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Archives for January 2011

Two countries, divided by a deficit

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Stephanie Flanders | 19:49 UK time, Friday, 28 January 2011

There are times when Davos feels like a trade fair for the world's economies, where leaders and ministers come to show off their wares. There were two countries on display here on Friday morning, each with a deficit of roughly 10 per cent of national income, each with a very different approach to bringing it down.

Exhibit A was the UK Prime Minister, David Cameron. In his speech in the main hall he said baldly that that getting rid of the spectre of government debt had to be job one. "Those who argue that dealing with our deficit and promoting growth are somehow alternatives are wrong. You cannot put off the first in order to promote the second."

Then, minutes later, on the same stage, we had Exhibit B, the US Treasury Secretary, Tim Geithner. He has never publicly made any negative remarks about the UK's current budget strategy. But he made quite clear in a set-piece interview with Charlie Rose that he thought rapid cuts in the US would jeopardise - not only the country's economic growth, but its long-term fiscal health as well.

There wasn't any public debate between the two men. But you couldn't help noticing two pieces of news that arrived on the same day. The first was that the American economy grew at an annual rate of 3.2 per cent - or a quarterly rate of roughly 0.8 per cent - in the last 3 months of 2010. That compares with that shocking 0.5 per cent decline in the same period for the UK. The second bit of news was that a key measure of consumer confidence in the UK had suffered its largest decline in a single month since the depth of the recession in 1992.

The comparison between the two countries isn't very fair. As long as the dollar is the world's main reserve currency, everyone agrees that America can get away with a lot more borrowing than anyone else. But there were have been some prominent voices here voicing alarm about the UK.

George Soros warned earlier in the week that Britain would fall into recession if the government went ahead with its cuts. When I raised the issue with John Lipsky, the number two at the International Monetary Fund, he said he didn't want to jump to any conclusions about the GDP data. The Fund has endorsed the coalition's budget strategy before and still does.

But the careful Mr Lipsky did seem to think it would be natural to adjust the fiscal strategy, if growth in 2011 appeared to be a lot weaker than previously thought. These were his exact words:

"The programme for this year and next year was deemed consistent with moderate growth. If those forecasts prove to be too optimistic, I'm sure there will be grounds to think about adjustments." (I asked, does that mean adjustments to fiscal policy?) ......"It seems to me anybody would be willing to re-consider and make adjustments if there was a need and the outlook was substantially different from what was anticipated."

You will be surprised to hear that the Chancellor didn't choose to share any back-up strategy with me when we spoke Friday afternoon. Let alone a Plan B. He said to abandon the government's plans now would be a disaster.

It all took me back to a year ago, when David Cameron came here to Davos as leader of the opposition - and made news when he seemed to suggest that the early spending cuts under a Conservative government would not be as great as people had thought. This time it's the British economy that's wobbled. But Prime Minister Cameron is holding tough.

Among the Davos movers and shakers, Britain's rapid approach to cutting its borrowing stands out as a bold experiment. (As Mr Osborne would doubtless point out, its deficit rather stands out as well.) Those observers won't write off the UK on the basis on a few bad numbers. But some do wonder whether Mr Cameron can really mean it, when he appears to suggest that he will stick to the programme, come what may

Google at Davos

Stephanie Flanders | 23:33 UK time, Thursday, 27 January 2011

When Google announced last week that Eric Schmidt would be standing down as Chief Executive, he tweeted that it was because "day to day adult supervision no longer needed" for the company's co-founders, Larry Page and Sergei Brin.

Page will take over the day to day running of the company, with Schmidt kicked upstairs, as Chairman. It was a flip comment - but curious. The general view in Silicon Valley these days is that Google is rather too grown up. What it needs to do is regain its youth.

When I interviewed him a few minutes ago, you will not be surprised to hear that Mr Schmidt rejected this criticism - and most of the others that I threw at him. Like the complaint that Google has become a copy-cat company - "scaling up" other people's ideas, rather than coming up with something new of their own. He also had no problem with the fact that Google still makes most of its money from search and advertising based on it. "The companies that raise this issue", he said smugly, "would kill to have our numbers."

But - he did accept that Google had been slow to engage with the social networking piece of the web (a polite way of saying that they missed entirely the most important development in the Internet in the last five years). Facebook, Twitter and others are so much more evident here in Davos than they were last year, when Mark Zuckerberg and the rest were still the new kids on the block and it was still possible for lowly folk like me to capture some of his time.

In the industry, it's an open secret that Google is livid with Facebook for poaching so many of their people. I asked Schmidt whether he was sad that relations between them had turned so bitter: weren't they supposed to be above this kind of thing? In his reply he protested just a bit too much: the way he told it, Google had barely noticed that their people had gone. And he couldn't help observing, moments later, that he was rather worried that social media like Facebook were threatening the openness of the web.

He also had some interesting things to say about Google's complex dealings with Germany and China - and their engagement with governments, regulators and lawyers around the world. He thinks he could spend as much as two thirds of his time dealing with all of that in his new job as Chairman. I wonder whether he ever finds time to spend any of his tremendous wealth.

Has-been? Visionary? Megalomaniac? All of the above? Watch the interview on Newsnight or BBC World, and decide for yourself.

The "exorbitant privilege" of the US

Stephanie Flanders | 11:27 UK time, Thursday, 27 January 2011

Davos: What's going to happen first - sensible US fiscal policy, or a global revolt against the dollar? In all my discussions about the global economy so far here in Davos, that's the question we keep coming back to.

In my earlier post I spoke about the "new economic reality". The first thing you notice about this new landscape is that the successful developing countries are doing much better than the old, developed ones. The second thing you notice is the extraordinary fiscal position of the US.

America's exceptional approach to the public finances comes out starkly in today's new budget forecasts from the Congressional Budget Office. These show the federal deficit rising to nearly $1.5 trillion in 2011, the highest on record. At 9.8% of GDP, it will be only very slightly higher than it was in the depths of the financial crisis, in 2009.

In every other major advanced economy, public borrowing is going to fall in 2011. America is the only country in which both the headline deficit and the structural deficit are going up.

That increase is entirely due to the package of tax cuts agreed last month. There is a coherent case for fiscal stimulus in the US in 2011. But, as the IMF commented on Monday, when it comes to stimulating the economy, the tax cut deal agreed with Congress does not provide much bang for the buck. And it involved a lot of bucks. The CBO says the package will add $858bn to federal borrowing over time.

In theory, US politicians are committed to getting the deficit under control. But as I noted the other day, they have a funny way of showing it. In his State of the Union address this week, President Obama repeated his commitment to eliminating the deficit, outside interest payments. But the concrete spending cuts he suggested to help reach that target will reduce borrowing by a measly $40bn a year.

No-one here at Davos was expecting to hear anything very different - from the President or Congress. The rule is that America gets a free pass to run larger deficits, for longer, than anybody else. Who knows, with the likes of China growing so fast, Asian and other emerging market demand for treasury bonds might even grow faster than Washington's ability to print them.

But you have to wonder - and everyone I speak to in Davos is wondering - how long America's "exorbitant privilege" is going to last.

The only other country to have had this status - and lost it - is the UK. It took several decades, and two punishingly expensive wars, for the world to tire of holding sterling. But when they did, it changed British economic policy making forever. Indeed, we are still seeing the consequences today. Rightly or wrongly, the British government believes it cannot risk borrowing a lot more from international markets. The Americans know they have a lot more leeway.

They will have it for some time yet. But the lesson of sterling's rise and fall is that if you run current account deficits long enough, and depreciate your currency far enough, the world will eventually stop giving you the benefit of the doubt. The biggest difference between Britain in 1945 and America now is that back then, there was a ready replacement for sterling, in the form of the dollar.

The renmimbi can't replace the dollar any time soon - neither China's government nor its financial system are ready for what that would entail. Heaven knows, the euro is in no fit state to replace it either.

But looking at the way the global economy is shifting in China's favour, many I've spoken to here think the emergence of the renmimbi as a serious alternative to the greenback is only matter of time. If the past few years are any guide, this supposedly long-term change might well happen faster than we think.

To return to where I began - the question is whether the US can stop borrowing dollars before the world stops wanting to buy them.

Davos: A new reality

Stephanie Flanders | 07:49 UK time, Thursday, 27 January 2011

Davos: Twelve months ago, the world leaders who gathered here were still in shock - counting the cost of the financial crisis, and breathing a sigh of relief that their economies were starting to recover. A year later, the focus has shifted, to the new global economic landscape that the crisis has left in its wake - and the threats which it could face in the future.

For the Russian president, who gave the opening address, the threat has been tangible - and not in the future at all. He spoke here yesterday, barely 48 hours after the terrorist attack at Moscow's main international airport. For the big advanced economies, the threat seems more existential.

True, all seems well on the surface. Even the notoriously downbeat Nouriel Roubini found some upbeat things to say about the global recovery in the first major economic discussion. The Americans are feeling less nervous, after a string of decent economic statistics (though I'd still be plenty nervous about the state of the US housing market). Globally, the IMF's updated growth forecasts - released at the same time as Britain's dire GDP figures - painted a fairly strong recovery for 2011.

Except, there's no getting around the fact that some here are recovering a lot faster than others - indeed, they didn't really have to recover at all. The Russians have long had a major presence here. Far more visible than usual, this year, are the delegations from China and, especially, India. At a dinner I attended last night, one US-based economist predicted that India would be the next bubble - basing his forecast partly on the amount of hype and exuberance about the country this year in Davos.

The theme of this year's meeting is "shared norms for a new reality". A big part of the new reality - written about enough times in this blog - is that these countries are leaping ahead - while the major advanced economies are still struggling to get back to where they were. On one estimate, the UK would need to grow by more than 6% a year for the next two years to get to the path we would have been on, if the crisis had not happened, and growth had continued as before.

Most Davos men and women from the "old" world want to take pleasure in the success of the new. They really do. But if they're honest, most will admit that there is still a zero-sum part of their brain, warning that the newcomers' gain will be our loss.

Even those who have got rid of that nagging voice may wonder how on earth, in this new global economic order, we are going to get anything done. The buzzword doing the rounds is that the G20 has turned into the "G-zero". The idea is that everyone is now responsible - and no one is in charge.

The odd sense of limbo may explain why the subject of commodity prices has raced up the agenda. The rising price of oil and other commodities has all the requirements for a perfect Davos issue: the problem is immediate and easy to identify; no-one in Davos can be directly blamed for it; and, crucially, developed and developing countries are nearly all suffering the effects.

The same cannot be said of the eurozone crisis, or even the battle to build a more stable global banking system. This time last year, I couldn't understand why the impending crisis in Greece - and the eurozone - was not being discussed. I was told that it was not a good subject for Davos: the disagreements between countries were too intense, and the problems too close to home. A lot has changed since then, but I suspect the European reluctance to wash their dirty linen here has not.

Mervyn King ne regrette rien

Stephanie Flanders | 07:20 UK time, Wednesday, 26 January 2011

I don't know whether Mervyn King is a fan of Edith Piaf. But where monetary policy is concerned, we can say he is not a man burdened by regrets. Last night in Newcastle, the governor of Britain's central bank had the following to say about Britain's above target inflation, and the Bank's response to it.

First, nearly all the inflation that Britain had seen in the past few years was due to factors beyond the Bank's control - like changes in VAT, and sharp rises in the world price of fuel and food. He said these would push inflation up again in 2011 - to "between 4 and 5 per cent". Partly as a result, we could expect real wages to fall for the 6th year in a row, the first time that has happened since the 1920s.

Mervyn King

But, raising interest rates to prevent that leap in inflation would have squeezed living standards even more, by hurting growth. To think otherwise was a delusion:

"There is a misapprehension in some quarters that the MPC could have prevented the squeeze in living standards by raising interest rates over the past year to bring inflation below its present level. That view is a misunderstanding of how monetary policy works... if the MPC had raised the Bank Rate significantly, inflation might well have started to fall back this year, but only because the recovery would have been slower, unemployment higher and average earnings rising even more slowly than now. The erosion of living standards would have been even greater. The idea that the MPC could have preserved living standards, by preventing the rise in inflation without also pushing down earnings growth further, is wishful thinking."

Some, such as the Financial Times' Economics Editor Chris Giles, have asked whether the Bank would really have followed the same approach, if they had been able to predict all the forces that would push inflation up. But the governor's answer last night was yes - he would do it all again:

"Even if we had known a year ago that 2010 would bring further increases in food, energy and other import prices, as well as a rise in VAT, it would not have been sensible to pretend that a tightening of monetary policy to offset those upwards pressures on CPI inflation was consistent with aiming to keep inflation at the target in the medium term."
Many in the Bank will see yesterday's poor growth figures as a vindication of their decision to keep the official interest rate at a record low. But they surely admit that the bad news from the economy has not made their job any easier.

Looking ahead, the Bank's governor admitted there were upside risks to inflation, which it would carefully consider. But - to return to his theme - the MPC was not going to be spooked into the wrong policy by misplaced chatter about its credibility:

"The headlines will inevitably focus on the immediate effect of shocks on CPI inflation rather than the outlook further ahead. Central banks, though, do not set policy or react according to headlines. They simply do their work. We shall try even harder to explain the basis for policy decisions. Credibility was not earned in a year, and it will not be lost in a year."

Mr King's speech will not silence Andrew Sentance. This week he repeated his call for higher interest rates, on the grounds that not tightening could force the Bank to impose much harsher medicine down the road.

Nor will it silence the critics in the City, who wonder whether the Bank has the nerve - or even the wherewithal - to bring down inflation in the unfavourable global environment I described on Friday, where prices are turning against the UK and against British workers. But after last night they cannot say the governor has failed to make his case.

Lessons from the latest growth figures

Stephanie Flanders | 12:05 UK time, Tuesday, 25 January 2011

Once again, the consensus has been consigned to the dustbin. We knew that the growth rate in last quarter of 2010 would be harder than usual to get right: as it turned out, none of the leading City economists even came close. The lowest forecast was growth of 0.2% - instead the first estimate is for a contraction of 0.5%.

As Joe Grice, the chief economist at the ONS points out, this figure needs to be treated with even more caution than usual - thanks to the weather. He reckons that, without the bad weather, we'd be looking at a figure of 0.0%: no contraction, but no growth either. But even that calculation must surely come with a lot of health warnings attached.

As I noted at the time, the fact that the bad snow came so close to Christmas meant there was a quite a strong possibility that the short-term loss in sales on the High Street - and online - would not be recouped. If you don't buy a Christmas present before December 25th, there's a fairly good chance you won't buy it at all.

What are the broad lessons of these figures?

One is that the "two speed recovery" is even more pronounced than we thought. Output in the production industries increased 0.9% in the fourth quarter - leaving output in this part of the economy 3.6% up on the year. Output in the service sector, by contrast, fell by 0.5%. The ONS estimates that most of the impact of the snow was to services; without the snow, services output would have been 0.1% lower - in other words, broadly flat.

Long-term, it is good news that manufacturing and the like are strengthening, relative to the service sector. It is also, incidentally, good news that the pound has fallen in response to today's figures. The recent rise in sterling, on the expectation of rate rises, has not been welcome at all. But, you can definitely have too much of a good thing, too quickly. Services still account for the lion's share of Britain's economic activity, and this recovery won't get far without them.

The second is that everyone - and it has been nearly everyone - is right to worry about where Britain's growth is going to come from in 2011, especially now that higher than expected inflation has a dealt a further blow to household budgets. As I mentioned in my last post, real household income in the UK at the end of 2010 was lower than it was 5 years ago. And there will now be further hits in 2011 from rising prices, higher VAT and real pay cuts and job losses and in the public sector.

Usually, we would expect a strong bounceback in the first three months of 2011, just as the economy bounced back after the bad weather in the first quarter of 2010. But that assumes that households hold on to their spending plans, despite all the bad news on VAT and prices. You have to wonder whether they will instead seek to cut back.

Finally, we are reminded, not for the first time, that these quarterly figures can and will bounce about a lot in the early months of the recovery. Just as it would have been foolish to break out the champagne after that surprising 1.1% growth figure for the second quarter of last year - no-one should be writing any obituaries for Britain's recovery on the back of today's news. But Mr Osborne has said they are very disappointing - and that they certainly are.

Update 1217:The opposing camps at Westminster have naturally rushed to offer their take on today's figures. Ed Balls, for one, can't resist pointing out that the quarterly growth had slowed sharply since Labour left office. But he can't seem to decide whether these figures are the government's fault.

Initially, it seems that they are not to blame. The statement put out by the shadow chancellor's office says that the fourth quarter figures "are all the more worrying because they cover the period before the government's VAT rise and sharp public spending cuts have even begun". That seems right: the construction sector may have been affected by the sharp slowdown in public investment, but overall, the coalition's modest additional spending cuts for 2010-11 will not have had a large impact on these numbers (indeed, we had that surge in public spending in November).

But, later, Mr Balls asserts that "now we are seeing the first signs of what the Conservative-led government's decisions are having on the economy". He does not seem to be able to decide whether the economy is weak as a result of the coalition's decisions, or in anticipation of them.

Sources close to Mr Osborne naturally wish to stress the provisional nature of the figures, and the impact of the weather. More interestingly, perhaps, they say we should be encouraged by what's been happening to the the claimant count, and to tax receipts. According to the Treasury, each of those has provided useful early warning, in the past, that something was going seriously wrong with the economy.

The claimant count actually fell very slightly in December, and tax receipts throughout the quarter came in almost exactly in line with the official forecasts - which, in turn, were based on the OBR's forecast of modest growth. That is not something you often observe in a shrinking economy.

There's been some support for this assessment from independent commentators - though remember they are the ones trying to explain why their forecasts were so wrong.

This is what Nida Ali, economic adviser to the Ernst & Young ITEM Club, had to say about today's public finance figures:

"Tax receipts seem to be growing nicely and it's interesting to see that VAT receipts were up almost 9% on last December. Though part of this reflects the higher VAT rate (17.5% against 15%), it also suggests greater consumer activity in December than other sources have reported."

The world is squeezing us more than Mr Osborne

Stephanie Flanders | 09:56 UK time, Friday, 21 January 2011

Ministers complain that the commentariat is overstating the impact that coalition budget cuts will have on ordinary households in 2010-11. That is up for debate. But we are almost certainly under-estimating the squeeze being inflicted by the rest of the world.

The structural primary budget deficit is a fairly good indicator of how much a government is actively choosing to loosen or tighten policy in a given year, because it (theoretically) excludes the cost of debt interest, and purely cyclical changes in taxes and spending.

George Osborne


On that measure, policy is due to tighten by 2.2% of GDP in 2011-12. That's roughly 0.6% of GDP more than would have happened on Labour's pre-election plans, and more than most major advanced economies, but it's not much more than 2010-11, when the deficit is likely to have fallen by 1.9% of GDP.

On Tuesday I suggested that higher inflation - and other costs such as rising pension contributions - would probably have a larger direct impact on family incomes this year than the VAT rise and the like. Now I find that the economists at Goldman Sachs have conjured some numbers that make a similar point.

They calculate that the rise in VAT will cost households 1% of their disposable income in 2011. The public sector pay freeze may take another 0.3%.

Turning to prices, they reckon the lagged effect of recent big leaps in the price of energy and other commodities like wheat (up 60% in 2010) will increase household bills by nearly another 1% of income in 2011.

Assuming that other prices - "core" inflation (excluding VAT) - rise by around 2%, the average household would need to get a nearly 5% pay rise to keep their disposable income broadly the same. (Sharp-eyed readers will recognise that number: the Tax and Prices Index, a broad measure of the cost of living that includes taxes, rose by 5% in 2010 as well.)

Against that, the OBR is expecting average earnings in the UK to grow by just 2.2% in 2011: in other words, household income is unlikely to keep up.

You will also have noticed that the 'hit' from commodity prices is roughly the same as the hit from higher VAT. But that's forgetting the much bigger punch in the stomach that the global marketplace has already delivered to the UK consumer.

For much of the nineties and the first half of the noughties, the world - from a British household's standpoint - was getting cheaper. Outsourcing and the rise of cheap production in China meant the stuff we liked to buy as consumers became cheaper, relative to the things we made. If you were in work and had money to spend, it was a nice wave to ride. (In a later post I'll get into the crucial question of whether the Bank of England should have allowed inflation to come in below target more often during this period of adjustment, just as it is allowing inflation to go above the target now.)

In essence, companies can only shift their production overseas once. You can't generate these kinds of cost savings indefinitely. The Goldman Sachs economists suggest that the end of the great outsourcing boom, coupled with the rise in the pound and the jump in commodity prices, has now reversed nearly all of the gains that consumers made in that earlier period.

They reckon that this big change in the terms of trade for UK consumers has depressed household income by 4%, for a given amount of national output. In other words: it's not just that we've lost income thanks to the recession - it's also that the output we earn as employees now buys us less.

Oh yes, and they also think that the amount that we pay into company pension schemes (if we have them) has risen by about 2.5 % of wages since 2005, because very low bond yields in Britain and around the world have made the long-term funding gaps in these schemes even larger than they were before.

Putting it all together, the research suggests that, for any given level of GDP, UK households' real employment income had fallen by 6% in the last few years, even before the latest commodity price jumps. That might not make you feel any better about the increase in VAT - more likely the opposite. But when you're cursing Mr Osborne, you should also reserve some time to curse the global economy.

No labour market miracle, but no doomsday yet

Stephanie Flanders | 17:54 UK time, Wednesday, 19 January 2011

Today's labour market figures were not far off expectations, but that may show how low expectations have become. Last spring, we were all marvelling at how quickly unemployment had started to come down.

With several months of flat or rising unemployment, it is fair to say that the excitement has now worn off. But total unemployment, at around 2.5m, is still lower than many expected in 2009. A 6% decline in national output had most economists expecting a similar-sized fall in employment; the actual fall over the course of the recession was closer to 2%, in large part because workers have proved so willing to take cuts in pay and hours, either in their existing job or a new one.

I've said all this plenty of times in this blog. I thought it worth repeating today, because the mood around the labour market has swung from surprised optimism, to deepest gloom. True, anyone who announced a jobs market miracle on the back of last year's falls in unemployment has been disappointed. (In truth, most were a lot more cautious than that.) But that doesn't make the doomsday scenarios any more correct.

For all the ups and downs, I'm struck that the unemployment rate in the three months to November was 7.9%. In the same period in 2009 it was 7.8%. That is to say, we are more or less back where we were in the last months of the recession, when most were still expecting the jobless total to continue to rise.

That said, there are three developments under the surface that are worth mentioning - one somewhat encouraging, the others definitely not.

The encouraging fact is that overall employment in the UK has risen by 184,000. The data on private and public sector employment is less timely, but in the year to September 2010, employment in the private sector grew by 184,000, or 0.6%. For part of that year, Britain was still in recession.

Over the same period, public sector employment fell by 77,000. So, last year, at least, the private sector is likely to have created more than enough jobs to offset losses in the public sector.

That doesn't tell us anything about the future, of course. And we do know there were more public-sector job losses in the last months of 2010. But bearing in mind that this was only the first year of recovery, and the OBR is forecasting a total loss of employment in the public sector of 330,000 over four years, it's not too dispiriting.

More worrying - though perhaps not surprising - is the rise in the number of young people unemployed, and the creep upwards in long-term unemployment.

Of the record 951,000 of 16 to 24-year-olds out of work, around 270,000 are in full-time education (but looking for part-time work). That has sometimes distorted the "headline" changes. But not this time. The rise in unemployment among this group in the three months to November was due to falling numbers in employment or education - and a big rise in the number not in work and not in school. Not many silver linings there.

The rise in long-term joblessness is also striking: during the recession, labour market experts at the Department for Work and Pensions were surprised and pleased to see that the "exit" rate out of unemployment had held up, even as the number losing their jobs was going up. It's difficult to tell for sure, on the basis of the published numbers, but the rise in long-term unemployment suggests that this is less true today. Or at least, there is a growing "hard core" of people who are not finding work.

One-third of people on the unemployment rolls have now been there for over a year. The share was a third when the recession began. As John Hawksworth, chief economist at PwC points out in the chart below, this is still far below the peak of 45%, reached in the early 1990s. But it is worrying all the same. No jobs market miracle there, either.

PwC chart showing the rising proportion of unemployment is long term

Inflation: Risks on both sides

Stephanie Flanders | 10:47 UK time, Tuesday, 18 January 2011

The December inflation numbers are at the high end of expectations - with the target measure of inflation, the CPI (Consumer Prices Index), rising by 3.7% compared to December 2009. But energy and food prices are responsible for most of the rise - indeed, the 1.6% increase in food prices between November and December is the highest on record.

Person carrying shopping bags


No-one is happy that inflation has remained so far above target, for so long - least of all the Bank of England. With so many households seeing the effect on their shopping bills, you can see why David Cameron would want to signal recently, in an interview with Andrew Marr, that he shares their concern. Indeed, the chances are that the CPI will rise even further in the next few months - maybe reaching 4% by February or March.

However, there is little sign that a majority of the MPC (Monetary Policy Committee) is minded to respond with an early rise in the base rate. They remember that this has happened before, in only 2008, when commodity price rises pushed the CPI up to 5.2%. At that time, above target inflation led to the MPC seriously contemplating an interest rate rise, just weeks before Lehman Brothers collapsed. The Bank of England then had to slam into reverse, with unprecedented cuts in rates.

At least, in 2008, the Bank had room to slash rates to support the economy. Those who say the MPC should keep rates low point out that there isn't that kind of leeway today, if the recovery falters. They also note that inflation itself could pose a risk to the recovery.

Asked to name the single largest threat to growth this year, most would probably say public spending cuts, and the recent rise in VAT. But the recent rise in the price of energy, food and other imported goods - not to mention increases in pension contributions and the like - will probably have a much larger direct impact on the disposable income of the average household than this year's squeeze in public spending.

In predicting moderate growth for the UK in 2011, the OBR (Office for Budget Responsibility) is assuming that consumers will continue to do their part, with little change in Britain's still low personal savings rate. But, in the face of this kind of squeeze, it is surely possible that households will instead seek to cut back, with negative consequences for growth.

If that argument is right, high inflation could actually be deflationary in the medium term, and the MPC should continue to provide the economy with all the support it can get.

But of course, there is another possibility: that the squeeze in incomes will eventually lead people in work to demand - and obtain - higher wages to compensate them for their losses. If that happened, the private sector would not be able to create as many jobs, for a given amount of demand, as the OBR is expecting, meaning that unemployment would stay higher, for longer.

A broad-based rise in wages would also, almost certainly, trigger a response from the MPC. Naturally, the committee that sets Britain's official interest rates will be watching the inflation figures over the next few months. But they will be looking just as closely at what happens to wages.

Update 1240: Most City analysts have taken today's inflation numbers in their stride - many of them urging the MPC not to be "spooked" into raising rates. But Simon Ward from Henderson Global Investors has some interesting points to make for the other side. Here's what he says:

“It has recently become fashionable to quote the tax-adjusted inflation measures, CPI-CT and CPIY, which are running well below headline inflation, at 1.9% and 2.0% respectively (up from 1.5% and 1.6% in November.) CPI-CT is calculated at constant tax rates while CPIY excludes indirect taxes altogether.

“These measures, however, understate "true" inflation because they are calculated on the assumption that indirect tax hikes are passed on in full to consumers. ONS research on the December 2008 VAT reduction from 17.5% to 15% indicated pass-through of only one-third. Assuming that one-half of the increase in VAT and other indirect taxes last year was reflected in the prices charged to consumers, inflation would now be about 2.8% had tax rates remained stable.

“The current inflation overshoot should be viewed in a longer-term context. The consumer prices index for December was 4.4 percentage points above the level implied if the Bank of England had achieved 2% inflation since the target was switched to the CPI in December 2003, implying an average overshoot of 0.6% per annum. The RPIX measure (i.e. retail prices excluding mortgage interest costs) has exceeded the previous 2.5% inflation target by 5.3 percentage points over this period.

"Advocates of a rise in interest rates are not "inflation nutters" but believe that believe that action is required to prevent an upward drift in inflationary expectations that would worsen the output-inflation trade-off, thereby depressing medium-term growth prospects.”

The point is well made. It is simplistic to look at CPIY or CPI-CT and say, just because they are below 2%, there is no reason to worry. After all, those aren’t the measures of inflation that the MPC is legally obliged to target. Nor do they correspond to any common understanding of inflation. When we get to the check-out, we can't ask the cashier to charge us only at "constant tax rates". We have to pay the whole lot.

It's also worth remembering that these, more "benign" measures of prices rose just as much as the target measure in December. CPI at constant tax rates rose by 0.4 percentage points between November and December, from 1.5% to 1.9%; CPIY rose from 1.6% to 2%. That is what you would expect: the rise in VAT in January can only have affected the December figures indirectly. Food and transport prices were doing most of the work.

I don't get the impression that the MPC relies too heavily on either CPIY or CPI-CT in making their judgments. They are a rough indication of what might be going on beneath the surface - nothing more.

Like Mr Henderson, their focus is on what these high inflation figures might mean for future wages and inflation expectations, and ultimately, the long-term potential growth of prices and the economy. But for now, at least, they are drawing a different conclusion.

Do eurozone leaders need to keep failing?

Stephanie Flanders | 08:37 UK time, Tuesday, 18 January 2011

We are told that eurozone finance ministers meeting yesterday and today (with other EU ministers) in Brussels are keen to put the crisis in the single currency behind them.

Euro coins and notes

Well, maybe. But you could argue that they shouldn't put it too far behind them. Why? Because across the eurozone, governments are pinning their recovery hopes on a weak euro. And in 2011, most analysts are expecting the euro to go up.

Arguably, the only way to stop the euro from strengthening, in the current global environment, would be for ministers to continue to mismanage the crisis. In other words, to support the real economy, they need to fail to put at least some of the markets' worries to rest.

Naturally, I am being a little facetious. But I have been struck by the number of city forecasters predicting that the euro will go up in 2011. Goldman Sachs, for example, is betting that one euro will be worth $1.50 by the end of this year.

The logic is not so much that Europe is strong - more that the dollar has to fall for the US current account deficit to come down. And of course, monetary policy is also on the side of the euro. Jean-Claude Trichet's remarks last week confirmed that the ECB is a lot closer to raising interest rates this year than the Federal Reserve.

You have to imagine the euro would have strengthened a long time ago, had it not been for Greece, Ireland and the rest. There was a relentless rise in the value of the euro against the dollar in the first years of the single currency, peaking just shy of $1.60 in the summer of 2008.

It fell sharply in the wake of the crisis, only to creep up again in 2009, when European investors were bullish, and no-one was paying much attention to what was going on in Athens - or Madrid.

By the end of November 2009, the euro was back up at $1.50. But then, the world discovered the PIIGS. Bad news for Greece, Ireland, Portugal, Spain and the rest, and anyone holding their government debt - good news for the eurozone's exporters, especially the German ones.

The longer eurozone policy makers fudged and delayed, the more competitive German exporters became. At the end of May 2010, the euro was down at $1.20.

Since then, the currency has been even more closely linked to ministers' ability to keep a grip. Amazingly, it was back at $1.40 at the end of the year, as traders briefly stopped worrying about Portugal and Spain. Then it slumped again - falling again, today, on fears that ministers would not make much headway on proposals to expand the eurozone's new bailout facility - the EFSF - and/or make it more nimble in response to market shocks.

I don't think that the eurozone's finance ministers are failing to resolve the crisis on purpose. It's not as if this is an easy problem to fix. And of course, a full-blown panic over Europe's sovereign debt would do far, far more damage to Europe's financial system and its economy than a rise in the value of the euro. And this degree of volatility in exchange rates does no-one any good - exporters least of all. Still, in this "race to the bottom" among the major currencies, Europe's knack for crisis mis-management may be the strongest weapon it has left.

Commodities can still shock

Stephanie Flanders | 19:28 UK time, Thursday, 13 January 2011

The global economy may have come a long way, but in large parts of the world, the past few weeks are a reminder that ordinary life still revolves around a handful of basic goods. And rising food prices can still all too easily bring a government to its knees.

Just ask the Indian prime minister, who recently authorised emergency onion imports from Pakistan - after the domestic price of an onion trebled, in just one month. According to the FT, at least two Indian governments have been felled by the rising price of onions in the past.

We also have the government of South Korea releasing emergency supplies of cabbage, pork and mackerel, among other things, to keep control of rising inflation. And the Indonesian president launching a national campaign to encourage people to grow their own chillies. As I discovered from taking part in a special segment on the GMT programme this afternoon, in Indonesia, chillies are a very, very big deal. And their price has quintupled in barely a year.

Depending on how you measure it, commodity prices are now close to where they were in 2008, when food riots broke out around the developing world, and rising inflation in the UK and other big Western economies made it more difficult to cut interest rates in the lead up to the financial crisis in the autumn (see the chart below).

Headline food prices

Many hope that this time it's different, because only part of the rise in prices is due to rising demand. The rest is due to (hopefully) temporary hits to supply, from crop failures and other shocks. Commodity prices have also been inflated by the fall in the value of the dollar.

In its latest edition of Global Economic Prospects, the World Bank shows that the domestic currency price of food, in many countries, has not risen nearly as fast as the dollar indices suggest (see chart below). Not that this is likely to be much comfort to anyone struggling to make a decent bhaji in downtown Mumbai.

Chart showing food prices will remain well below 2008 peaks

Even if it is temporary, food inflation is clearly making an awkward situation worse in countries like China and India, which were already struggling to keep a lid on prices.

We shouldn't forget there is an important benefit to higher food prices: by raising rural incomes, they can actually help to lower the gap between urban and rural incomes. That is especially helpful in China. But the authorities there are rightly terrified of letting prices get out of control. Controlling inflation, in 2011, is priority number one.

But when it comes to oil, steel and other basic materials, the likes of India and China can at least comfort themselves that rising prices come partly from their own economic success. It is their growth is pushing up demand for these goods, even as the major economies struggle to put their recessions behind them. That had not happened very often in the past. With the notable exception of the oil crises of the 1970s, where rich country demand has gone, commodity prices have tended to follow.

Not for the last time, consumers and policy makers in the West are learning that when it comes to the global economy, they no longer call all the shots. There is also that lurking worry, that ultra loose monetary policy in the US, Britain and eurozone might be having a greater effect on prices and activity in the emerging world than it is having here.

Portugal: The next chapter

Stephanie Flanders | 12:15 UK time, Wednesday, 12 January 2011

The Portuguese government almost certainly has the ECB to thank for being able to borrow 10 year debt from the markets this morning at an interest rate of around 6.7%.

A Portuguese broker talks on the phone in Lisbon

But even with this auction, most now consider it a question of when, not if, Lisbon will join the list of eurozone governments turning to Europe and the IMF for emergency support.

Today's much anticipated auction will come as a relief. But Portugal's government needs to borrow around 20bn euros from the markets this year - a big chunk of it in the first few months. It is not plausible to anyone that they will finance that debt at an interest rate even close to 7%.

By my (very rough) reckoning, its long-term cost of borrowing needs to move below 6%, for it to have a chance of stabilising the stock of government debt relative to GDP within the next few years.

You might wonder what the fuss is all about. Like Greece and Ireland, Portugal represents a tiny fraction of the eurozone economy, and the eurozone bailout facility - the EFSF - has plenty of money in the kitty to back a joint IMF-European support programme that could keep Portugal from needing to return to the markets for a few years. The figures mentioned have been in the region of 50bn euros.

As I said on the Today programme this morning, European policy makers - and investors - worry about a Portuguese bailout, not because of any inherent concern for that country, but for what it symbolises - and for what might happen next.

The key point is that Portugal is not an outlier. Its government has borrowed more than it should, and delayed a bit too long in getting on top of that borrowing. The upcoming election is producing some unhelpful mood music on that subject. But even a year ago, you would not have said that its fiscal position was inherently unsustainable. It is not Greece.

Yes, Portugal's banks are being kept afloat by the ECB (like Ireland's have been in the past year). But they do not have a mountain of bad private debt sitting on their balance sheets. It is not Ireland.

As Robert Peston has described in the past, Portuguese banks would need to be re-capitalised as part of any bailout. But they have been made weak by lack of confidence in government debt: the contamination runs from the sovereign to the banks. This is not an Irish situation, where toxic private sector assets have contaminated the balance sheet of the government via a sweeping sovereign guarantee.

No, Portugal's problem is that whatever issues it has with its banks and its public borrowing are being greatly magnified by the country's weak prospects for growth.

The consensus forecast is for the Portuguese economy to shrink slightly in 2011, after very meagre growth in 2010. By contrast, Germany is expected to grow by at least 2.5% in 2011, after growth of around 3.6% in 2010.

If the Portuguese had that kind of recovery to look forward to, the world would have been a lot less interested in the results of today's auction. And investors would not be placing their bets now on a pre-emptive show of support for Portugal's much larger neighbour, Spain.

It would be easier for everyone if Portugal looked just like Greece - or Ireland. But it doesn't. Arguably, it has more in common with other countries on Europe's periphery that are being held back by a lack of confidence in future growth. If the markets are right, a Lisbon bailout is a matter of time. But after Portugal, it becomes more difficult to draw a line in the sand.

The US as deadbeat: discuss

Stephanie Flanders | 18:04 UK time, Friday, 7 January 2011

Asked to name the biggest threat hanging over the global economy in 2011, most people will tell you it's the crisis in the Eurozone. Newsnight spent a lot of time debating its future only last night.

But since I'm moonlighting tonight as Newsnight's presenter, I decided we should also think about a more distant - but ultimately much larger - cloud on the global economic horizon. That is the possibility of a full-scale loss of confidence in US assets.

It's not an issue for the next few months, perhaps, especially with decent prospects for US growth in 2011. But both at the state and the federal level, America is awash with red ink, with debt rising "as far as the eye can see." Looking at these numbers, and America's dysfunctional politics, if investors ever started to question America's creditworthiness, or seriously sell the dollar, it could make the bailouts on the European periphery look like a tea party.

Ben Bernanke, the head of the US central bank got his first chance to address the New Republican congress today. He was cautiously optimistic about the US economy - too cautious for many in the markets - the dollar went down today on the back of his remarks, and some disappointingly weak new jobs figures. But this is what he had to say about the long-term threat posed by America's 1.4 trillion dollar federal budget deficit:

"It is widely understood that the federal government is on an unsustainable fiscal path. Yet, as a nation, we have done little to address this critical threat to our economy. Doing nothing will not be an option indefinitely; the longer we wait to act, the greater the risks and the more wrenching the inevitable changes to the budget will be. "

If it were any other country, the ratings agencies would have got that downgrading pencils out for the US a long time ago. The US budget deficit last year was well over 10 per cent of GDP - and thanks to another round of tax cuts, it's going to be at least that high in 2011.

By contrast, the average deficit of the so-called "PIIGs" - the troubled Eurozone economies - was about 7.5 per cent of GDP.

Government debt is rising nearly everywhere, but the IMF forecasts that America's national debt will rise to more than 110 per cent of GDP by 2015 - compared to a developed country median of 81 per cent. And America is the only major economy to have just passes a fresh stimulus package for 2011 and 2012.

The new Republican congress has promised its 'tea party movement' followers that it will cut spending and "take back Washington". Republicans have already supported a new rule, whereby every spending increase has to be matched by a corresponding spending cut. That kind of mechanism has been successfully used in the past to keep a lid on deficits. But there's a big problem: on the new rule, tax cuts do not have to be paid for in the same way.

So, in the new Congress, taxes can go down - but they are extremely unlikely to go up. (Even though, as I've commented before - the IMF and others believe that the US is 'under-taxed'.) And, as the Economist pointed out last week , for all the talk of spending cuts - there is a zero support - in or outside Congress for cuts in the benefit programmes for retirees which take up an ever-larger share of the budget.

Though signs of faster growth have pushed up US bond yields in recent months, you have to say that investors have been remarkably calm about all this so far - for the usual reasons. The US is still the world's largest economy and the dollar is still the world's reserve currency. When it comes down to it, there aren't a lot of other places for investors to take their cash. But if the past few years have taught anything it is that once market doubts start to take hold, they can be very difficult to turn around.

Investors may spend much of 2011 watching Congress and the White House battle it out over the budget - with no agreement on any long-term strategy to cut borrowing. They may also shortly get a few frights at the state level, with serious questions now being raised about a California default or messy bailout, for example.

If any of that leads the financial markets to start questioning the creditworthiness of the US government - or the long-term value of the US currency - things in the global financial system could get quite ugly, quite fast.

Measuring the VAT squeeze

Stephanie Flanders | 15:32 UK time, Tuesday, 4 January 2011

Who will pay for the rise in VAT? It's such a simple question. Unfortunately, the facts leave plenty of room for politicians - and others - to disagree.

Shopper with bags


You would think it was all pretty easy. The government is raising an extra £12.1bn in 2011-12 from increasing VAT to 20%. There are 26 million households. So, you would think, the average household will pay an extra £465 per year.

Except, you'd be wrong. Because it turns out, only around two-thirds of VAT is paid directly by households. As Bill Dodwell, Deloitte's head of tax policy, reminded me, the rest is paid by property companies, government departments, charities, and other businesses who for one reason or another can't claim back their VAT. (Of course, all taxes are paid by households, eventually - either as consumers, or shareholders, or employees - but I'm talking here about the direct hit from raising VAT).

So there's maybe an extra £8bn being raised directly from households with this increase (two-thirds of £12.1bn). If you divide that by 26 million, you get an average loss of around £307 per year.

But of course, a lot gets lost in an average. Mr Dodwell and his colleagues at Deloitte have taken the trouble to look at what families in different parts of the income distribution actually spend on VAT-able items, as revealed by the ONS Family Spending survey [1.52MB PDF]. On that basis, they were able to tell me what the impact would be on different families' weekly expenditure, if they tried to buy the same goods as they were before.

On average, Deloitte calculates that as a result of the VAT rise:

Households in the middle of the distribution (the fifth and sixth decile, by spending) will have to pay an extra £3.96 per week, or £206 per year.

Those in the top 10% of households will pay an extra £10 per week - or £520 per year.
And those in the bottom 10%, by expenditure, will pay an extra £1.30 a week, or £68 a year.

As a share of expenditure, the Deloitte figures show the poorest losing 0.8%, the middle losing 0.96%, and the richest just over 1%. In that sense, these figures back up the point made by the government, that the VAT rise is not regressive if you look at the impact on households, relative to their expenditure.

Back in the summer, the IFS made this point in their response to the June Budget [488KB PDF]. It came up with roughly similar percentages to Deloitte.

And yet, the traditional definition of a regressive, or progressive tax is relative to income. In those terms, the VAT rise is clearly regressive (as you can see on page 9 of that presentation from the IFS) The hit to the poorest 10th represents about 2.5% of their income, versus a roughly 1% hit for the those at the top. In that old-fashioned sense, the tax change is regressive.

The same point emerges, more strongly, when you consider the combined impact of all of the tax and benefit changes due to come into force over the next two years. As the IFS has said for some time, these are clearly regressive across the bottom 9/10ths of the income distribution. The poorest 10th stand to lose 3.4% of their income, by January 2013, which is more than any other group except the top 10th, which lose 4.1%. Again, the picture looks fairer if you measure the losses relative to expenditure. By that measure, the poorest lose 1.9% and the richest lose 6.2%.

Looking beyond today's news, to the freeze in child benefit, the removal of family tax credit from many families, the real terms cut in the higher rate threshold, and all the rest, James Browne at the IFS tells me that households in the middle of the income distribution (the fifth and sixth deciles) will have lost about £10.60 a week - or more than £550 a year - by January 2013. So VAT going up to 20% is, quite literally, not the half of it.

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