Before we delve into the guts of the McKinsey report, there are a couple of points you need to bear in mind.

Firstly, in a mature economy investment does not need to be that high. See it in terms of two farmers, a farmer that is well established and one that has only just set up. Our established farmer will probably have a decent combine harvester, all the necessary number of tractors, and lots of mod cons that help make the farm as productive as possible. Such a farm does not need much investment, normally requiring further input only to maintain equipment, or if a new wonder product comes out which will help improve productivity. This farm is analogous to a mature economy in which innovation, and not investment, leads to growth. The second farmer, on the other hand, has insufficient infrastructure, and every pound of investment leads to a significant rise in productivity.

It seems that when the Second World War ended, the developed areas of the world were all operating way below potential. All of the world’s economies had vast potential to increase productivity by investing in infrastructure, machinery and any other forms of capital you can think of. And so, for 25 years the global economy enjoyed a golden age. It was an age that ended in the mid 1970s.This column has argued before that inflation in the 1970s occurred because output growth slowed, but growth in demand didn’t. In Japan it was even worse, as she suffered from the triple blow of the bursting of a bubble in asset prices, an ageing population, and the ending of her period of technology catch up.

Secondly, economic theory says investment is funded by savings. So if saving is high and investment low, we get low interest rates. If investment is high and saving low, interest rates shoot up.

During the golden age of growth, disposable income per person in the developed world rose sharply. Your average household in the UK was much better off in 1973 than in 1950, and yet throughout this period, real interest rates were quite high. The fact that real rates were high was not a good thing per se, but the factor that caused them to be high was good. Or to put it another way, high real interest rates were a symptom of the fact we were becoming better off.

From the mid 1970s onwards, investment in the developed world slowed. McKinsey estimates that total global investment between 1980 and 2008 was round $20 trillion less than it would have been had total investment as a proportion of GDP stayed at the level seen during the 1950s and 1960s.

By the late 1990s and noughties, saving had risen too. Saving rates were high in Japan, and the money saved flooded into the US and Europe via the carry trade. And then as China started to save, in part as a reaction to the shoddy treatment handed out by the IMF to the Asian Tiger economies after their 1997 crisis, we saw the emergence of a global saving glut.

This saving glut fed the credit boom in the West.

It seems that during the period we also saw an increasingly uneven distribution of wealth, but the populace were placated largely because of the combination of cheap interest rates and ready supply of credit, which led to rising property prices and made people feel better off.

And then for the final act in this chapter came the credit crunch and the global economic crisis.

But maybe the global economic crisis was little more than the death-knell of that particular economic era.

And death-knell suggests a new era is beginning.

McKinsey Global put it this way: “Developing economies are embarking on one of the biggest building booms in history. Rapid urbanisation is increasing the demand for new roads, ports, water and power systems, schools, hospitals and other public infrastructures. Companies are building new plants and buying machinery, while workers are upgrading their housing. At the same time, ageing populations, and China’s efforts to boost domestic consumption, will constrain growth in global savings. The world may therefore be entering a new era in which the desire to invest exceeds the willingness to save, pushing real interest rates up.

Higher capital costs would benefit savers, and perhaps lead to more restrained borrowing than we saw during the bubble years. However, they would also constrain investment and ultimately slow global growth somewhat.”

In other words, investment across the world is set to explode. The report went on to say: “The world is now at the start of another potentially enormous wave of capital investment, this time driven primarily by emerging markets. We predict that 2020 global investment could reach levels not seen since the post-war rebuilding of Europe and Japan in the era of high growth in mature economies.”
McKinsey predicts that by 2030 global investment will be around $24 trillion, compared to $11 trillion today.

But as investment rises, suggests McKinsey, savings are set to fall.
Firstly they will fall as China’s consumers begin to save less and spend more. We have written about this many times, so we don’t need to go into more detail here today.

Secondly, suggests McKinsey, savings will fall as the ratio of retired to working population rises, meaning more money will be spent on healthcare, and less saved.

The result, says McKinsey, will be higher real interest rates, but at the same time the global economy may embark on another golden age of growth. One assumes that during this transition period, we will see default by a number of individuals, companies, banks and countries with high debts.

That leaves us with just one comment: the baby boomers.

Several times before, this column has argued that as the baby boomers approach retirement, saving rates will rise, creating deflationary pressure. Then, once the baby boomers have all retired, those savings will be eaten into, and inflationary pressures will be created.

The McKinsey report is fascinating indeed, and the report’s key assumption is surely right.

We suspect, however, that the baby boomer effect muddies the picture, and as yet it is not clear how the combination of ageing in the West will interact with an investment-led boom in the developing world.

For the McKinsey report, see:
Farewell to cheap capital? The implications of long-term shifts in global investment and saving

But there is another point of view. Some say the real problem is growth itself. The New Economic Foundation (NEF) isn’t one of your more typical economic think tanks.  It talks about things like happiness, and says that our big problem isn’t so much how we get back to growth, rather that it’s our need for growth in the first place. Yesterday it released a new report with the main title “Growth isn’t Possible”, and with the sub heading “why we need a new direction”. 

Are these New Age ideas put forward by NEF right?

Imagine, if you will, a hamster. Now, imagine that hamster doubles in size every week. But this hamster is different from the other little animals of its kind that kids seem to love. For this hamster doesn’t reach maturity, and then stop growing. Rather, it continues to grow. According to the new report from NEF, by the hamster’s first birthday it would weigh 9 billion tonnes.

NEF’s key argument is that growth is only supposed to take place while we are reaching maturity. It is not meant to occur indefinitely.

They make some good arguments. In fact, they make some very powerful arguments; strong enough, perhaps, to make your hair stand on end. Even so, there is another side to the debate.

Here is the bit to make you sit up. At least, your hair should be standing if the NEF is right. It has listed a number of all important boundaries to our exploitation of the earth. For example, it lists the proportion of CO2 in the atmosphere, the rate of biodiversity, and global use of fresh water.  And then suggests that each of these variables has an upper limit, beyond which it is simply dangerous to tread. And lo and behold, according to NEF we have already passed the safe limits for carbon dioxide concentration, the rate of extinctions, and the amount of nitrogen we have removed from the atmosphere. And for the quantity of phosphorus flowing into oceans, concentration of ozone, and ocean acidification we are perilously close to the limit.

And here is something else that should make even more of your hair stand up.

The NEF said: “Between 1990 and 2001, for every $100 worth of growth in the world’s income per person, just $0.60, down from $2.20 the previous decade, found its target and contributed to reducing poverty below the $1-a-day line. A single dollar of poverty reduction took $166 of additional global production and consumption, with all its associated environmental impacts. It created the paradox that ever smaller amounts of poverty reduction amongst the poorest people of the world required ever larger amounts of conspicuous consumption by the rich.”

To explain why NEF reckons growth isn’t possible, it then delves into physics. The First Law of Thermodynamics, as you may remember from your school days, says that within a closed system energy is not created or destroyed, it merely changes form.

The Second Law of Thermodynamics says that heat escapes. This law has also been called the Law of Chaos, because it says that eventually heat spreads out everywhere, right across the universe. If you pour milk into a cup of tea, chances are the milk will spread out evenly across the drink. It is possible, of course, that by a remarkable fluke, all the milk atoms remain in close proximity to each other and that the milk stays at the surface of the drink. It reality, the chances of this occurring are so tiny, that it is effectively impossible. The Second Law of Thermodynamics says that unless there is an external force in operation, energy will spread out evenly across the universe, eventually. It explains why buildings crumble, and cars rust.  So we can stop Venice from sinking, but only by constantly working on the city’s foundations. We can stop a drink from cooling, but only by applying more heat.

The NEF quotes a certain CP Snow who said: “The first law says you can’t win, the second law says you can’t even break even.”

So that’s it then. We have got to stop the emphasis on growth.

Now NEF has some good points.

But there is another point of view.

NEF says we can’t keep growing. Take, as an alternative, this view expressed by the economist Paul Romer, who has a quite different view on our ability to see continued growth.

He has said: “I’ll say until about 5 billion years from now, when the sun explodes – we’re not going to run out of discoveries. Just ask how many things we could make by taking the elements from the periodic table and mixing them together. There’s a simple mathematical calculation: it’s 10 followed by 30 zeros. In contrast, 10 followed by 19 zeros is about how many seconds have elapsed since the universe was created.”

Then there’s the population explosion. Part of the problem we are facing is that the world’s population is growing so fast that we are being forced to innovate just to keep pace with the needs of this growing populace.

As for the argument that global warming means we have got to stop growing, the argument suggested here on numerous occasions is that actually the real problem is that we learnt to specialise in the wrong form of energy. We put too much emphasis on carbon fuels. If we were to start throwing resource at renewable energy, our ability to exploit this form of energy would improve, until it eventually became cheaper than traditional carbon based fuels.

Maybe the real problem with growth is the way it is measured. Maybe the global economy’s GDP should be measured the way a company measures its strength, via profit and loss and balance sheets.  We don’t draw up balance sheets for the economy, and that may be the problem. If we measured the economy using this method, then if we were to run down natural resources, this would show up as a fall in assets, and be reflected in the P&L.

Then there is another point. In its report NEF says: “The American economist Herman Daly argues that growth’s first, literal dictionary definition is ‘…to spring up and develop to maturity’. Thus the very notion of growth includes some concept of maturity or sufficiency, beyond which point physical accumulation gives way to physical maintenance.”

But is it not the rather sad case that once we stop growing, we know the process of ageing has begun. As all readers of this article who are of a similar age to its author will be all too aware, the end of growth is followed eventually by death.

So the NEF says that continued growth is not natural.  But death is natural. And the alternative to an end to growth, could be something quite nasty.

See Growth isn’t possible from NEF for more

http://www.neweconomics.org/publications/growth-isnt-possible?utm_source=nef+%28the+new+economics+foundation%29+List&utm_campaign=38f51069f9-eletter-hamster&utm_medium=email

Then in the last budget it all changed. Net debt was forecast by the chancellor to peak in 2014 at 80 per cent of GDP.  Since then analysts have pored over these estimates, and it seems there’s a good chance Al will up his estimate of the final size of net debt in the Pre-Budget Report.

And so commentators predict doom. Writing in the Telegraph, Liam Halligan talked about the nonsense of Keynesian economics. He reminded us that next year fiscal borrowing as a percentage of GDP is likely to be double the highs reached in the mid 1970s, when Britain had to call in the IMF for help.

Across the blogoshere commentators are spreading their tales of woe. They are saying that debt will be so high that investors will simply be unwilling to lend the government the money it requires, unless they are offered a much higher return. So interest rates will rise, and it will become nigh on impossible to fund the interest on our debt.  Britain will then join Argentina in the list of once-wealthy countries that went bust.

So that’s the argument. The question we need to ask is are they right? Are things really that bad? Today we attempt to answer that question. The conclusion may surprise. For while it is true that there is a danger things could turn nasty, the more likely scenario is far less dire. But it does all rather depend.

The first thing you need to bear in mind is that the future course of interest rates is crucial. Earlier this year, the Institute of Fiscal Studies concluded that providing interest rates stay at the low levels we have seen of late, then the cost of repaying debt will actually be similar to the cost incurred in the 1990s.

So, if you think the cost of repaying debt is more important than the size of the debt, in a low interest rate environment our projected fiscal debt would appear to be affordable.

The second thing you need to bear in mind is that fiscal debt in the UK has been much higher in the past. It reached 250 per cent of GDP after the Second World War and the Napoleonic War.

The third thing you need to bear in mind is that the UK is not alone. Japan’s fiscal debt is already over 200 per cent of GDP, and is expected to rise further still. A few months ago the National Institute of Economic and Social Research predicted that net debt would peak at an even higher level in Italy, Germany and the US, and would only be marginally lower in France and Canada.  In other words our projected fiscal deficit is actually better than the predicted G7 average.

Rather than ask the question is the UK set to go bust, it may be more pertinent to ask will the G7 go bust?

The Japanese experience is illuminating. Japan has never had any major problem funding government debt at all. The main reason is simply this: savings are high in Japan, meaning spending is low, meaning economic growth has been anaemic. But because savings are so high, the government has had no problem funding debt. In other words the very factor that created poor economic performance leading to high government borrowing, was the same factor that meant the government had no problem raising the money it required, and at a low interest rate too.

The same argument applies, but if anything more so, when you look at the G7 as a whole. One assumes the only occasion in which the G7 governments will find it impossible to raise the money they require would be in circumstances in which savings start to fall, and rising consumption pushes up growth. Under these circumstances the government wouldn’t need to borrow so much anyway.

Finally, you need take into account the retirement of the baby boomers. One assumes that as the horrible truth dawns on this generation that they don’t have enough money saved for their retirement, the savings ratio will shoot up, which should in turn push down on interest rates.

There is a snag with all this, however.

One of the reasons why the massive fiscal debt after the Second World War was affordable was because the economic growth that followed over the next 25 years was without precedent.

If your debt equals your annual income, but then your annual income increases by 3 per cent a year, and all you do is repay the interest, within 25 years the debt will have fallen to just half of you annual income. For a government this argument is even stronger, because if national income is rising, so too are tax receipts, meaning borrowing should automatically fall anyway.

The UK economy enjoyed its best ever run of growth during the 25-year period after the last world war.

By 1973 this growth rate had slowed down. Maybe that is why the UK’s debt suddenly became unmanageable; we had become so used to high growth that we simply hadn’t adjusted our habits to a lower growth regime.

Right now the potential for growth is probably as impressive as was the potential back in the late 1940s. Technology seems to be advancing, if anything, at an accelerating rate. In the US, productivity has been rising at an annualised rate of 4 per cent.

If we let capitalism work, let businesses that are getting it wrong go bust, and provide the opportunity for new businesses to expand, the growth rate over the next decade or two could indeed be impressive; meaning net debt will be reduced quite rapidity.

But the backlash against capitalism threatens this. The banking rescue has set a precedent for saving struggling businesses.

The real danger to the UK’s future performance lies not in the size of government debt, but in the government and public overreacting, creating a backlash against risk, and sending us into a cosy world of corporatism, in which large companies are not allowed to fail.

So last night and this morning we have seen a raft of reasons for cheer. From a buoyant High Street, to news that more regions saw rises in house prices in April than in any other month since the beginning of last year, while even the OECD sounded optimistic.

It is just that there is another side to it.

For one thing, it was a funny type of optimism displayed by the OECD. Sure, it sees improvements in the UK, France, Italy and China, but rather than beating the drum of exuberance, it used the word “pause”. It talked about these economies seeing a “pause in the economic slowdown”.

So that’s a little odd. If someone is trying to prove that if it was made into an Olympic sport, then they could talk for Britain, and then they “pause for breath”, you may count your blessings, but you know the verbal onslaught will continue.

So it is strange that the media were so euphoric over the OECD’s “pause” in the slowdown comment.

In fact, the OECD had warnings aplenty. Its chief economist Klaus Schmidt-Hebbel said that the global recession will be even worse than estimated by the IMF a few weeks ago. He talked about the recession being at its worst point so far – that’s now, right now. “There’s no doubt. I think this quarter will be the worst quarter of all,” he said. He fretted about the bogey of protectionism, saying “under no circumstances should mistakes from previous crises be repeated. Keeping markets open and avoiding new protectionism is key to strengthen prosperity throughout the world,” he lectured.

And then he turned his ire on the talk of subsidies that is going around at the moment. He wants to see any form of state aid to a non financial organization “phased out quickly”.

In the article above, it was told how the OECD’s index which tracks leading economic indicators and produces a composite score, had improved for the UK, France, Italy and China. But, alas, the indices for the US, Germany and Japan are still down, deep into recession territory.

It seems hard to believe the UK can enjoy that much of a recovery when so many of our leading trade partners, including the US, Germany and Ireland, are in such a state.

Capital Economics had a warning about the banks too. You may know, history tells us that more businesses go bust coming out of a recession, than going in. The longer the recession lasts, the more businesses will go bust. This means banks will see bad debts rise. Capital Economics put it this way: “Lloyds has seen a ‘significant rise in impairment levels’ and expects this rise to continue. RBS said that impairment losses had ‘been building… across all businesses and sectors’ and that conditions will deteriorate further over the next few quarters. And Barclays expects ‘the loan loss rate to increase further across all business lines’.”

It concludes: “A big question mark remains over whether the boost to banks’ reserves from quantitative easing will translate into a wider boost to bank lending. In turn, a return to positive growth in the economy could yet be some way off.”

The price of government bonds is falling, meaning the markets are demanding a higher return on loans to governments across the world. There is no surprise here. China has made clear its reservations about funding the US fiscal deficit. Debt levels in the UK and the US are so high, that there has to be a very real risk that interest rates will have to rise in order to ensure adequate flows of money.

Those people who are being seduced by low interest rates should take this into account. The current pick up in the market could be creating more problems further ahead. Remember, house prices to salaries are still high relative to the 1990s.

The surge in Chinese investment has helped boost commodity prices, which is not good for consumer affordability – although Capital Economics thinks the real factor behind recent rises in oil and the like has been speculative.

But it seems the bigger problem lies in overreaction.

When times are good, we all tend to jump on, making the good times seem even better, creating a bubble. When times are bad, we jump off, making things even worse. This is why some say the government can even out the cycle, dampening demand during a boom, boosting it during a slowdown.

And that brings us to the real underlying issue. The real danger to the economy does not lie with the natural economic cycle – rather, it lies with the best laid plans of humankind, creating a much bigger mess. To see why, read the next article.

This time it was the latest comments from the IMF’s big cheese, Dominique Strauss-Kahn, who has become even more bearish, and has now coined the phrase “Great Recession” to describe the current conditions.

Meanwhile, the National Institute of Economic and Social Research released its latest set of economic estimates for growth in the last quarter up to February, while the latest trade figures from China made last month’s figures, which at the time seemed awful, look rather good.

But cheer up, it’s Wednesday already, and besides, you can make a positive twist on all this.

The IMF was the first to try and drown us in bad news. Dominique Strauss-Kahn warned yesterday that the IMF was set to downgrade its projections for global economic growth this year, from positive 0.5 per cent to contraction. There has been no global contraction since the end of the Second World War; normally when some parts of the world contract, others grow.

He said: “I think that we can now say that we’ve entered a Great Recession. This recession may last a long time unless the policies we’re expecting are put in place, in which case 2010 can be a year of return to growth.”

As for the National Institute of Economic and Social Research (NIESR), in its latest monthly report it pencilled in a 1.8 per cent fall in output during the three months to February. NIESR said: “The level of economic activity has now fallen back to that in August 2006 and is 4.3 per cent below its peak of April 2008.

“The economy is experiencing a combination of a sharp reduction in stock levels and very weak demand for manufactured goods. The contraction is likely to slow only when businesses have reduced their stock holdings to desired levels.

“It is possible that increased availability of bank credit may make it easier for businesses to finance stocks and thus slow the rate of contraction. The policy of quantitative easing may help in this respect, but it is a pity that it is not focused more on supporting the market for corporate debt since that would help businesses directly.”

And finally, there was China. Exports fell by 25.7 per cent in February, imports were down 24.1 per cent. As for China’s trade surplus, it stood at just $4.84 billion in February. To put that in context, in November the surplus hit $40bn.

There were hints, however, that the government’s stimulus package is beginning to have an effect, with investment spending rising and data to suggest growth in loans.

So what’s the good news in all this? Well, for one thing, it is Wednesday already, and for another thing, what was it now… Oh yes, if there is any lesson from the developments of the last few weeks, it is that large exporting countries are suffering just as badly as the large importers. In fact, Japan saw a trade deficit recently, and in Germany the economy seems to be heading downwards faster than you can drive a BMW down the autobahn. But, if you believe the underlying cause of this crisis was global imbalances, then at least we are seeing signs the global economy is adjusting. The recent collapse in sterling is another sign of this.

Whichever way you look at it, when this crisis ends, the countries with large trade surpluses and too much savings will come out the other end stronger. It seems that ultimately this crisis will see the transfer of some assets from debtors to credit countries, and probably at rock bottom prices. China will come out the other end stronger. The US, weaker.

So, never shy of course of meeting a challenge, today we are supplying you with a whistle-stop tour of these fascinating developments.

Before we get into some of the profound stuff that has been uttered and occurred, and which we will be coming to in the articles below, here is a quick run down of the major developments seen over the last 24 hours.

Strap yourself in. There is enough news and analysis packed into today’s relatively short articles, to keep your mind working for days after you have finished reading.

The headline of the day, of course, is that the UK is officially in recession. According to the Office for National Statistics, the UK contracted by 1.6 per cent in Q4. This followed a 0.6 per cent contraction in the quarter before. For the UK economy, a recession is defined as two quarters of successive negative growth. Incidentally, in Q2 this year growth was flat.

The fourth quarter did in fact see the largest contraction since 1980. The last two recessions both lasted five quarters.

One of the curiosities of the ONS stats is that it has the High Street performing quite well. Indeed, the retail sector was one of the stars of the quarter. Not everyone is convinced, but whether you agree with the data or not, it seems certain the next quarter will see falls in retail.

Meanwhile, the CBI produced supporting data yesterday demonstrating the plight of manufacturing. The CBI’s headline index for tracking the manufacturing sector fell to its lowest level in 17 years. Just 56 per cent of companies reported a fall in the volume of new orders compared with the previous quarter, while just 14 per cent reported a rise, giving a balance of -43. 

And what about expectations? The CBI survey found that 70 per cent of companies are less optimistic than three months ago, while just 6 per cent are more positive, giving a negative balance of -64, the lowest in more than 28 years, since July 1980.

Put the news from the CBI together with pessimistic expectations on retail, then it seems likely that the first quarter of this year will see an even bigger fall in GDP.

Meanwhile, the FSA revealed its latest data on property repossessions and arrears. In Q3, no less than 339,700 mortgages were in arrears. That’s 25 per cent upon the year before, but more worryingly, 10 per cent up on the previous quarter. 3,161 mortgaged properties were taken into possession by lenders in the quarter, and this was… well, take a deep breath, the next stat isn’t good. Q3 saw a 93 per cent rise in the number of properties taken into possession compared with the same period a year ago.

The government is trying its best to reduce the number of properties taken into possession, but latest estimates suggest no more than 15,000 households will benefit from the current schemes available. So really, compared to the third of a million mortgages in arrears, that 15,000 is just tiny. In the early 1990s, property repossessions peaked at 75,000 a year. Capital Economics reckons we will see this number surpassed this year, and it’s hard to disagree.

Alan Greenspan once said that economic conditions will only start to improve once US house prices reach bottom. So what’s the news on that front? Well, the latest data on US housing starts is out. Data for December indicated that US housing starts were down 50 per cent over the last year, and by 75 per cent from the 2006 peak. Capital Economics said: “With inventories of unsold homes still very high and credit still hard to obtain for builders, there is no reason to suspect we will see a turnaround soon. The only good news is that, with starts getting closer to zero, they can’t fall much further and, even if they did, residential construction is now such a small part of overall economic activity, the wider impact of a further decline would be relatively muted.”

Finally, and to take a step away from data, yesterday also saw the ignominious exit of one of Wall Street’s biggest hitters. John Thain, former chief executive of the US stock exchange, and only at the mantle of Merrill Lynch a few months before all hell broke loose, has gone.

It was around a year ago now, when Mr Thain said he thought the worst from Merrill Lynch was over, and that things would start to pick up. Well, how wrong was that? You will probably recall, it was revealed that Bank of America was going to take the investment bank over on the same day Lehman Brothers went bust. What would normally have been the story of the year was almost lost because the day the news broke, the story of the decade was also revealed.

At the Bank of America he was head of global banking, but it appears the relationship between him and his new boss Ken Lewis was not a happy one. Stories circulating suggested Bank of America was not aware of the full extent of Merrill Lynch’s losses. A couple of weeks ago the FT said Bank of America “… executives are livid about the true depths of the problems at Merrill, which they feel were glossed over last fall in Merrill’s rush to find a saviour.” To rub salt into the wound, word is out there that John Thain asked for a £10m bonus, and it was reported that Ken Lewis was “purple faced with rage” over the request.

But it appears the final blow came with news that Merrill Lynch paid executives bonuses just before the handover.

It is very easy to jump on the bandwagon and slam the bonuses offered to bank staff. And sometimes the criticism is not fair. It does seem a little harsh to blame Northern Rock, for example, for the payments it made as bonuses to its staff, when in fact they were being rewarded for meeting targets set by the government. If we are going to recover from this crisis, we have to put the past behind us. Write off mistakes and, providing we learn from them, start anew. But it is very difficult to conceive of circumstances that justify Merrill Lynch’s approach to bonuses during the dying days of the company’s existence as an independent firm.

When the story of this time is told, it seems bonus payments at Merrill even as it was being handed over to the Bank of America, along with executives at the big three US car makers flying in private jets to Congress asking for money, will be cited as examples of how corporate greed had been replaced by madness.

Those three famous moments were characterized by one implicit belief. It wasn’t down to consumers to get us out of recession, it was down to business. The onus was on supply side.

Now, however, all the talk is on consumption. In this morning’s Telegraph, Roger Bootle made a persuasive argument against saving, saying: “In the current environment, trying to boost saving is the economics of the madhouse.”

So that’s a bit of kick in David Cameron’s teeth. He wants to encourage saving by removing tax on interest payments.

The likes of Mr Bootle are effectively saying Keynes would be turning in his grave. Keynes’ big discovery was to realize that what makes sense for individuals does not make sense for the economy as a whole. He called it the paradox of thrift. It may seem sensible for an individual worried about job security to save more. But when everyone does this, aggregate demand falls, and job losses mount. Fears about job security become a self-fulfilling prophecy.

Mr Cameron’s other big idea got something of a slamming in The Sunday Times. The newspaper’s economics correspondent, David Smith said: “The Tories have proposed a £50bn loan guarantee scheme for small firms, which Cameron wants to ‘shake the Prime Minister’ to introduce. But Treasury officials fear that losses under a scheme could amount to £12bn, making guarantee costs prohibitive.”

Mr Smith, by contrast, is a fan of the chancellor’s move to cut VAT. Many have criticized this move because they say it makes no difference. They aren’t going to spend more because prices are 2 per cent cheaper. But that misses the point, said Mr Smith in a previous article. The fact is, as a result of the VAT cut, we will all be better off. For any given volume of goods and services we purchase, we will have more money left over.

But there is a snag with the arguments put forward by economists. It does seem that they have failed to grasp another reality. Consumption is just one part of the mix that creates economic success. The other part is innovation.

When businesses go out and introduce new products, or new productive techniques, then they are creating real wealth. Economies can not grow in the long term without creating real new wealth.

The economies of the UK and US were propped up by consumer spending for years. For years, the retail sector seemed to be the key sector in the two economies.

It is not that the global economy hasn’t seen the creation of real wealth in recent years, but it was economies in other parts of the world that did this. This created massive imbalances. Some countries really did produce. Others just shuffled money around. And that is surely why we have the economic crisis now.

The solution is for the economies that have for so long been reliant on consumers, to shift the emphasis to business. And maybe for economies that have been reliant on business to shift more emphasis to consumers.

It is questionable how beneficial a boost to savings will be. In the long term the UK needs to see saving rates rise. But it is not clear that that would be a good thing right now. A boost in savings will only be a good thing in the current environment if the money saved is then invested into the UK.

Gordon Brown’s latest idea is to provide employers with a financial incentive to employ people who have been unemployed for six months or more. There is a snag with that, however. There has to be a risk that this will simply encourage employers to take on people who have been unemployed for over six months instead of people who had only recently been made unemployed. The Brown move does smack of crowding out.

But the Cameron proposal for guaranteeing loans to business is the right idea. The argument that the Treasury estimates that of the £50bn Cameron wants to spend £12bn will be lost, misses the point.

That’s the thing about innovation. Most ideas do fail. Ask a venture capital firm or a business angel, and they will say most of the investments they make fail. It is just that the successes can make up for the failures.

The mistake economists make is to assume managing the economy is a zero sum game. It isn‘t. By providing new funding to business, and especially by providing funding to start up businesses, new opportunities will emerge. Jobs will be created. The low value of the pound makes these arguments even stronger. Exporters could provide the impetus for the UK’s recovery. But these exporters need funding. It takes time for a new business to emerge. First of all a business goes through the R&D phase, and product design. Investments must be made before a company can start producing and selling. Now is the time for these investments.

The credit crunch means there is insufficient funding available for business. That is why the government needs to bridge this gap.

Actually, the UK could come out of this crisis stronger, with a more robust economy. But any money provided by the government should be made available to business (and maybe used to boost the UK’s infrastructure).

It was too much spending that caused this crisis. The UK does not need to see rises in spending. It needs more investment.

This time, it’s the Office for National Statistics with news on manufacturing, and the National Institute of Economic and Social Research with woeful data on economic growth.

The bottom line is this. Manufacturing saw the biggest monthly fall in output since 1985. Meanwhile, in the last three months of 2008, the UK saw its biggest contraction in economic growth since 1980.

Capital Economics said it all when it said: “The latest news on the UK’s manufacturing sector is simply awful.”

If you are up for a bit of masochism, then here is a bit more detail. Manufacturing output fell by 2.9 per cent in November. Industrial output as a whole was down 2.3 per cent.

Capital Economics said: “Our forecast that by the end of 2010 manufacturing output will have fallen by 12 per cent is looking increasingly optimistic.”

Mind you, at least producer inflation is down.

The annual rate of input inflation is now down to 4.3 per cent, from 31.3 per cent in July. As for output prices, annual inflation is now down 4.7 per cent, from 10 per cent in July. Actually, the month on month comparison was not so favourable, but 12 months worth of data makes up the annual figures. It seems likely these two indices will continue to fall for some time, and will probably go negative in a few months.

As for GDP, NIESR said: “Our latest GDP figures show that output fell by 1.5% in the three months ending in December after a revised estimate of 1.2% for the three months ending in November. While the recession began in May, the rate of recession increased sharply in the Autumn of last year. Since 1955, when quarterly figures were first produced, there have been only five quarters in which output has fallen more sharply, with the lowest figure of -2.6% in 1958.”

How bad is that? Well, let’s put it this way, in its main chart projecting growth, the IMF showed 24 economies/economic areas. The UK came bottom.

The second-worst performers on the IMF list were Spain and the US, in joint second place, with their economies expected to contract by 0.7 per cent each.

The IMF expects every G7 economy to contract next year, with the exception of Canada.

Japan is expected to be the second-best performer, with a mere 0.2 per cent contraction.

The IMF expects the Commonwealth of Independent States to see the sharpest slowdown, with growth falling from 6.9 per cent in 2008, to just 3.2 per cent in 2009. Russia is expected to see growth slow from 6.8 to 3.5 per cent.

China is expected to slow from a 9.5 per cent expansion to 8.5 per cent.

The IMF said: “Markets have entered a vicious cycle of asset deleveraging, price declines, and investor redemptions… Emerging markets came under even more severe pressure. Since the beginning of October… Emerging equity markets lost about a third of their value in local currency terms and more than 40 percent of their value in U.S. dollar terms, owing to widespread currency depreciations.”

The big snag though with these forecasts is that they have proved to be so unreliable up to now. The last time we covered an IMF outlook report, the headline ran: “The incredibly shrinking projection.” Well, the projection has shrunk some more. The IMF has reduced its forecast for growth for almost every economy and region.

Also, bear in mind that, 18 months ago, it struck a bullish note on both the global and UK economy, and over the last few years, when the seeds for this crisis were sown, the UK came in for a huge amount of praise.

Maybe it is time we had forecasters for forecasters. But then, who will forecast what they will say?

“The UK economy is in danger of being crushed between the jaws of world credit and commodity markets, with little prospect of early relief,” began the report. It went on to talk about flirting with recession. Actually, though, a mere flirtation will be a real achievement when seen in the context of what is going on.

The ITEM club predicts growth of 1.5 per cent this year, followed by 1 per cent next. If it is right, and, frankly, the ITEM club has a good track record and it may well be right, then actually the UK will have done extraordinarily well.

The tough one, though, is this:

The ITEM Club says consumers are in denial.

It said: “… a tightening of credit and money market conditions. Domestic expenditure fell in the first quarter, but that was largely due to a fall in spending on inventories and investment. Households remained in denial, digging even deeper into savings to keep spending moving ahead in the face of rising tax, food and energy costs. The household saving ratio fell back from 3 per cent to just over 1 per cent.”

The report continued: “Mortgage equity withdrawal fell back to £5 billion in the first quarter (2.2 per cent of consumer spending), from £13.9 billion (6.6 per cent ) in the first quarter of last year, and ITEM expects it to fall further. With secured lending becoming less freely available, people are increasingly resorting to unsecured borrowing. This raised £1.4 billion in May, with credit card borrowing increasing by £0.6 billion, the largest figure for two years.”

But then the ITEM Club really rattled the optimists’ cage. It said: “Denial could turn to despair. Now, May is beginning to look like the last dance at the summer ball. Top retailers like John Lewis and Marks & Spencer have turned very negative. The worry is that without the required medication from the Bank of England, consumers will now move straight from denial into despair.”

Then ITEM club then rattled on about the Bank of England dilemma. About how it can’t reduce interest rates because of surging inflation, but needs to stop a nasty recession. In fact, the ITEM Club has predicted it will be another year before inflation falls back to less than 1 per cent above target.

Whether inflation takes off in the longer-term does depend entirely on what happens to wages. The threat of job losses is likely to curb wage demand in the private sector. But, as the ITEM Club warned: “This risk is most acute in the public sector, where pay increases have been held below those in the private sector and below the cost of living for nearly two years. Unison and other public sector unions want three-year pay deals to be reopened, but the government knows it cannot cave in on this one because that would mean base rate hikes which would cost it the election.”

It does, however, seem to us that while we all have sympathy with low paid workers struggling to make ends meet in the current environment, we are all too worried about our own jobs to be willing to give them much support. That is why union leaders are being asked by the media to justify their action in the light of the knock on effects it could have on the economy.

It wasn’t like that in the 1970s; back then, union demands for higher wages had much greater public support. So while inflation looks worrying right now, it is sure to fall quite a bit next year.

In this vein, ITEM Club said: “Price increases already in the pipeline will push CPI inflation to 4 per cent or more in the coming months, sustaining the letter-writing activity at the Bank of England. However, the big increases are almost entirely in food and energy prices. The core CPI inflation rate (which excludes the direct costs of food and fuel price increases) remains subdued at 1.6%. Providing that line can be held, inflation will drop back into line with the target over the next 18 months as commodity prices flatten out or fall back.

“The slowdown in the economy should help here, and a major collapse in world oil prices would bring a reduction somewhat sooner.”

For that reason, its expects cuts in the rate of interest this winter.

There is a danger implicit in cutting rates, however. And it’s a danger that even quite esteemed economic forecasters like the ITEM Club seem to overlook. This is a crisis born of too much consumer borrowing. We need, as was argued above, to save more. A cut in interest rates does smack a little of allowing consumers to borrow their way out of difficulty. And to quote James Callaghan, but slightly out of context: “I tell you, in all candour, this option no longer exists.”

If, on the other hand, rates fall, making existing debt cheaper, but credit remains tight and our borrowing is still restricted, this may be a good thing.

In short, a credit crunch coupled with low interest rates could be precisely what is needed to to end the real crisis, which is too much debt and the cost of repaying the debt.

We would still argue, however, that in the longer-term, the tax cuts outlined above would be even more effective.