier for mums who work; for others it means extra incentives and payments for mothers who chose to stay at home.

Often, voters will believe both of these things. The government should somehow be giving women incentives to work, and incentives not to work. (Though where low income families are concerned, there tends to be more emphasis on the former.)

If the chancellor didn't know already he does now: he will never be able to reconcile all of these views. And, in an era of cuts, he can't take the Gordon Brown route of giving "special support" to nearly everyone.

Which brings me to lesson three: Labour tilted the tax and benefit system in the direction of children and families, particularly low income single parent families. For better or worse, that is what their target of eradicating child poverty encouraged them to do. It is going to be hard to raise serious money from the benefit system without tilting it back.

According to the IFS, single parents are now about 13-16% better off as a result of Labour's tax and benefit changes, depending on whether they work. Non-pensioner households without children, on average, are worse off than they would have been if the 1997 system had remained unchanged. (These averages exclude people earning more than £100,000 a year who have been hit by higher tax.)

Interestingly, given this week's debate, Labour's changes also turn out to have favoured families with "stay at home" mums.

Other things equal, the average one earner household with children was nearly 6% better off in 2010 than they would have been under the old system, whereas, households with children where both couples work were just over 1.2% worse off.

But note this last group still did a lot better than dual earner couples without any children in the house, who were about 4% worse off as a result of the changes Labour brought in.

The upshot is that the coalition is not going to be able to take a lot of money out of the system they inherited without leaving a lot of families worse off. Put it another way: "family-friendly" deficit cuts on the scale that Mr Osborne believes to be necessary are almost certainly a contradiction in terms.

Trading places: Who's risky now?

Stephanie Flanders | 16:59 UK time, Tuesday, 5 October 2010

There are two very different worlds described in the IMF's latest report on the global financial system. Increasingly, one looks a much better bet to international investors - and I'm afraid it's not the one we live in.

One of these worlds has enjoyed rapid growth for most of the last decade, and can boast low and falling levels of government debt, high levels of investor confidence, and a rising share of global investment flows.

The other world look a much riskier prospect to international investors: its economies and financial systems are still fragile after a series of highly damaging boom-bust cycles which have left governments and households with a heavy burden of debt.

Growth is weak, and many governments face big political obstacles as they try to put the level of public debt on a downward path.

Not so long ago, that would have been a fair description of many "emerging market" economies. Now - not so much.

As the report makes clear, the fast-growing economies of Latin America and Asia have plenty of challenges ahead of them - but most are what they would call "upside" risks. Like managing excessive capital inflows, they arise as a consequence of the rising economic success.

Most of the downside risks these days are in the mature, supposedly stable, advanced economies - like the US, the euro area and, yes, the UK. Or, as the Fund politely puts it, in the global financial system, "the crisis in advanced countries has shifted perceptions of risk-reward in favour of emerging market assets."

As the chart below shows, equity returns in the advanced economies always used to be higher than in the emerging markets. But that stopped being true a long time ago: returns in emerging markets have been higher since 2003.

IMF chart

The balance of risk in sovereign debt markets is also shifting, and for good reason:

"Developed country sovereigns have experienced 25 downgrades since early 2008, while emerging market sovereigns have seen 21 upgrades during 2010, concentrated in Latin America. This trend is set to continue, particularly as public debt levels in emerging markets are expected to near pre-crisis lows in the next few years (Figure 1.27b). In contrast, debt levels are projected to remain elevated in the near future for advanced economies."
IMF chart

As I have said, this change in the natural order of things holds great risks for the fast-growing developing economies, especially the smaller ones (and, by extension, foreign investors).

Countries such as Indonesia and Poland are already struggling to cope with a wave of incoming cash, and the problem may be about to get a lot worse.

The Fund points out that many developed country investors have yet to follow the trend.

Emerging market equities accounted for 16% of the world's market capital in 2009, but only around 2% of the shares held by US investors. If just another 1% of the global equity and debt securities held by the four largest economies were moved into emerging markets, that would mean another $485bn in portfolio flows to emerging markets - even more than the record $424bn they received in 2007.

The Fund has some advice for these economies, some of it rather different from the advice it would have given a few years ago: notably, governments are now allowed to think about outright capital controls, though only "as a last resort".

And make no mistake: the advice for the advanced economies has changed too.

In effect, the message for many rich country governments coming out of this crisis is that have to learn to think like emerging markets. They can't take their privileged status for granted. Like many a developing country government before them, their focus will have to be on avoiding further crises, fixing the financial systems and preserving the capacity to borrow on international markets.

Put it another way: we are all emerging markets now. And not in a good way.

Capping benefits (and families?)

Stephanie Flanders | 15:24 UK time, Monday, 4 October 2010

As predicted, the chancellor had some more bad news for families on benefits in his speech this afternoon: from April 2013 there will be a cap on the amount that any non-working family can receive. I've now got some more details of this policy - and some initial thoughts on the implications.

Man and boy count money


The Treasury is talking about an "indicative" level of the cap of around £500 per week - or £26,000 a year - which is its forecast of what the median working family will be earning, after tax, in 2013-14. If the cap were set at this level, they reckon that up to 50,000 families would be affected, and the savings would be in the region of £300 million a year.

So, we should say first that we're not talking big bucks. For reference, Mr Osborne is expecting to save £3.9bn - £3900m - in 2013-14, simply from uprating benefits to CPI rather than RPI. The total benefit bill this year will be around £270bn.

There are three reasons why families end up receiving a lot of benefits. First, they have special needs - for example, a disability - and are therefore thought to face extra costs. Second, they have very high housing costs which are subsidised by the government. Third, and most important, they have a lot of children.

By excluding families claiming Disability Living Allowance, the government is giving some protection to families in the first category - though it's worth pointing out that other benefits such as Carer's Allowance and Industrial Injuries Disablement Benefit will be included.

Housing benefit is the second way that the benefits for a single family can add up. There will probably be many among those 50,000 families who live in south-east England or live in those very large houses in Chelsea which feature regularly in the Daily Mail.

But, remember that 50,000 is the number the Treasury expects to be affected in 2013 - after the introduction of sweeping cuts to housing benefit which, among other things, will cap the amount that families can receive from this single source at £290 per week for a two-bedroom property and £400 per week for four bedrooms or more. The implication is that rather more than 50,000 families would be affected if the cap were introduced now.

One key conclusion is that most of the families who now earn a lot of benefits will see their payments  cut long before 2013, as a result of the housing and other cuts already in train, which by 2013 will be saving £8bn a year.

Seen in that light, the cap on the total amount of benefits any one family can receive is almost a "mopping up exercise" - a symbolic effort to ensure there aren't any shocker case studies left knocking around for the Daily Mail.

The other key conclusion is that the vast majority of the families who will be affected by this cap will be households with a large number of children. After all, the cap will be set with reference to the net earnings of the "median working family", not the median working family with the same number of kids. By design, families with an above-average number of children will be relatively penalised.

That will not concern the editorial-writers at the Daily Mail or, perhaps, many in the hall in Birmingham. But it could provide some awkward case studies when the reform comes in.

Mr Osborne says he wants to cap the total amount of benefits that non-working families can receive. The effect will also be to cap the number of children that the government is willing to support, in households in which nobody goes out to work.

Update 1637: As suspected, the child benefit change hasn't gone down well with tax and benefit purists, who don't like the idea that a couple with a combined income of £80,000 will still get the benefit, whereas households with one earner on a similar amount will have it taken away.

As I said earlier, this is because the Treasury was looking for something simple. But if you remember, child benefit was originally introduced to compensate families for the loss of the child tax allowance. In effect, it was supposed to be the state's way of saying  that (a) society benefits from people having children, and (b) families with children face higher costs.

Today the largest extra costs are usually child-care expenses - and those, in turn, are often higher in families where both parents work. So you could argue that there is some rough justice in allowing dual-earner households to keep the benefit, even if their total income is more than £45,000. But high earning single parents will still lose out.

A bigger objection, to the likes of the Institute for Fiscal Studies, is the odd earnings barrier that it creates for people who are now earning just below the higher rate. Under the new system, a person in that situation would have to think hard before taking a better-paid job or accepting a raise. In fact, if they have two children, they would need to be making an extra £2,975 a year to see any increase in their net income at all.

Mr Osborne could have avoided this problem - and raised a similar amount, £1.1bn - by simply taxing child benefit. That would have maintained the universal principle, but it would also have created a lot of losers further down the income scale, who only pay basic-rate tax. You can see why he wouldn't want to do that. But it's ironic that he's introducing a more-than-100% marginal tax rate for people just below the the higher-rate tax threshold, just as Iain Duncan Smith is pledging to get rid of high withdrawal rates for people on benefits.

Child benefit cut: No such thing as an easy reform

Stephanie Flanders | 10:45 UK time, Monday, 4 October 2010

A government that is cutting benefits for the very poorest families has no business handing upwards of £1,000 a year, tax free to everyone in the top 15% of taxpayers who happens to have a child.

George Osborne


That is George Osborne's defence of his decision to remove child benefit from higher rate tax payers, and it is a pretty good one.

Economists who wanted to see the benefit properly means-tested will say this is the very least the chancellor could have done - saving only £1bn from a total child benefit bill of close to £12bn in 2010-11.

Quite possibly, he will come back for more. The proposal to remove it from 16-18 year-olds is not entirely dead.

But - as Margaret Thatcher learned in the 1980s and Mr Osborne is about to be reminded - when it comes to the benefit system there is no such thing as an easy reform.

We heard at the weekend that the work and pensions secretary has won the Treasury over to wholesale reform of the benefit system. "Making work pay" has been the holy grail for benefit reformers for decades - it's not as if this is something new. When we see the details we'll be able to judge how far Mr Duncan Smith has avoided the pitfalls, and how far benefits are to be cut to make the numbers up.

But the government will get a dress rehearsal in the downsides of benefit reform in the popular reaction to this change in child benefit.

By far the largest of these is the messy overlap between households versus individuals, which is the reason why we have a benefit system separate from the tax system in the first place.

The first "tricky examples" put to Mr Osborne in his interviews this morning have all revolved around this basic issue: how can you justify, he was asked, taking benefit away from a household with one earner earning £45,000 a year, when you will keep paying it to households where each parent earns £40,000? The problem arises because benefits are paid to the household - but taxes by the individual.

The chancellor's answer, in effect, was that the Treasury had to find some way to keep it simple. It's certainly true that if you are only saving £1bn a year, you can't afford to spend a lot on extra administration. But it is going to make for a lot of perceived - and widely publicised - inequities.

Supporters of the principle of universal benefits have always said that any suspension of that principle would be a slippery slope - that, from here, the end of child benefit is only a question of time. Perhaps.

Much will depend on the political reaction to Mr Osborne's reform in the weeks and months to come. But whatever Mr Miliband says now, I would not put much money on a future Labour government ever feeling the need to give this money back.

The most important question

Stephanie Flanders | 10:10 UK time, Friday, 1 October 2010

Economists have drawn such contrasting conclusions about the future of the recovery this week, you'd be forgiven for giving up on the lot of them.

Pound notes


First, we had the IMF giving Britain's economy a big thumbs up. It said the government's deficit plans had done wonders for our standing in global markets, and the recovery would be strong enough to withstand the cuts.

As Martin Wolf says this morning in the FT [registration required] - theirs was more a love letter than a sober report. George Osborne couldn't believe his luck.

Yet barely 24 hours later, a leading member of the committee that sets Britain's monetary policy offered a much darker view. Adam Posen said the Bank of England should rush to inject more cash into the economy, or else risk a long period of high unemployment and low growth. As I discussed in my post on Tuesday, he's an expert on what happened in Japan in the 1990s - and he sees a real possibility that we will have our own lost decade now in the UK.

So - you might say - economists can't agree. What a shock. Posen has one vote on the committee, out of nine. Another member, Andrew Sentance, is worried about inflation. He has already voted to put base rates up.

But there is a larger lesson here: that the most important question mark hanging over Britain's economy is not whether we suffer a double dip. The recovery will probably bounce around a lot in the next year - but none of these economists expects it seriously to go into reverse.

In fact, they all think we're looking at a slow and painful road out of recession - because slow and painful recoveries are what countries coming out of financial crises usually get.

The difference is that the IMF thinks that's the best we can get. Whereas Adam Posen thinks we could do better - and the Bank should try. I went into his reasoning in that earlier post, but the basic idea is that by pumping more money into the economy, the Bank could not just raise demand in the economy - but also the long run supply.

I described Posen's view as "subversive". In central bank circles, some of them are. This week,  two members of the Federal Reserve's policy committee also gave  contrasting speeches on the case for doing more. This stuff is hard: if the answer were obvious they would all agree.

But in both countries, you have to say the wind is blowing in Dr Posen's direction. Right now, inflation is much higher here than it is in the US, but the recovery in the UK, if anything, is a little bit weaker.

With the possible - very limited - exception of inflation expectations, it is hard to identify a single indicator suggesting inflation is about to pick up. And many on the MPC accept the point that under-estimating potential growth could carry a long-term cost.

Given the relative balance of risks, I think it's quite likely that the MPC will opt to do more QE by the end of the year - albeit less enthusiastically than Posen would like.

In normal times, pumping even more money into the economy would be a disaster. "This time is different" is the mantra that got us into this mess. Coming out of the crisis, central banks are still deciding whether this time, it's really true.

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