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Archives for December 2010

Is it the 30s - or the 70s?

Stephanie Flanders | 12:20 UK time, Thursday, 23 December 2010

"Whatever happens, we don't want to repeat the 30s." That has been the mantra of policy-makers since the financial crisis began. The last time the world had seen a banking crisis on this scale, the result had indeed been the Great Depression. But the reference point in thinking about the 1930s is always the horrendous experience of the US. We forget that in the UK, the Depression was not nearly as Great.

Nicolas Crafts and Peter Fearon remind us in the latest edition of the Oxford Review of Economic Policy that Britain's national output rose by 18% between 1929 and 1938. That's feeble. But in the US, output barely managed to grow at all (and the economy actually shrank, by more than 25%, between 1929 and 1933).

The 1930s were also a much worse time to hold US stocks: the value of the US stock market fell by nearly 40% over the decade. In the UK, share prices in 1938 were "only" 12% lower than in 1929.

Why this trip down Memory Lane? Because the most important reason the UK avoided a US-style fall in output in the early 1930s was that it avoided lasting deflation. In 1938, the UK price level was almost exactly where it had been in 1929; in the US, prices were more than 25% lower. And the main reason we prevented prices from falling is that we left the gold standard in September 1931, which caused a 25% fall in the value of the pound against the dollar.

In that crucial sense, Britain has indeed repeated the experience of the 1930s - and that is good news. The question now facing the Bank's monetary policy committee is whether they have done too good a job of avoiding America's fate in the 1930s, to the point where we risk a repeat of the 1970s instead.

The minutes of the last Monetary Policy Committee meeting, released yesterday, show that the Bank thinks the target measure of inflation, CPI, could well reach 4% in the next few months, and is likely to remain above 3% for the rest of 2011. If so, the governor would end the year having written a total of 13 letters to the chancellor.

As I've written many times in the past, the Bank has some decent explanations for the consistent overshoot. It's become known as the "Lemony Snicket" defence: a series of unfortunate events, like rising import prices and the switches in VAT.

Interestingly, we tend to talk in similar terms about the stagflation of the 1970s, which we always blame on an "external shock" in the form of the Opec oil price rise. In fact, as Spyros Andreopoulos points out in a recent paper for Morgan Stanley, the downturn in the global economy happened before the big oil price hike, not afterwards. And subsequent oil price rises, in the 1990s and after, didn't produce stagflation at all.

He thinks that stagflation in the 1970s was only partly due to Opec and other "unusual events". More important was a long period of loose US monetary policy, which the rest of the economy was forced to follow, at least until the 1971 collapse of the Bretton Woods system, which indirectly linked other countries to the dollar. On this view, it was loose US and global monetary policy that generated the conditions that allowed Opec to raise prices as high as it did. The Fed then loosened policy even further, in response to the oil price rise, thereby laying the ground for the Great Inflation.

There are important differences between now and then - not least, the fact that, outside of the UK, prices are flat and even falling in many of the largest economies. But you have to say the similarities are interesting. (I will have more to say about today's rise in commodity prices, and what it means for the advanced economies, in a future post.)

In the past two years the UK has applied the lessons it learned in the 1930s, and once again shown its capacity to devalue its way out of deflation. But we should probably also get clear what the lessons of the 1970s are - in case we start to repeat them as well.

The future: Even more imbalanced

Stephanie Flanders | 18:12 UK time, Tuesday, 21 December 2010

The Bank of England's most consistently interesting economist had some bad news today for anyone worried about the problem of global imbalances. He thinks that those current-account imbalances are likely to get bigger, probably a lot bigger, in the next 10 to 20 years - and there may not be very much that anyone can do about it.

Andy Haldane, who runs the bank's financial stability division, has given some seminal speeches on the banking crisis over the past couple of years. In today's remarks at Chatham House he's branched out into international macroeconomics, to ask why global current-account deficits and surpluses grew so big in the lead-up to the crisis - and what is likely to happen to them in future.

His boss, Mervyn King has what you might call a keen interest in this issue. You'll remember that before last month's G20 summit in Seoul he warned that if the leaders didn't agree how to bring down these imbalances, "the next 12 months might be an even more difficult and dangerous period than the one we have been through." In the event, they agreed that they needed to agree, and that was about it. We'll probably see the same debate again next year, with China wanting a gradual path to lower Chinese savings rates and a stronger currency and America wanting more adjustment, more quickly.

The Seoul summit was disappointing, if not much of a surprise. But the message of Andy Haldane's speech is that even if the major economies were able to come with a "grand bargain" to resolve global imbalances, it might not make much of a difference.

Stepping back from the arguments in Seoul, he identifies some major long-term forces behind rising surpluses in the emerging market economies, and rising deficits in the West. Most of these trends will intensify in the next few decades - in other words, that the deficits and surpluses are going to get even bigger.

The speech is worth reading in full [311Kb PDF].

He starts by pointing out that the imbalances we have seen in the past few years are larger than any we have seen in the last 100 years, and they seem to have been driven by (a) more integrated global capital markets and (b) changes in national savings rates. The difference between what America invests as a nation, and what China and other emerging economies invest, is roughly the same as it always was. What's changed is that China and the rest are saving much more, and America and other deficit countries have been saving a bit less. With a more integrated global capital market, it's become easier for differences in national savings and investment rates to turn into different current-account positions.

Here's the question, as Haldane puts it: "Is the problem impatience in the West, or excessive patience in the East?" His answer is both - and neither.

Some say it is cultural differences: Asians have a "savings culture", maybe even a savings gene, whereas Americans have a deep cultural propensity to spend. But there isn’t much evidence of this. In one academic study, 68% of American students were willing to sacrifice a short-term pay-off, to get a larger long-term reward. The figure for Chinese students was 62%.

The two more important factors behind high Chinese savings rates are that Chinese companies retain profits, whereas American companies prefer to distribute them to shareholders, and Chinese households must save more of their income, to pay for their family's education, health and old age. As I pointed out in another post, the repressed Chinese financial system plays a big role here - giving companies no alternative way of raising funds to invest, and giving households such a bad return on their money, they have to save more and more of their income to keep up.

Switch to the US, and you can see that the American financial system has been all too efficient at getting financing to US companies - and US households - without anyone having to take the trouble to save. Housing equity withdrawal alone accounted for 4% of personal disposable income in the US in 2005, up from less than 2% in 2000. This rise was primarily due to poorer households getting greater access to finance: as Haldane says, "liberalisation fed impatience".

Intriguingly, Haldane thinks that rising income inequality in the US has also lowered the savings rate among poorer households, as families strive to "keep up with the Joneses". Among rich countries, it's striking that a higher level of income inequality seems to go with a larger current-account deficit. (see the chart below).


All of this is very interesting, you might say, but does it tell us anything about the future? The answer is yes - but perhaps not in the way you think. In talk of a "grand bargain", the focus has been on the level of real exchange rates (particularly China's) and long-term structural reforms, for example, developing a social safety net and a health system in China, to encourage households to put less of their income aside. Those things could be helpful, but they sound like small beer, relative to the deeper global trends that have taken current-account imbalances to such highs.

On this analysis, sweeping structural reform of the Chinese financial system would probably help more - especially if it made it easier for funding to flow to companies, and reduced the incentive for them to hang on to every yuan they can. However, that would involve the Chinese giving up control over the banking system. The current leadership will find it a lot harder to do that than to build a Chinese NHS.

And... even if they did both, Haldane argues that the combined effects of global capital market integration and demographic change are likely to make global current-account imbalances bigger, not smaller, in the years ahead.

First, emerging market economies are likely to get richer in the next few decades, and as they get richer they are likely to expand their external balance sheet - that is, to acquire more foreign assets. Assuming (and it is a big assumption) that the G7 economies maintain roughly the same ratio of foreign assets to GDP, Haldane reckons that the Brics would catch up with the G7, on this measure, by around 2035. By 2050, over half of all G20 external assets would belong to the Brics, compared with around 9% today. The US share would fall from 28% to 12% (see the chart below).


This may be an extreme case - for one thing, you'd expect the G7 countries to be increasing their stock of foreign assets, as a share of GDP, over this period (see my post from October). But, looking around the world, we are looking at a period of dramatic shifts in global financial power, and that could have some thorny consequences. As Haldane notes:

"If this path were to be even broadly followed, it would have implications for the scale of global imbalances, which will tend to rise as gross capital flows outpace GDP growth. It would have implications for financial stability, as the scale of gross capital surges (fuelling bubbles) and reversals (fuelling crises) increases. And it may also have implications for the dollar’s reserve currency status."


Second, there's our old friend, demography. As the chart above shows, there will be a rising proportion of "prime savers" in developing countries for at least another 20 years, while the share in the advanced countries continues to go down. Other things equal, that means savings in rich countries will continue to fall, while savings in emerging countries keep going up. The forecast is that demographics alone could increase India's savings rate by 10 percentage points of GDP by 2050. By that point, China could account for half of all global savings - the US, a mere 5%. If things are not so equal - the retirement age goes up in rich countries, perhaps, or the emerging market economies develop their welfare systems - that could slow down these trends, but it's unlikely to reverse them.

So where does all this leave us? I think it leaves the world facing a very difficult choice in the next few years, and it's not whether and how to revalue the Chinese currency. If Haldane is right, we either have to learn to live with large current-account imbalances, and all the destabilising swings in capital flows that go with them - or we have to stop having a fully integrated global capital market. It may really be that simple.

Cruel and unusual for savers

Stephanie Flanders | 12:34 UK time, Monday, 20 December 2010

The CBI has predicted that base rates will start to go up in the spring, reaching 2.75% by the end of 2012. This has generally been greeted as bad news. But, as some will add, as an after-thought - it's good news for the hordes of people in the UK who live on the income from their savings, or are planning to do so in the next few years.

For them, 2010 has been a peculiarly terrible year. And it won't be so much better when base rates - Bank Rate - is back at 2.75%. Until this crisis, official interest rates had not been below 3% for generations.

Usually, there would be some comfort, for savers, in record-low interest rates - that at least inflation was not going to be eating into your cash. After all, don't interest rates go up, when inflation does? But not this year; that's what I mean by cruel and unusual. In a year in which savings accounts offer well below 3% interest, the TPI index of prices - which includes the impact of tax changes - has risen by nearly 5%.

One of the Bank of England's Deputy Governors, Charlie Bean, got into trouble a little while ago, when he suggested to savers that they ought to be "eating into" their cash reserves to get through this period. On that occasion, the reporter took the side of savers. What is striking, to me, is how rarely that happens.

In Japan, they say that one of the reasons that deflation could continue as long as it did was that there was a large, and political influential part of the population that benefited from falling prices. Most pensions were fixed in nominal terms, and the value of a given pot of savings goes up in real terms when prices fall, even if interest rates are zero. So for older people, deflation meant rising real incomes. Only when the law was changed, to allow index-linked pensions to go down in cash terms as well as up did the government start to come under real popular pressure to reflate.

As the baby boomers prepare for their retirement, you might have expected the same kind of shift in the centre of gravity to occur in the UK. As David Willets describes in his book Pinch, through their lives, the baby boomers have been good at imposing their priorities and interests on the population at large. But on this issue, it seems that the zeitgeist is a few steps behind.

The average baby boomer is a net saver, these days - and certainly the average voter is a saver, given the much greater chance of older people bothering to vote. Yet we still feel and sound like a nation of borrowers: low interest rates are good, higher interest rates are almost always bad. Then again, perhaps that's for the best. Even if the economy does recover as the CBI and the government expect, the Bank of England will be punishing savers - and rewarding borrowers - for quite a long time to come.

Inflation wars (cont'd)

Stephanie Flanders | 17:05 UK time, Thursday, 16 December 2010

Adam Posen has continued a war of words with his fellow Monetary Policy Committee member Andrew Sentance in a speech in Essex today [377Kb PDF]. You'll remember that Mr Sentance repeated his call for higher interest rates after Tuesday's inflation numbers came out. But Mr Posen is not letting another rise in inflation faze him. He still thinks monetary policy is not loose enough as it is, and that anyone who thinks interest rates ought to go up is a ninny.

OK. He doesn't actually use the word "ninny". It isn't a word they use very much in New England, where he grew up. But he comes pretty close:

"Suggestions that the current observations of above target inflation in the UK are due to overheating are to me misguided examples of focusing too much and too literally on the latest data without a sensible story to explain it. Not only do such suggestions have to assume no effect on inflation from past VAT and Sterling movements (otherwise, there is no high inflation to attribute to the supposed overheating). More dubiously, they also have to argue that this time is different in the UK, and productive capacity was destroyed rapidly in the aftermath of the financial crisis.

"Yet, if anything, the specifics of the UK current case suggest that productive capacity should have declined even less than usual in a post-crisis situation: unemployment rose by less and corporate liquidations were fewer for the size of the drop in GDP than in past crises. It is the destruction of human and intellectual as well as physical capital associated with redundancies and business closings that destroys capacity. As I am fond of pointing out, the workers of the United Kingdom did not wake up one morning in October 2008 and find that their left arms had fallen off and half of their offices had disappeared."

It's fun to read. It may also be right. What is most striking to me about the debate between Messrs Posen and Sentance is how certain they both are. For economists, they leave very little room for doubt, on an issue that has created shedloads of the stuff for everyone else.

At the Bank's Christmas drinks earlier this week I was party to a very intense discussion between three extremely senior economists from the Treasury and the Bank on precisely this question of spare capacity. (Yes, I know: you're wishing you were there. We economists really know how to let our hair down.) Each of them had a different take on how much permanent damage had been done by the financial crisis - and thus, how much room the economy now has to grow. But they did agree that the data on this was limited, not to say downright confusing.

I talked a little about the spare capacity issue in Tuesday's post. One of those senior officials at the party gave me a good illustration of why it's so hard to pin down.

Imagine you're an estate agent, who was matching 20 buyers and sellers a day, at the peak of the boom. Now, you're bashing the phones to get even one match a day, if that. If someone asks you if you have any spare capacity, you say "are you kidding? I've never had to work so hard." But given the right market, you could be back to 20 a day in no time. Unless and until the estate agent goes out of business, the supply will be there to meet the demand.

If that describes a large part of the UK economy today, then Mr Posen could be right - we don't have to worry about Britain's long-term capacity to grow without inflation. But Mr Sentance also has some decent arguments on his side. After all, the MPC has been wildly wrong in its forecasts of inflation over the past two years - it could easily be wrong about the next two years as well.

In a future post I'll contemplate the depressing possibility that they are both right: that we do have a great deal of spare capacity in the economy, but that isn't going to bring down inflation as the Bank expects, because our prices are being set to a large extent by China, India and the rest.

But we know that Sentance and Posen can't both be right about the best policy now for the MPC. One of them will turn out to be wrong. I fear it's not something either of them is well-prepared for.

Unemployment, and that 'Plan B'

Stephanie Flanders | 13:50 UK time, Wednesday, 15 December 2010

For some time, the UK labour market has been "Exhibit A" in the government's defence of its budget cuts. When anyone questioned whether the economy could absorb an estimated 330,000 in public-sector job losses, ministers would point out that an extra 350,000 jobs had been created in Britain since April.

People walking past Job Centre

It would have been astonishing if the economy had continued to create jobs at such a rapid pace. It has not.

Today's figures show employment falling by 33,000 over the three months to October. That was largely due to a falling public-sector job count: the private sector workforce remained broadly unchanged. The broad, ILO measure of unemployment went up, for the first time since April.

You can see shift in momentum, from public to private sector, in the divergent fortunes of men and women. In the year to October, the number of men out of work has fallen by 71,000, but joblessness among women has risen by 89,000. That is an increase of more than 9%.

The figures are disappointing, but - to repeat the point - the bigger surprise would have been if we had seen another massive rise in the number of jobs, at a time when many employers still have doubts about the future of the recovery. Even with the new data, employment has risen by 264,000 since the start of the year.

For those who worry about the government's tough approach to the budget deficit, these figures will underscore the need for a "Plan B" - something that has been much discussed in Westminster in the past 24 hours. Supposedly, the Cabinet Secretary, Gus O'Donnell, has drafted a memo outlining what could be done if the economy got knocked off track [subscription required].

On Tuesday's Ten O'Clock news, the shadow chancellor, Alan Johnson, said the existence of the memo showed that the government was getting "very nervous"... that its"huge gamble" on the economy was not going to pay off.

With all respect to Mr Johnson, I don't think most economists would see it that way. But perhaps it depends on what you mean by a plan B.

In political terms, "Plan B" is shorthand for "rethinking budget cuts because the economy is tanking". In the past day I have talked to a range of senior officials about the cabinet secretary's memo, including some who have been nervous about the scale of the government's budget cuts. None considered the memo to be that kind of plan B.

The paper is a description of the options that would available to the authorities, in the event of a major shock. The big shock that everyone serious is worried about in the first part of the year is not a sudden weakening of the UK economy, per se, but a sudden drying up of bank funding in the UK and across Europe, either as a result of the ongoing crisis in the eurozone, or worries about US banks related to the still declining US housing market.

That is why the emphasis, in the memo, is on possible ways to lend directly to the corporate sector - either through bigger Bank purchases of corporate bonds, or through some form of direct lending programme to British companies, financed by the Bank but underwritten by the Treasury. In such circumstances, you would be thinking about how to keep the corporate sector growing without the help of banks.

How should fiscal policy respond? The official answer has long been that "the automatic stabilisers would be permitted to operate". In other words, if the economy weakened, borrowing would rise automatically, as a result of higher social-security spending and weaker tax revenues. The government would not seek to offset that with cuts elsewhere. Since the government's deficit target is the cyclically adjusted figure for borrowing, that would not technically require any change in the government's strategy at all.

In other words - the government would say that none of this is plan B. It is plan A, subclause (b).

At which point, you might think this is all getting rather silly. And you would be right. But there is a serious distinction here, important to both sides.

Allowing the automatic stabilisers to operate means spending money on things you'd rather not spend money on, because the economy is not as strong as you had hoped. That, for Labour, is the big downside of the government's approach. If you are going to end up having to borrow the money anyway, they would say, isn't it better to spend it on valuable things like roads and education - than to cut those programmes, but end up spending more on unemployment benefit instead?

That, in a nutshell, is the Labour argument on this entire issue. But the government has a response, which is equally central to their way of looking at the world.

George Osborne would say that it is a false choice, because the government would only be able to let the automatic stabilisers operate (ie to let borrowing go up again in response to a shock) because of the credibility it has built up since May.

If Labour had stayed in power, and stuck with its spending plans, Mr Osborne likes to say that Britain would now be on the same list, in the financial markets, as Portugal, Spain and the rest. That might be an exaggeration. But we would probably have less room for manoeuvre, in the face of another downturn.

Of course, if you're on Labour's side you might say the cuts themselves have made a downturn more likely. But arguably, the state of the world economy - and global financial markets - will play a larger role in Britain's recovery than the government's tough spending plans. (After all, they would have been fairly tough under Labour as well).

That is probably the key change in this debate, relative to six months ago. There is still plenty to worry about. But the gravest risks hanging over the recovery these days look more foreign than domestic. It will be interesting to see how long that lasts.

The IMF according to Keynes?

Stephanie Flanders | 13:10 UK time, Tuesday, 14 December 2010

Is the International Monetary Fund up to the job of fixing the global economy? That's the question I've been thinking about for a radio documentary which will be broadcast on Radio 4 on Tuesday evening.

Dominique Strauss Kahn

Over the past six months we've spoken to a lot of people inside - and outside - the institution, including several interviews with the Fund's ebullient Managing Director, Dominique Strauss Kahn, and the IMF mission chief in Greece.

I came away thinking that the world probably has more need of a muscular IMF now than at any time in its 65 year history. But I'm not sure big players like America or China are ready for the kind of loss of national sovereignty that a strong IMF would require.

When we first started thinking about the programme, at the start of 2010, the Fund had already played a key role in the global financial crisis. But few would have predicted that there would be two massive IMF programmes under way in the eurozone before the year was out. (There's a couple of weeks left - who knows, maybe Portugal will be make it three?)

When the G20 had trebled the Fund's resources - to $750bn - at the London Summit in 2009, everyone thought the money would be lent to emerging economies, so they didn't get sucked into the financial maelstrom in Europe and the US. They didn't think it would be used partly to bail out the euro.

When we spoke to him, Mr Strauss Kahn was uncharacteristically humble about his role in pulling together the $750bn rescue programme for the single currency in that fateful weekend in early May, when most European governments were still kidding themselves that another $50 or $60bn would stop the rot.

But I am reliably informed that Mr Strauss Kahn and the US Treasury Secretary were central to turning $60bn into $750bn - in less than 24 hours. The Fund's managing director did joke to me that it had been "good pay per hour".

If we had not had an IMF, we would probably have had to invent one in the past two years. But the Fund isn't supposed to be only fighting financial fires. It's also supposed to be helping to prevent them from breaking out, banging heads together to stop a return to the massive global financial imbalances that built up in the years before the crisis.

I've written endlessly on that subject in the past few months: suffice to say, it's a lot easier to say what a more balanced global economy would like than to explain how we get there from here.

In a sense, it all goes back to the original debates about the IMF at the Bretton Woods conference in 1944. That was when the Allies came together to create a new world economic order - the experience of the 1930s still firmly in their minds.

John Maynard Keynes

Famously, John Maynard Keynes, was the British mastermind at the meeting. He wanted to create an International Payments Union, which would literally manage global trade and capital flows, to keep a lid on surpluses and deficits - and prevent a return of the costly trade battles of the 1930s. But the key US advisor, Harry Dexter White, had different ideas. The Americans didn't want anything that would be a counterweight to US power.

Predictably, the US won. The Americans even objected to the word "union" - because, for them, being in a union meant giving up real power. Instead of a grand International Payments Union, the world got the International Monetary Fund.

All it was supposed to do was to help countries stick with the new system of fixed exchange rates. And bail them out - when they came unstuck.

A lot has happened in the global economy since then. But we still seem to know a lot more about responding to crises than we do about preventing them.

Mr Strauss Kahn thinks the world might now be ready to re-visit Keynes' more ambitious vision of the Fund. Intriguingly, he even thinks the eurozone has shown the way - by demonstrating just how important it is for countries to work together, to keep imbalances in check. Perhaps. But Europe's governments have not yet shown they are ready to put the greater European good consistently ahead of their own.

My worry is that the two sides of the Fund's job - the fire-fighting, and the prevention of fires - are not entirely complementary. In fact, some would say it's the firefighting that the Fund did in the 1990s (egged on by the US) in Mexico and elsewhere that helped give investors confidence that government  would always be bailed out, and contributed to the mess we are in today.

By introducing ever more elaborate safety nets for countries that get into trouble - and "precautionary facilities" for the ones that haven't -  the risk is that the Fund is adding to the mountain of moral hazard that many fear will be the result of all of the bailouts of the past few years. It could thus be helping to make the next crisis more likely.

Perhaps we would not worry quite so much about that, if the Fund were also in a position to make sure the economic policies of the largest economies make up a coherent whole. That would lessen the scope for massive global financial imbalances, and the crazy financial bets that tend to accompany them. But so far there's not much evidence that the great powers are ready to be told what to do - by the IMF or anyone else.

Inflation OK (just don't pass it on)

Stephanie Flanders | 17:27 UK time, Monday, 13 December 2010

The Bank of England's deputy governor, Charlie Bean, was a bit defensive about the Bank's recent inflation record in a speech he gave in London this morning [44KB PDF]. And well he might be.

Bank of England


In August, 2009, the Bank was forecasting that CPI inflation would now be around 1.5%. In fact, it is running at an annual rate of 3.2%.

As the Chief Economist, Spencer Dale, pointed out recently, in the past four years, inflation has been above target for 39 of the past 48 months. It has averaged almost 3%.

There are some plausible explanations for this, which the deputy governor went through in his remarks, the most important of which are unexpectedly high energy prices, and a surprisingly high degree of "pass-through" into final retail prices of the impact of a lower pound.

(Put simply, when a 25% fall in the pound caused a sharp increase in the cost of imported materials, companies have chosen to pass this increase on directly to the consumer.)

The other, more worrying, explanation is that there is less spare capacity in the economy than we would think, given the depth of the recession - because the financial crisis has destroyed more of our long-term capacity than we thought. That would suggest we have less room to grow without triggering inflation.

This has been a running theme here. There is some evidence of this in the business surveys: companies do not report having as much room to grow in the short-term as you would expect, on the basis of what they were producing during the boom.

But if companies were really hitting bottlenecks, you would expect to see an increase in pay, at least for skilled workers in high demand. There is not much sign of that, so far.

Relative to the scale of the downturn, you've also seen surprisingly few corporate bankruptcies: if there has been an exceptional hit to Britain's supply potential it doesn't seem to have come from firms going bust.

That speaks to the larger surprise about the increase in inflation - which is the degree to which the cost has been shouldered by consumers rather than companies.

As I've mentioned many times in the past, corporate profitability has held up surprisingly well in this recession (see, for example, my post Feast and Famine for UK businesses). It is real disposable income that is taking the hit.

At the end of the second quarter of 2010, the economy was 1.7% bigger than it was 12 months earlier, but real household disposable income was 2.6% smaller. You get a similar picture from the TPI - a cost of living index which measures not just the impact of price increases but higher taxes as well. That suggests that the overall cost of living has risen by 5% since the end of 2009, whereas average weekly earnings (including bonuses) have risen by just 1% in that time.

As the deputy governor says, this is how the Bank's "constrained discretion" on inflation is supposed to work. The Bank "looks through" temporary increases in inflation, because it seems more sensible to let the inflation rate wander around a bit than to force big swings in the real economy, just to keep inflation rigidly to target (assuming that kind of fine-tuning were even possible).

It makes a lot of sense. But we shouldn't be under any illusions: this approach says that inflation isn't really worth worrying about, as long as households continue to bear the brunt. Price rises can be "looked through" - wage increases to compensate for those higher prices must be stopped.

The inflation may be temporary - and it may be due to "exceptional" increases in energy and other costs. But that doesn't make the price increases any less real. Households have been squeezed in 2010 and, with higher VAT and more benefit cuts coming down the track, they are going to be squeezed again in 2011.

De-constructing the recovery

Stephanie Flanders | 17:16 UK time, Wednesday, 8 December 2010

Is there anything fishy about Britain's recent GDP numbers? At least one economist thinks there might be. To be precise, he thinks there might be a problem with the figures for the construction sector, which has accounted for an unusually high share of Britain's recent growth.

I hesitate to get into this, having got embroiled in a similar debate about Britain's official output data this time last year (see my post Small difference: Britain's third-quarter GDP). You'll remember, at that time, many economists thought the economy was stronger than the official numbers implied. The numbers for the third quarter were considered especially dubious. Everyone was expecting the numbers to show positive growth - instead they showed the economy continuing to shrink.

At that time, Danny Gabay, of Fathom Consulting, was one of the few economists prepared to stand up for the ONS. The preliminary GDP data weren't perfect, he said - but they were better than anything else out there. Since then, the official estimate for growth in those three months has jumped around a bit, but the official story is still that the economy shrank by 0.3% in the third quarter of 2009. The first estimate was of a decline of 0.4%.

Perhaps the numbers will be revised up sharply in a year or so, as the critics suggest. The point is that Gabay is not usually one to knock the ONS. But the construction figures for the past six months have him a bit concerned. If he's right, that would suggest the recovery has not been quite as strong as we thought. Construction has accounted for 40% of the UK's economic growth in the past two quarters, even though it accounts for just 6% of the economy.

The figures show real construction output has been growing at an annualised rate of 27% since the beginning of April. A number of explanations have been offered for this: for example, companies had to catch up on the ground lost due to bad weather in the first quarter. Some have also pointed to a flurry of public construction projects in the months leading up to the election.

But we're not just talking catch-up. I'm not sure public investment can explain it either. After all, the figures show the construction sector making up all of the ground that it lost in the recession, in just those two quarters. After the last recession it took 11 years (see chart below).

Chart showing UK construction output

Is that plausible? The man from Fathom is not so sure, for three reasons.

First, there's the surveys, like the PMI. These do suggest a sharp rebound this year, but they are still well below their long-term averages, and Gabay notes that the PMI has actually decelerated since April.

Second, and more curious, you can look at the labour market figures, to see whether this construction boom is leading to a similar jump in employment. The answer is not really. Instead the official numbers show each worker suddenly becoming enormously more productive.

Now, it's perfectly usual for productivity to rise sharply coming out of a recession, as output comes back faster than jobs. Manufacturing productivity is now 7.5% higher than a year ago (it fell sharply during the recession because, as I've discussed many times, output fell much further than employment). But the construction sector is streets ahead, with a 13% increase in output per head.

You have to wonder whether one of those figures - either the output, or the number of heads - might be slightly wrong. It's not beyond our wildest imaginings that construction companies might, shock, have people working for them that they don't tell the ONS about (or the tax man). But it's not clear why they would be doing this a lot more than they did, say, two years ago. As the chart below shows, these productivity figures are much stronger than in any recent boom.

Finally, there is the awkward fact that the ONS has just changed the way it measures construction output, with  the introduction of a new, monthly, output survey.  The new survey got its first outing in - wait for it - the second quarter of 2010, the same quarter in which construction output jumped by nearly 7%. The ONS clearly think the new series is reliable, or they wouldn't have introduced it. But, having not used it before, they can't say for the sure that it's not made a difference.

It's possible that Britain is in the middle of the biggest construction boom in recent memory. Given the lead-times on construction, you'd want it to lead the recovery rather than lag, and there are some enormous buildings going up  in the City.  But has the sector really make up all of the ground lost in the recession in just six months? I leave it for you to judge. I'd especially like to hear from people in the construction business, what things feel like to them.

In the meantime, we can take some comfort from this week's very strong manufacturing figures for October - output grew by 0.6%, the strongest figures since March. Happily, Britain's recovery is built on more than construction. It also seems to have some momentum - even if the middle of 2010 turns out to be slightly less marvellous than the ONS thought.

Keep calm and muddle on

Stephanie Flanders | 17:55 UK time, Tuesday, 7 December 2010

It was a technical meeting, they said - not a time for big new ideas. And that was probably just as well - because right now there do not appear to be any big new ideas which all of Europe's finance ministers can support.

Even before the meeting began, Germany had shot down the idea of a common European bond, which might make it easier for weak economies to borrow, and make European bond markets more liquid, among other things, but could also lock Germany into guaranteeing other countries' debts (see yesterday's post European bonds: For and against).

At a press conference last night, after the dinner of euro group ministers, Jean-Claude Juncker stuck to his view that the E-bond idea was "intellectually attractive". But he also accepted that it's time had not yet come. If ministers rejected a diluted version of the common bond proposal, when the markets had a gun to their heads in early May, it's hard to see why they would accept the full-strength version now.

The German finance minister - and others - also ruled out putting more money into the European Financial Stability Mechanism, even though the head of the International Monetary Fund has suggested that expanding the fund might help reassure nervous investors.

Instead, they stuck to the formal agenda: approving last week's 85bn euro support programme for Ireland - and putting the finishing touches on a plan to make future crises less likely which the heads of government will approve at their meeting next week. There was even time for a lengthy discussion of how best to account for the impact of pension reforms on national budgets for the purposes of the new stability and growth pact. (In case you're interested, the subject was introduced by Poland, and it wasn't resolved.)

The Germans say that Europe doesn't need grand new schemes - it needs to get on with implementing the schemes it's already come up with. They have a point. After all, Europe's got into plenty of trouble in the past few months with proposals that haven't really been thought through. In fact, it was Germany's own rather half-baked ideas about restructuring European government debt in future crises that got the markets worried about Ireland - and helped to put them where they are today.

After weeks of crisis, today's "business as usual" message probably came as a relief. But few in Brussels - or the financial markets - seem to think that this period of calm will last.

When people come up with their doomsday scenarios for the euro, ministers like to say, grandly, that the markets are underestimating their determination to hold the eurozone together. Perhaps. But many in the markets think the politicians are overestimating their capacity to muddle through.

European bonds: For and against

Stephanie Flanders | 12:37 UK time, Monday, 6 December 2010

A Heathrow departure lounge is not the best place to consider the pros and cons of common European bond issue. But when I get to Brussels, there will be plenty of officials debating the subject in the lead-up to the eurozone finance ministers' meeting this evening.

Jean-Claude Juncker and Giulio Tremonti


The chairman of the Euro group, Jean-Claude Juncker and the Italian finance minister, Giulio Tremonti, talk up the merits of common European sovereign bonds - or E-bonds - in today's FT.

There are some positives, which were widely discussed when the rules for the euro were being drawn up.

One is to provide deeper markets for European sovereign bonds. Another is to express the irreversibility of the euro and the strength of the countries' common commitment to make the single currency work. Another advantage - not discussed at that time but sorely missed by the ECB - would be to give the central bank a way to ease monetary policy by buying bonds, without appearing to prop up individual governments or underwrite their borrowing.

The authors keep returning to another motivation for the proposal - that it would "halt the disruption of sovereign bond markets" and "ensure that private bondholders bore the risk and responsibility for their investment decisions". That is not so clear. Or at least, not until we know the precise terms under which such a market would operate - or the obligations that it would impose on governments.

There is the suggestion that investors would be offered the option of converting national bonds into E-bonds, at a discount reflecting current market differentials.

This would provide welcome liquidity to institutional investors who are stuck holding peripheral bonds they can't get rid of. But the conversion would also crystallise their losses. It's not obvious that they would be any keener to buy more Spanish or Greek debt in the future than they are today.

This gets us to the big unanswered questions in the article, which explain why Germany remains opposed to the idea (it was German opposition that scuppered E-bonds at the start of the euro.)

The first is how you could possibly create a bond market for which all European Union member countries were responsible, without changing the treaties on which the single currency is based. Apparently, the E-bonds would have a different credit rating to national bonds (and enjoy "a higher status as collateral for the ECB".) But that suggests they would be collectively guaranteed by the members (and we're talking the entire EU here, not just the eurozone).

If so, that would surely demand a much greater degree of fiscal and political cohesion than is being contemplated formally in any of the taskforces now beavering away in Brussels.

There would be "discipline" to the extent that the cost of issuing the bonds for any individual country would depend on their current standing in the markets. In this variant of the proposal, governments would only be able to issue around half of their debt in the form of Eurobonds - so they might continue to pay higher rates on the rest. There would thus be less moral hazard than moving to common Eurobonds across the board. But the 50 per cent limit could be raised to 100 per cent in "extraordinary circumstances" - ie a crisis. More generally, the authors surely hope that the bonds will make it easier for European governments to borrow - otherwise there wouldn't be much point in doing it.

In the absence of true centralised control of budgets (which Germany clearly favours), someone will have to explain to me how a proposal that "insulates countries from speculation" will also "foster fiscal discipline". A common European bond could do either of these things. I cannot see how it could achieve both.

We know which option Germany favours - more discipline by markets, and more discipline from the euro system itself. Possibly, Messrs Juncker and Tremonti would prefer their market discipline to be more of a one-way street. Investors must take responsibility for their decisions - but governments should be "insulated" from the consequences.

Update 1356: A colleague reminds me that the Bruegel think tank has a different version of the E-bond proposal. It would overcome some but not all of the moral hazard concerns, but it would definitely involve important treaty changes. One attraction over today's proposal is that it would explicitly classify the Eurobonds as senior to the national ones. Countries would only be able to issue the common bonds up to an agreed ceiling - say 60 per cent of GDP. This would add some market discipline, by increasing the marginal cost of funds above that limit. But you would still be 'insulating' countries from their poor credit ratings, to the extent that their average cost of borrowing is likely to fall.>

If Germany left the eurozone

Stephanie Flanders | 10:55 UK time, Friday, 3 December 2010

It may be unthinkable, but I'm not the only one thinking about it. Since my last post, both Capital Economics and Graham Turner of GFC Economics have independently put some numbers together to see what we'd be talking about if Germany took the high road out of the euro. The results are suggestive, to say the least.

As I discussed before, there would be a big upfront financial and an economic cost of Germany leaving the single currency - not to mention an enormous political price for walking away from a project in which so much has been invested.

The major economic cost would be the hit to competitiveness, because the new German currency would surely go up. It's up for debate how much this would force the much talked about rebalancing of the German economy. Listening to Germany's politicians and industrialists, you would expect it to have very little impact: in the world market, they tend to argue, German companies compete on quality, not price.

But there is no debate about what a revaluation against the rest of the world would do to Germany's national balance sheet. It would hurt. Capital Economics has come up with a back-of-the-envelope calculation - with a fairly sophisticated envelope.

Chart showing net international assets (% GDP 2009)

It assumes that the new German currency would appreciate by 20%, which is roughly how much German industry has increased its competitiveness relative to the rest of Europe since 1995. Then it asks what that would mean for the value of Germany's net foreign assets - which, as the chart shows, are pretty large. Their answer is that a 20% appreciation would reduce the value of those assets by about E160bn, or 7% of German GDP.

Chart showing possible losses on international debt and assets (% GDP)

That is a big hit. But remember that German creditors will also take a hit if these countries ultimately have to default. As the second chart shows, 7% of GDP looks manageable compared to the price that Greece or Portugal would pay, if they were forced out of the euro, and their domestic economy subsequently depreciated by 20-25%. (Though, as I said earlier, precisely for that reason, you would expect them to restructure in that instance as well.)

It's interesting to compare these numbers with the massive positive shift in the UK's balance sheet after the pound fell by 25%, on a trade weighted basis, in 2008. By the end of 2008, net foreign liabilities of £352bn had turned into net foreign assets of £92bn - even though we ran a balance of payments deficit throughout and exporters had not even begun to start taking advantage of the lower pound. Amazing what a little - OK, a large - depreciation can do.

Of course, it is precisely because they can't restore their national balance sheet and competitiveness the old fashioned way that Greece and the rest are now facing such a miserable few years within the euro.

But what if Germany left, what would the new eurozone look like? Graham Turner has done those numbers: he reckons that, without Germany, the euro area would have had a current account deficit of 1.9% of GDP in 2009. With Germany, there was a slight surplus of 0.6% of GDP.

Interestingly, the budget numbers would not be all that different. With Germany, the average budget deficit across the single currency area was 6.3% of GDP last year, and the average public debt ratio was 79.2% of GDP. Without Germany, the deficit would have been 7.5% and the debt ratio just slightly higher, at just over 81% of GDP.

Looked at that way, you wonder whether the periphery would get the depreciation they would need if only Germany left. Investors might not think the new euro looked very different from the old.

But imagine, as I suggested previously, that the other major surplus countries (Austria, the Netherlands and Finland) all joined Germany in this implausible departure scenario: then the average current account deficit outside this new DM bloc would rise to 3.4% of GDP. In Graham Turner's view, these remaining countries could enjoy lower borrowing rates, "if investors thought that a weaker exchange rate gave them a better chance of growing again".

Of course, there would be enormous legal and practical obstacles - but, as Capital Economics notes, these don't look insurmountable. And managing the status quo is not exactly a walk in the park.

The better reason to doubt that any of this will happen is that in European politics, governments rarely take the radical way out of a crisis when there's an incremental alternative, even if they both end up costing the same in the end. It's much more likely that countries like Germany will progressively contribute more taxpayer funds to supporting the euro with its current membership, and hope that their populations won't take to the streets.

Put it another way, the current European leadership have tended to put the "grand European narrative" before economics in their approach to European integration. But if they did put economics before everything else, what these numbers show is that a German exit from the euro might now be the best option available.

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