This is what he said about banks: “I meet many people who run small and medium-sized enterprises and the thing that really makes them angry is that, having built up a business often over several generations and had the same banking relationship for 60, 80 years, then suddenly comes a letter churned out of a computer saying the terms of our relationship have changed; and I have seen many of these.” He added: 2It is heart-breaking sometimes. It is a lot harder to build a business than it is to sit in London and trade away.”

Dr King was venting his frustration over banks’ treatment of customers. Mind you, that’s the problem with bailing banks out. It kills evolution in the banking sector. But at least new banks seem to be emerging anyway. Maybe they will offer the service that the current crop of banks seem unwilling to offer. See: The great banking experiment: what matters most – price or service?

The second hornets’ nest relates to the UK’s Deputy Prime Minister. In the build up to the election, Nick Clegg was critical of Conservative plans to slash the fiscal deficit. And yet once the allure of power was waved in front of his eyes, all those doubts seemed to evaporate.

So why did Nick change his mind? Well, our Nick reckons he bumped into Dr King while treading the road to Damascus. The Lib Dem says the Bank of E man made it absolutely clear the government had to do more. But yesterday the central banker told a House of Commons select committee he said no such thing: “I said nothing that was not already in the public domain. In the telephone conversation I basically repeated what I had said at the press conference,” said the good doctor.

Actually, none of the politicians were honest with us before the election. Deep down inside they must surely have known cuts would have to be deeper than they were saying. But had they told the truth, they would not have been elected. Alas, the British public don’t vote for politicians who tell the truth, who say “I Don’t know””when in reality no one really knows, and they don’t vote for politicians who tell us things are going to be bad.

The final hornet’s nest that Dr King ruffled yesterday related to the economy. He said that because of the hike in VAT, inflation would stay above target for around 18 months. His colleague on the MPC, Charlie Bean, went further, saying: “Inflation has surprised us on the upside fairly consistently in the recent past. Some of that is because there have been unexpected events like oil prices that are substantially higher now than they were two years ago, but there are other aspects where basically our initial judgement about the inflation process turned out to be incorrect. In particular, it looks as if the effect of the depreciation of sterling has been rather larger and faster than we were expecting.”

But for all his doubts about inflation, Mervyn King hinted that rates would stay low for the foreseeable future. And he is right. The truth is, there are two types of inflation. There is the inflation that can get out of hand, caused by demand being greater than supply; this is what we had in the 1970s, and it got worse and worse. Then there is inflation caused by external factors. The VAT rise, the hike in oil and the fall in sterling are what lie behind inflation. In all three cases they have the effect of reducing demand. You will recall under Mrs Thatcher, a VAT hike was seen as an anti inflationary policy – at least in the long run. High oil, higher VAT and a cheap pound have the effect of reducing demand for UK consumers. As such, these forces are deflationary in the long run.

But where things can go wrong is when wages rise to match the increase in one-off costs. This is where we risk seeing an upward inflation spiral.

In other words, the good news is that inflation is unlikely because the recent price hikes have not been met with hikes in wages. The bad news is that the recent price hikes have not been met with hikes in wages.

The National Institute of Economic and Social Research reckons we will have to wait until 2015 before consumer spending per person equals the levels seen at the peak of the boom. It sees future growth coming from exports. The ITEM Club said something similar on Monday, saying that it is now time for business spending on investment and exports to take off where consumers and government spending can go no further.

The banking stress tests were just awful. The tests looked at a worst case scenario and examined whether banks would be able to retain a Tier 1 capital ratio of 6. Its conclusion, of the 91 banks it looked at only 7 would be unable to meet this criterion. In other words, just seven banks failed the tests.

But the assumptions behind its worst case scenario were absurd. The EU assumed there would be no sovereign debt default. If you are a regular reader here, you will know that such an assumption was based on hope and little else. EU politicians seem to have found a new place they can call home, and that place is a large hole in the sand where they can bury their heads.

In any case, who said a Tier 1 ratio of 6 is appropriate? As Capital Economics pointed out, if instead it had called for a ratio of 7, 24 banks would have failed the test and 11bn euros would have been required to sort the problem out, instead of the 3.5bn euros under the assumptions actually used.

The truth is, the chances of a eurozone-wide banking crisis remain high. Countries such as Greece, Portugal and Spain desperately need a cheaper currency relative to Germany’s currency. But since their debt is measured in euros, then if they were to do the eminently sensible thing and exit the euro, the value of their debt would shoot up and default would be unavoidable.

So, if UK consumption is in recession, if government spending is set to plummet, and if a banking crisis could yet stymie our main trading partners, where is UK growth to come from?

Turkey is one such place. Unlike much of Europe, its population is young. Economists believe that within ten years Turkey could be the second fastest growing economy in the world. And that is why Cameron is there, around now, singing its praises and calling for it to be allowed into the EU.

He is expected to say: “I will remain your strongest possible advocate for EU membership and for greater influence at the top table of European diplomacy” and “Together, I want us to pave the road from Ankara to Brussels.” And he is expected to add: “I believe it’s just wrong to say Turkey can guard the camp but not be allowed to sit inside the tent.”

And then it is off to India. The problem we have with trading with India is that the economy of the subcontinent makes trading difficult in precisely the areas where the UK is supposed to have a lead, in banking, legal and accountancy sectors.

Next year, India may well be the fastest growing large economy in the world – overtaking China. And the UK has one big advantage over other countries wishing to trade with India – a high percentage of its population are of Indian descent.

It is time for economic links between India and the UK to go beyond good curries and outsourced call centres.

NIESR reckons the UK will limp forward this year and next. It has forecast a growth rate of 1.3 per cent for 2010 – which implies of course that since the UK expanded by 1.1 per cent in Q2 and by 0.3 per cent in Q1, it will go perilously close to recession in the second half.

As for 2011, NIESR has forecast a growth rate of 1.7 per cent. But it has a caveat. This is what it said: “Tax and spending plans in the Emergency Budget will reduce the economic growth rate by 0.4 per cent in 2011. This has raised the probability of a decline in output in 2011 as compared to 2010 from 14 to 19 per cent.”

In other words, the austerity Budget has meant the chances of a recession next year have gone up.

This does not necessarily mean the Budget’s cuts weren’t essential. A double dip recession may simply be the price we have to pay for long-term sustainable growth.

Yesterday, it was told here how the ITEM Club from Ernst & Young is predicting that business is set to take up the charge. Its economic guru Peter Spencer said: “It is time for businesses to take advantage of the tax incentives presented in the Budget. This time the consumer is in no position to pull us out of recession, indeed the outlook for households continues to be bleak – what with pressures from the labour market, pay pauses and higher taxes there will be a major strain on real disposable incomes in the short term. The impetus for the economy has to come from business spending, private sector employment and entrepreneurial initiative. Without that response, it will certainly be very hard for the government to pull off the trick of retrenchment and recovery.”

NIESR came at the problem from a different angle, but effectively drew the same conclusion as the ITEM Club. It reckons the UK savings ratio will be 6 per cent. It said: “Per capita consumer spending will not reach its pre-recession peak until 2015.” It forecast that future growth will come from trade.

We are a tad worried about the current return of savings.

For individuals, especially baby boomers who face impending retirement, savings rates must rise. But for the economy as whole, rising savings could be disastrous.

The same argument applies to house prices.

The idea that soaring property prices could provide for us in old age was perhaps the single most dangerous idea of the noughties. For an individual this approach may work, but for the economy as a whole, reliance on rising house prices can be crippling.

In the long run, the only way the needs of the baby boomers can be met is by rising productivity. Only if the UK is able to produce more goods and services per working person, can it avoid a crisis when the baby boomers retire.

Surging house prices were a bad thing because they fooled us into thinking we were doing better than we really were, and would-be entrepreneurs were seduced away from creating wealth to speculating in property instead.

It is like that with saving. Saving is fine providing that the money saved is then invested into businesses that can have the potential to create wealth. If, instead, savings simply slosh around the system, pumping up gilt prices and then gold, then we are effectively seeing potential being sucked out of the economy. The final result of this may be deflation and negligible growth, and paradoxically, a consequence of a rising savings ratio could be that debt, measured in real terms, will rise.

Well, in a nutshell, this is what the report says. The austerity budget will mean emphasis will be shifted from the public sector to business. Investment and exports will take up the slack left by government spending. By the time the austerity drive sets in the recovery will be in full swing, and as a result the pain of fiscal cuts will be manageable. Meanwhile, interest rates will stay at the current rock bottom levels well into 2013.

Peter Spencer, chief economic adviser to the Ernst & Young ITEM Club comments: “The new coalition’s plans to cut the deficit are certainly ambitious. But the bulk of the additional tightening is set to come in the second half of the parliamentary term, when we believe that the recovery will be firmly entrenched and the economy should be able to deal with the headwinds from the Budget.”

Spencer adds: “On the assumption that the government is able to implement the overall reduction of £40 billion set out in the budget, we expect that UK growth will struggle to reach 1 per cent this year but will gradually speed up in the following years to give the UK a high-quality recovery based on trade and investment.”

As for rates, this is what the ITEM Club had to say: “High energy prices and the increases in VAT will keep CPI inflation above target over the next 18 months, but ITEM believes that it will then move well below 2 per cent as these effects wear off and spare capacity bears down on pricing decisions and wage bargaining.

“To prevent CPI inflation moving below 1 per cent it will be necessary keep the Bank base rate low at 0.5 per cent for much longer than the OBR and the markets have anticipated. The ITEM forecast suggests that the base rate will remain on hold until the end of 2013, although this is dependent on the assumption that the impending spending cuts actually come through.”

Peter Spencer said: “A base rate of 0.5 per cent will begin to look like the new normal.”

And finally there is business. Spencer said: “It is time for businesses to take advantage of the tax incentives presented in the Budget. This time the consumer is in no position to pull us out of recession, indeed the outlook for households continues to be bleak – what with pressures from the labour market, pay pauses and higher taxes there will be a major strain on real disposable incomes in the short term. The impetus for the economy has to come from business spending, private sector employment and entrepreneurial initiative. Without that response, it will certainly be very hard for the government to pull off the trick of retrenchment and recovery.”

The ITEM Club report is full of warnings. Warnings about how the European crisis could unravel, and hit us. Warnings about the fragility of the UK consumer. But, wearing his positive hat, Spencer said: “The emphasis on spending cuts rather than tax increases over the medium term reduces damage to incentives and increases the chances of success, as does the business-friendly nature of the tax changes. A reduction in the uncertainty around the fiscal and monetary policy outlook should also support investment and employment. However, this forecast – not to say the success of the coalition’s fiscal strategy – hangs critically upon a positive response from UK plc and the financial markets.”

The ITEM Club’s optimism may be justified. But …

The big snag is that just about every economy in the world is trying to adjust through putting more emphasis on exports. This is not viable.

The UK’s austerity drive may well be essential. It may well be that we have no choice but to cut, cut and cut some more. The problem, however, is that everyone else seems to be doing the same thing.

Above all, before the credit crunch the problem may actually have been that the fruits of capitalism were not being appropriately distributed. Corporate profits were occurring at the expense of wages. This is fine for individual companies, but when profits are racing ahead of wages across the world, demand will lag behind capacity. And the only way this gap can then be closed is via consumer debt. We fear that this underlying problem has not gone away.

The quarter on quarter growth rate in Q1 was 1.1 per cent. That’s impressive. Clearly the growth rate will slow; the recovery seen in the last quarter would not be sustainable in any developed economy.

In the US, growth in the final quarter of last year was even more impressive, with the economy expanding at an annualised rate of 5.6 per cent in Q4 2009. In the first quarter of this year, the annualised rate was 2.7 per cent. The figures for Q2 will be out this week, and most expect growth to slow further still.

The big drop in US growth from the end of last year to the beginning this may well be mirrored in the UK over the next three months.

But then again, bear in mind the IMF has forecast a growth rate of 1.2 per cent for the UK for the whole of 2010. The IMF projections are looking wrong already, although they were only published a few weeks ago. For their forecast to be correct, the UK would have to contract in the second half of this year. Few expect that. It just goes to show, economic forecasting is about as accurate as guessing.

The biggest surprise relating to the latest GDP figures was how surprised the markets and media were.

The Purchasing Managers Index (PMI) from CIPS/Markit for manufacturing has been booming for several months now, hitting its highest level since the middle of the 1990s the month before last. The CIPS/Markit index tracking services has not been quite so impressive, but it has been pointing upwards all the same.

When they were published, this column was puzzled over why the growth figures for Q1 were so low. We predicted that when the ONS finally came round to revising them, it would revise them upwards. Well it did, but not as much as we excepted. The original estimate was for a growth rate of 0.1 per cent; this was revised to 0.2 per cent, and finally to 0.3 per cent. Why so low when the bell-wether indices were looking so good? Well, it turns out that the explanation lies with time lags. It just took longer for the impressive forecast entailed in the CIPS/Markit figures to show up.

However, the most recent PMI index showed a modest fall on the previous month. The fall was nothing to fret over. It still stood at a high level, and was consistent with a healthy growth rate for the UK economy. But it is this trend that counts.

The next set of CIPS/Markit figures will be out next week. And this data will provide the big clue as to how much our growth will slow in Q3.

Never lose sight of the fact that the higher our growth rate, the higher will be government tax receipts, and the quicker our fiscal deficit will fall.

The real challenge for the UK will follow in 2011.

Next year is when the debt problems across the eurozone may finally prove too much. The chances of sovereign default in 2011 have got to be high. Although, there is a funny story there – or at least funny in a sad sort of way. See: All stressed up; banks pass stress tests as regulator plays calming music.

Next year is when the eurozone will face its severest test, and the fallout could be nasty.

Next year is also when there is a danger of a housing crash mark 2. We are already seeing irrefutable signs this is about to occur in the US. It is clear UK house prices are set to fall over the next few months. (Indeed, news from Hometrack this morning has shown that UK house prices fell 0.1 per cent in July. This was the first monthly fall recorded by Hometrack since April last year.) But a question markets hangs over whether the falls we are sure to see over the next few months will continue into next year. If they do, then UK consumer confidence will take a nasty knock.

The danger, then, is that 2011 will see a double whammy. Our main trading block may get hit by banking crisis, and our domestic economy may see consumers tighten their belts as falling house prices make them feel more cautious.

And yet two reports out over the last few days contradict the rationale for our fears.

First there’s the banking stress tests. The results were published on Friday. And boy were they good for relieving stress. It turns out that Europe’s banks are in fine health. It is just that the exhaustive examination of Europe’s banks turned out to be about as stressful as testing a range of chocolates. See: All stressed up; banks pass stress tests as regulator plays calming music.

And second, there’s Ernst & Young’s ITEM Club. It is not difficult to think of something sarcastic to say about the EU institution responsible for the bank stress tests, but the ITEM Club is a different matter. Their analysis is normally pretty good. So what did they have to say? See: ITEM Club puts thumbs up to austerity drive

Then Portugal found itself on the receiving end of Moody’s poisoned analysis. You could say the credit rating agencies have been hopeless, waiting for the moment that countries try to implement measures to pay back debt, before slamming them for their indebtedness. But then you could say it’s a long journey to the moon. Both statements are pretty much stating the bl***ing obvious.

It is just that it has taken China to spell the problem out, with a credit rating agency of its very own. And the agency ain’t much impressed with its Western counterparts.

Talking of not being impressed, there was just a hint earlier in the year that Bill Gross, he who heads the giant asset manager PIMCO, had his doubts about the UK. Mr Gross was very subtle in voicing his opinion of course. This is what he said: “The UK is sitting on a bed of nitro-glycerine.” Investment and Business News can exclusively reveal that our analysis of Mr Gross’s comments earlier in the year clearly demonstrates that the investment guru had some qualms about the UK. You see, wonderful things are journalists. When someone says something really ambiguous, we can clear things up. Anyway, Mr Gross has been at it again. But this time his thumbs have done an about turn, and are pointing upwards.

Meanwhile, Andrew Sentance is getting worried. He is the man who voted to up interest rates at the last Bank of England rate setting meeting. Inflation fell again in June, but by less than expected. The inflation hawks are revealing themselves now in growing numbers. Squawking and swooping, the hawks with all those warnings earlier in the year about inflation were right all along. Interest rates are on their way up, quantitative easing has been proven to be the work of the devil after all. Except, they aren’t really and it wasn’t. We are going through a dangerous phase, and now those people who totally failed to call the economic crisis want to impose policies that would make things a hundred times worse.

But finally, hope arrives at the party, all dressed up to the nines – or is that nine billion tiny little ‘nine-ers’. Intel has just posted its best results in a very long time. You would have to wind the clock back all the way to … well, actually, you would have to keep winding, for Intel’s results were its best ever.

You see, it’s the three Is: innovation, innovation and innovation; that’s how we can get out of trouble, and it is something that credit rating agencies, bond investors and the inflation hawks, just don’t get.

Credit rating agencies eat cake, but why can’t they have it, too?

The UK has kept its triple-A credit rating, as measured by Standard and Poor’s. Phew. But the agency is worried. There is a 33 per cent chance the rating may be downgraded, or so it says. “The negative outlook reflects the potential of a downgrade if the government does not implement its challenging fiscal consolidation programme on the scale planned,” said Trevor Cullinan from the agency. Or at least that’s how the Guardian quoted him. He added: “A slackening of that, in our view, could put the UK’s net general government burden on a trajectory that would be incompatible with a triple-A rating.”

‘Hello, is there anybody out there?’ Haven’t you heard of the austerity budget? George Osborne has just announced a budget that was much, much tougher than anyone had predicted in the build up to the election of just eight weeks ago, and now Standard and Poor’s, which kept quiet for so long when things were going all wrong, starts making warnings. It seems that during the boom they were comfortably numb, and now they have built a wall blocking themselves off from reality.

Mind you, the OBR doesn’t help. Alan Budd, its boss, is the economic world’s answer to Fabio Capello. His reputation was without equal. But then when it comes to the crunch, things don’t look so good. No one seems to believe the OBR’s predictions for growth. You can’t blame Budd. Economic forecasting is guessing, disguised to seem like science. A good technique they may want to try is called the ‘blindfold and pin’ technique. It can be a whole lot more accurate than the predictions of the professionals.

Still, at least Bill Gross seems to be more cheery about the UK. Apparently, thanks to George Osborne, PIMCO is more optimistic about investing in Britain. See this Guardian piece for more: PIMCO turns bullish about UK gilts in light of budget cuts and euro debt woes

Meanwhile, Portugal has seen its Moody’s rating downgraded from AA2 to A1. It’s quite confusing, all these As. Most of us were delighted to get an A-anything for an essay when we were at school. Even a B-minus was quite good. Presumably the awarding of B-plus would have been greeted with pleasure, too. And a BB-plus, one assumes, would have been even better. This is strange, because BB-plus is what Standard and Poor’s gives Greece. And yet a growing body of opinion says Greece will default. The grades are a part of the problem. Why not have an honest system and give Greece a D-minus? We all know what that means.

Maybe it is not so much cake that the credit rating agencies have been eating, but rather they have been taking something else entirely. The Guardian quoted one anonymous hedge fund manager as saying: “Credit rating agencies are always two steps behind the market… The time when a credit rating could determine whether people would buy your bonds is over: now politicians know they must do their homework to sell their bonds. Money is now expensive, and you need to pick where it works best.”

There is a good summary of the latest credit rating agency scores on this website: Credit Writedowns

It is no wonder that China’s top credit rating agency Dagong Global Credit Rating Co. has come up with a quite different conclusion. It reckons that when giving a country a credit rating, it should take into account things like the size of its debts. And would you believe it, according to its way of doing things, neither the US nor the UK have top notch ratings. China, Germany, and Canada all boast higher ratings.

Then again, the Chinese agency may have got it wrong, too. The fact is, Germany and China are reliant on these indebted countries to charge their growth. If the US and UK do go bust, which China seems to think is not an impossibility, the crash in global demand which will follow will create an even bigger problem for Germany and China, which are, after all, totally reliant on the rest of the world buying its products.

See this Telegraph piece for more: Chinese rating agency strips Western nations of AAA status

Break up the banks, says leading politician

Andrew Tyrie is no lightweight. He is none other than the new chairman of the Treasury Select Committee. And he is giving a good impersonation of John McFall, the previous chairman, but with a lot more teeth. (Not that we are casting aspersions on Mr McFall’s dentures.)

Anyway, this is what our new toothy chairman said yesterday about banks that are currently owned by the government: “I want to put the consumer first… and the only way that can happen is with the break-up of those banks.”

Is he right? Ahh … let’s think about that … ahh … yes.

You don’t need us to spell it out. We are getting an awful service from banks. If you have a question, you get put through to a call centre. Your local branch has virtually no decision making authority at all. During the boom, getting a loan to fund a jolly abroad, creating an exodus of money overseas, was easy; getting a loan to fund a business creating wealth was much, much harder.

Economic evolution works via failure. Bad businesses go bust, leaving a vacuum that may be filled by businesses that have better products. Banks that are too big to fail are a problem, because then economic evolution stops working.

It hurts to say this. It is, after all, so much more fun to point out when politicians are messing up, but Mr Tyrie has hit the nail right on the head.

Inflation dips, but not enough

Inflation fell from 3.7 per cent to 3.4 per cent in June. The retail price index dropped from 5.1 per cent to 5 per cent.

Stop right there. Re-read. Inflation, as measured by the retail price index, was 5 per cent in June. Deflation? – do me a favour.

No wonder Andrew Sentance is worried. He is the Bank of England Monetary Policy Committee (MPC) – the people who set interest rates – man who voted for a hike in rates last month. Upon the unveiling of yesterday’s inflation rate, he said: “If the recovery continues and headline inflation remains relatively high, there may be a further upward drift in pay growth in the private sector, offsetting some of the downward pressure from limited wage growth in the public sector… I favour a gradual rise in Bank Rate… to avoid destabilising confidence through a sudden lurch in policy.”

Mr S is worried about spare capacity. Excuse the pun, but he reckons the paragraph in the book on the UK economy that says ‘there lot’s of spare capacity’ may be over.

Or to put it another way, Mr Sentance has put a question mark on the Bank of England’s rosy view on inflation. Wage inflation is higher than one might expect, given where we stand in the cycle. Average wages rose 4.2 per cent in the year to April. Okay, that was lower than the retail price measure of inflation, meaning workers are becoming worse off in real terms. Even so, the wage increases are higher than common sense would have predicted.

Here is why we disagree with this viewpoint.

CPIX, that’s inflation with indirect taxes (VAT) stripped out, was 1.7 per cent. According to the British Retail Consortium, shop price inflation in the year to June dropped from 1.8 per cent in the previous month to 1.5 per cent. Even food inflation was lower, at 1.7 per cent. Producer prices fell in June. Input prices fell 0.2 per cent, output prices by 0.3 per cent. The Nationwide’s Consumer Confidence Index crashed to 63 in June, the lowest level since June last year. This suggests consumer demand will fall in the months ahead, again pushing down on prices.

But the big one is the money supply. M4 lending decreased by £15.1 billion (0.6%) in May. The twelve-month growth rate fell to 2.5% from 4.1% in April.

The untold story of 2010 is the change in global money supply, that is to say, the broad money supply. It is contracting fast. Such a development has deflation written all over it.

Corporate America provides hope

Where Investment and Business News differs from other publications is that we do have a belief in technology. New technology, be it faster chips or synthetic life, leads to new wealth; providing, and this is a big proviso, that demand rises with productive potential.

Globally, and over the last few years, demand has not been keeping pace with this potential. Or at least, it has only been keeping pace via increased borrowings from some, to make up for the higher savings from others.

But at least Intel has had a humdinger. In fact, Q2 saw the best quarter ever for the chip maker for both sales and profits. A year ago the company made a loss in this quarter, with $400 million flying out the door. This time around, net income has been $2.9 big ones, or billion, as big ones are also called. The company’s boss Paul Otellini said: “Strong demand from corporate customers for our most advanced microprocessors helped Intel achieve the best quarter in the company’s 42-year history. The PC and server segments are healthy and the demand for leading-edge technology will continue to increase for the foreseeable future.”

And that is where hope comes in. The US is like the economic equivalent of David Bowie and Madonna combined. It has this extraordinary ability to reinvent itself. Or at least corporate America does.

Its high indebtedness is the other side of a coin which says optimistic, and optimism fuels risk taking, which leads to wealth creation.

But even so, one snag still remains. Martin Wolf covered this well in the FT today. “As Corporate America has boomed, income distribution has got worse,” he said. Mr Wolf was himself quoting a new book by Professor Rajan called “Has Financial Development Made the World Riskier?” The FT piece quotes Prof Rajan as saying: “The political response to rising inequality . . . was to expand lending to households, especially low-income ones.” The financial sector’s “failings in the recent crisis include distorted incentives, hubris, envy, misplaced faith and herd behaviour. But the government helped make those risks look more attractive than they should have been and kept the market from exercising discipline.”

It is good news, really good news, that Intel is leading the way to record results. That’s one box ticked in the column that says road to recovery. But, somehow, another box has to be ticked, too; the one that says ensuring the fruits of globalisation and new technology are distributed in a way that promotes more growth. Martin Wolf and some others, and maybe this column falls into this bracket, have said what the problem is. But no one seems to have come up with an answer yet.

For months this column has warned you, and now the warning may be coming true.

The markets are in a right tizz. Economic indicators are looking decidedly peaky.

The FTSE 100 fell yet again yesterday, this time down to 4,805, the lowest closing prices since August last year. It is now 17 per cent down on the year high, which the index hit at the beginning of April. Of course, the summer is a notorious time for stock market volatility, hence the saying “Sell in May and go away.” But then again, the falls seems perfectly logical given recent economic data. The only real question mark relates to why markets rose so high in the first place.

Of course, some analysts will deny the need for this question and say the recent stock market boom was logical. They might point to the stunningly good corporate profits that have been revealed this year, and say there was a very good reason for buoyant markets. But as ever, they aren’t looking below the surface. To an extent, record corporate profits are a part of the problem. If profits were lower and wages higher across the globe, the economy would probably be more stable. For each single business, it is good to generate maximum possible profits whilst keeping wages as low as possible. But for the global economy this can be damaging. High corporate profits are a good thing if the profits are then invested. But in practice, companies are reluctant to invest when demand is so low.

Aside from the FTSE, the Dow fell to its lowest level since the autumn, but the Chinese Shanghai Composite Index, or SCI, still tops the list of crashing stock markets (actually, Greece is similarly cursed), and is now 25 per cent down on the early April price.

The problem is that the big fears some analysts have been expressing are beginning to come true.

Inventory cycle turnsFor the last few months, manufacturing across the world has been growing in leaps and bounds. But a niggling fear remained. Were we seeing a turn in the inventory cycle? Had manufacturers’ customers simply stopped the process of de-stocking, for the simple reason they had run their stock down to the bare minimum. In which case, went the fear, the recovery would be short-lived.

The last few days have seen the release of Purchasing Managers Indices (PMI) for manufacturing across the world. None of the scores that have been revealed are that bad. At the moment, if PMIs are falling, then they are falling like a feather from above, slowly. The problem relates to the fact that nearly all of these indices seem to be going in the wrong direction at the same time.

The PMI for the UK, from CIPS/Markit, for example is still only slightly below the highest score for the index since the mid 1990s. But the point is, it is down, falling from 58 to 57.3. Anything above 50 is supposed to indicate growth, so we are still well into positive territory. Taken in isolation, we might be saying something like “sure the index is down, but it remains at a level which is extremely high relative to average readings over the last 15 years.” But then, factor in that the index measuring new export orders fell very sharply, and then we have cause for concern.

Factor in that the US PMI from the Institute of Supply Management fell from 59.7 to 56.2, the lowest reading since January.

In Asia and Australia, PM indices all fell. More to the point, the PMI for China was down to just 52.1. The decline in China’s PMI is especially worrisome. If it falls much further the index will be consistent with contraction. Is it really possible for China to maintain anything like the heady growth rates it has become used to, when its manufacturing industry seems to be so close to recession? China desperately needs re-balancing. It needs its consumers to take up the slack. The fact that Chinese wages seem to be on the up is an encouraging sign. The question relates to whether this will be enough.

Finally, if you are still in doubt about the state of global manufacturing, consider JP Morgan/Markit’s global PMI for June. This fell to 55.0, from 57.0 in the previous month.

It’s good news for the price of oil

The falls in PMI indices are good news for the price of oil. And the chances that the price of the black stuff will fall sharply over the next few months, as predicted here some time ago, have risen.

US consumers tighten belts so hard it’s a wonder they can breathe 

Across the pond, the US consumer is making a passable impersonation of someone who is being bowed down by the weight of the world. Earlier this week, we told how US incomes rose 0.4 per cent in May, but spending rose by just 0.2 per cent. In other words, Americans are saving a good deal of any extra income they earn.

For so long the US consumer seemed indomitable. Economists wrote this creature off at their peril, as US consumer spending confounded the sceptics for over a decade. But in June US consumer confidence, as measured by the Conference Board, fell like a giant rock from the sky, dropping from 62.7, to just 52.9.

Okay, it’s been lower. It was even lower than that as recently as March, but during the boom the index was consistently over 100.

The economic comet

But, if manufacturing is falling like a feather, and US consumer confidence like a giant rock from the sky, there is another indicator that is doing a passable impersonation of a comet hurling towards the world’s economy.

On several occasions we have warned how in the US, the broad money supply, also called dollar M3, has been contracting on an annual basis every month this year. In the Eurozone, euro M3 contracted last month, and in the UK sterling M4 is stuttering. Well, we have seen sight of a chart showing the global broad money supply. If the chart does not put hairs on your neck, then there’s something wrong with your hairs. Right now, the chart shows global broad money supply growth as flat. But, more to the point, it has gone from rapid growth to zero in just a few months. The steepness of the drop is like nothing the global economy has witnessed since the 1930s. This is a forward indicator. The economic implication of this contraction will not show up for several months, maybe longer.

If the contracting global money supply does not become the big economic story of the second half of this year, then there is something wrong with the reporting of economics.

What worries us is the current backlash we are seeing against debt, and the fiat money conspiracy, and all these fears you see circulating about impending inflation. It is all very dangerous.

If productivity is rising, and given the advances in technology and the greater specialisation that is coming with globalisation, it surely should be, then we need an expanding money supply. We need debt levels to rise, or else demand will lag further and further behind potential.

Where this column differs from others is that we have an underlying optimism born out of our belief in technology. Moore’s Law is still working, computers still double in speed every 18 months, the functions they perform continue to multiply. The field of genetics is changing at a stunning rate. Craig Venter created synthetic life this year. Imagine that. The rapid advances in genetic science mean we could be just a few years away from a cure for cancer, heart disease, cheap renewable fuel, and the end of food shortages. But we seem hell bent on stopping this. We fret over the dangers of genetic science, and ignore the fact that without its advances starvation across the globe on a scale never before witnessed will result. But above all, we talk about austerity, and paying back debt.

Why do students take out a loan? Because they believe the extra income they earn as a result of their superior education will make this worthwhile. Okay, it does not always work like that and these days there seem to be too many kids going to university. But the theory is about right. Students are effectively borrowing from their future income to pay for their education.

It is like that for the economy too. Borrowing to fund innovation, even borrowing to create consumer demand, making innovation more profitable, is probably essential, given how the world’s population is likely to rise over the next few decades.

Saving is fine, if the money saved funds the right type of investment. It is when saving pumps up house prices as it did, or government bonds as it is now doing, or gold as it threatens to do, that we have a problem.

In reacting against the practices of the last decade, we are in real danger of overreacting, castigating all debt as bad, and sending the global economy into deep, deep recession, as a result.

They say we are not good at learning the lesson of history. Well, if history does indeed have a lesson, then it appears that the top men and women at some of the world’s most august economic institutions were doing something else when the history lesson was on. Maybe they chose woodwork or something. (Actually, highly advanced maths is more likely. Maybe mathematicians are not good at history, and are too busy producing complicated formulae to explain things, that a good history book would say in terms that are both much easier to understand and much harder to get wrong.)

But maths and recent history in tandem do tell us something of note. The FTSE 100 fell to its lowest closing prices since the summer of last year, says history. Last night it was down 16 per cent from the year high, says the maths. It was a similar story across the world, although for spectacular falls, China takes some beating. Its headline index, the SCI, is now 28 per cent off the start of year price.

Apologies for the next statement, but holiday season or not, Investment and Business News is suffering from a nasty bout of déjà vu .The similarities with 2007 and early 2008, when the more respected economists were saying there would be no recession, are staring us in the face.

So what’s going on this time?

What’s the answer for naughty banks?

At one level it’s all about moral hazard. If a schoolteacher or a parent never admonishes kids who behave badly, how will they learn? In nature, instead of strict teachers to punish wrongdoing, evolution uses extinction. It is supposed to work like that with economic evolution too. Bad businesses go bust, leaving a space for the more dynamic businesses to fill. Bail out loss-making businesses, then economic evolution grinds to a halt, and we are left with an economy going nowhere, or alternatively an economy that if it is going anywhere, it is backwards.

And that is the problem with the banking bailout. The lesson of the Great Depression was that when banks fail en masse, we get a massive contraction in the money supply. The lesson of the last half century is that banking crises are followed by economic crisis. And when governments bail out banks, like they did throughout most of Scandinavia a decade or so ago, the economic fallout is not quite so bad. But the lesson of the Greenspan years, say others, is that repeated efforts to avoid crisis, such as the Fed’s remedy for the savings and loans crisis, or the collapse of LTCM, meant our banks didn’t learn. And so, in the most spectacular way imaginable, repeated their errors across the world.

A year ago, European banks were staring crisis in the face. The European Central Bank saved them by providing loans of around half a trillion euros for 12 months. The loans were only for a year, because the ECB wanted the banks to learn the error of their ways. The year is up. And markets don’t like it.

The ECB doesn’t like it much either, and has with reluctance agreed on a temporary fix by providing short-term loans for the banks. It doesn’t want to go further, because it is fretting about moral hazard.
This leaves the market for inter-bank lending looking distinctly … iffy. Without ECB money, we would almost certainly have suffered another Lehman Brothers-type crisis by now, and most of the global economy would once again be in recession.

But there is another snag. It is all very well the ECB lecturing financiers on moral hazard, but not so long ago Spanish banks were meant to symbolise the best of banking practice. With their lower Tier 1 capital ratio, British banks were told they could learn a lesson from the banks south of the Pyrenees.
You can see how it is that German and French financiers allowed themselves to run up high exposure to these well-run Spanish banks. And if Spanish banks do a Northern Rock on us, will the Spanish government be able to do a Gordon Brown on us, and bail them out? And if it can’t, what does that mean for France and Germany?

It is not pretty, is it?

Economists lose the plot

The fundamental problem with banks is the financial instability of their customers. Housing crashes across the world have left Joe Public feeling insecure. Only record low interest rates have stopped mass default.

But what is worrying, very worrying, are the calls for higher interest rates. Not so long ago it was told here how the OECD wants to see UK interest rates put up to 3.5 per cent. See: Up rates to 3.5%, says ‘mad’ OECD

Now the Bank of International Settlements (BIS) has said central banks must up rates. The BIS has also called for governments to cut fiscal deficits decisively. See: Reuters, Central banks warn of new crisis if exit left too late This is an odd call. As all but those who are recently estranged from the planet Mars will know, fiscal austerity is precisely what most of the world’s governments are enforcing. So why call for governments to do what they are doing anyway? Is it possible the men and women from the BIS are indeed Martians?

Or maybe their rhetoric is aimed at the US. And if it is, they are joined by the IMF, which has also called for the US to join the rest of the world in driving for austerity.

Naughty governments

But Spanish banks which, not so long ago, sat on the good boys’ table, but now have been sent to the back of the classroom wearing a hat with the letter ‘D’ for dunce on it, are not alone. They are being joined by their government.

During the boom, when the French and German governments allowed their annual borrowing to rise above the limits they signed up to at Maastricht, the Spanish government paid back debt. You may recall those days. Gordon Brown seized on French and German borrowing as evidence that his beloved golden rule, which allowed borrowing during the bad times providing it was repaid in the good times, was superior. And the IMF and the Martians at the BIS loved our former PM for it. But then they loved Spain too, because the Spanish government’s total debt was actually quite modest. To borrow a phrase from David Cameron, Spain really did appear to ‘fix the roof when the sun was shining’.

Spain’s error was not really its fault. Money flowed in from Germany, and other countries, pumping up Spanish property prices, creating a construction boom. Spanish consumers thought they were better off because their home went up in value, and Spanish banks thought they were prudent because the value of their outstanding loans was much lower than the value of the property the loans were secured against.

And in warning that this was a problem, the I.M.F., B.I.S. and E.C.B. were all I.N.E.P.T.

Consumers prepare to fasten padlocks on their wallets and purses

According to a report in the Guardian, the government itself believes there will be 1.3 million job losses in the UK as a result of the Budget. See: Budget will cost 1.3m jobs – Treasury

What should the UK’s workforce do? It only makes sense for them to save. The rainy day looks more likely, so we should prepare for it.

Except, if we all start saving more, aggregate demand will collapse, and the rainy day becomes even more likely.

In the US this may have happened already. In May, US incomes rose by 0.4 per cent. So that’s good. And yet US spending rose by just 0.2 per cent. The US saving ratio is now 4 per cent. By US standards that is high, although by European standards it is quite low. But the latest data would suggest Americans are now saving an incredibly high proportion of any extra money they earn. Maybe they have got themselves into a position in which they are able to cover their essential costs, such that any incremental income is just saved.

Meanwhile in Germany, inflation dropped from 1.2 per cent to 0.8 per cent.

More to the point, other data out this week indicated that the broad money supply across the Eurozone, also called euro M3, contracted 0.2 per cent in June.

Put it all together and what do you get?

Sorry … we will say it again – sorry, but if another recession can be avoided it will be a big surprise. And here is our holiday promise: we will try and think of reasons how recession can be avoided. But here is the warning: for as long as the Martians at the central banks are running the show, the omens do not look good.

Yesterday the government revealed plans to speed up the raising of the retirement age to 66, and the new working age limit could be applied by 2016. It is also now talking about the possibility of raising the age to 70.

Today we are taking a look at the key issues. How fast is the UK ageing? What will be the burden left by the baby boomers to their kids when they retire? Is more saving really the answer? Maybe we need more immigrants. Read on

What the numbers say

If you were born in 1960, your life expectancy at birth was just over 71. So imagine that. If they had introduced a 70 retirement age, just under half of us really would have worked until we dropped. A child born in 2008 could expect to keep going until 80. If you are 65, then today and if you are a man you can expect to keep ticking another 17.4 years. A woman can expect to go all the way to 85. (See ONS. )

According to the ONS, the proportion of people aged 65 and over is projected to increase from 16 per cent in 2008 to 23 per cent by 2033.

To put this in context, back in 1960 the ratio was 11.6 per cent. But compare this with Japan. In Japan the ratio of people over 65 was 5.6 per cent, and in 2008 it was 21 per cent. (See World Bank data .)

That is all very well, but maybe what really counts is the proportion of working people to those aged over 65. In 1960, the percentage of people aged between 15 and 64 was 65 per cent. In 2008 the percentage number had actually increased (marginally). It was a similar story in Japan, where the ratio of people between 15 and 65 has barely changed over the last 50 years.

The real firework relates to the kids. In 1960, the percentage number of kids aged zero to 14 was 23 per cent in the UK, and 24 per cent in Japan. By 2008 we had seen the percentages fall to 17 per cent in the UK, and remarkably just 13 per cent in Japan.

Or to put it another way, Japan is in the midst of seeing a quite stunning change in demographics. Economists have all sorts of theories to explain Japan’s economic malaise, but surely they miss the point. The ageing of Japan’s population is not the elephant in the living room, it is the herd of mammoths in the bedroom.

The UK is ageing too, it is just that the process lags behind Japan. According to the ONS, in 2008 there were 3.2 people of working age for every person of state pensionable age in the UK. This ratio is projected to fall to 2.8 by 2033, taking into account the future changes to state pension age. (Although, the ONS made these calculations some time ago, so they don’t take account of the new government’s plans.)

The saving bomb

We hear about the demographic time bomb, we have used the phrase here often enough. But it may be more appropriate to talk about a demographic saving bomb.

In Japan, more people are saving. They are saving for the very good reason they are going to retire soon. This has led to a crash in consumer spending, which in turn has caused twenty years of economic anaemia. Policy makers try to solve Japan’s economic ills by creating money and slashing interest rates, but it does no good. That is surely because conventional economics does not have the answer. The obvious answer to Japan’s ills would be a pill to make all women more fertile, or mass immigration.

But there is another important point here. It is high savings in Japan that is leading to economic recession, which in turn is creating the necessity for the government to borrow. The good news is, high savings means there is plenty of money for the government to borrow. So in a way, the need for government borrowing is caused by the fact people want to lend to it. There is a similar, although far from identical relationship, between growing savings and government borrowing in the UK.

Japan’s high saving ratio is also a factor behind the global economic crisis. During the noughties, Japanese saving flooded Western money markets, and today, a sudden rise in Japan’s consumer spending would go a long way to kicking life into the Western economy.

The problem with saving is that it does not do much good on its own. We keep hearing in the West of how we need to save more. But just imagine if this happened. Just imagine all baby boomers doubling the rate at which they saved. And then they retired. Yippee, they have a nest egg from which they can fund their retirement.

But would they really? The only way the UK can fund its growing army of retirees is via producing more goods and services from a diminishing pool of labour.

This is why we believe the short and medium-term implications of the ageing of the UK will be more saving and less inflation. But in the longer term, when the baby boomers have all retired, we may find too much money is chasing too few goods, and we will get inflation.

What really matters is not that we save, it is what we do with our savings. If savings is pumped into high-risk enterprises, finds it way into the pockets of risk takers, then for individual savers this is high risk, but for the UK as a whole this is a relatively risk-free way of ensuring we can meet the needs of our future pensioners. If instead, savers’ money finds it way into property, like it did in the noughties; into government bonds, like it is doing now; or worse into gold, which it may well do going forward; this may feel like it is low risk for individuals, but actually on a macro scale we will be taking the most enormous risk with our future well-being.

There is another option of course, which is that savers invest their money abroad. In which case their retirement may be fundable, but the cost will be a UK economy that limps forward for decades.

It is quite interesting to note, by the way, that according to data from the Bank of England, in 2008 UK families saved more than they borrowed. In all, £24bn was put into deposits and £20bn was taken out as loans. Last year saw the savings ratio among households rise from 2 to 7 per cent. See the Telegraph, Families saving more money than borrowing for first time in 20 years. This development is largely being greeted as if it was good news. Maybe it is, but you need to see rising saving in the context of the above few paragraphs. You may think a rising savings ratio is good news for the UK, but it also explains why economic growth is low, and why government borrowing is high. It is only good news if we see a corresponding rise in investment into risk-taking enterprises. But in an environment in which consumer demand is falling, entrepreneurs are likely to be less enthusiastic about their business ideas.

Immigration

According to an article in the FT, senior Conservatives are re-thinking the party’s policy to immigration. Apparently they fear caps on immigration will be bad for business. They are right. Do it in the correct way, with appropriate limits, then immigration can solve the UK’s economic plight, and certainly solve the problem of the retiring baby boomers. Those who say immigration has caused the UK’s woes have completely missed the point. In fact, many of the Polish immigrants, the very same people who have been slated in the media, have been a terrific boon to the UK. They work hard, they pay tax, and are only modest users of the welfare system.
See the FT – Fears force immigration cap rethink

According to an article in Foreign Affairs magazine, the solution to the baby boomer problem may be mass emigration of retirees and immigration of workers. The article said: “One somewhat daring approach to immigration would be to encourage a reverse flow of older immigrants from developed to developing countries. If older residents of developed countries took their retirements along the southern coast of the Mediterranean or in Latin America or Africa, it would greatly reduce the strain on their home countries’ public entitlement systems. The developing countries involved, meanwhile, would benefit because caring for the elderly and providing retirement and leisure services is highly labour intensive. Relocating a portion of these activities to developing countries would provide employment and valuable training to the young, growing populations of the Second and Third Worlds. See The New Population Bomb

And the grass

The big trouble with changing the retirement age is that conditions vary across the country, and across the sectors workers are employed in.

Paul Kenny, who is the general secretary of the GMB union, said: “The government knows that manual workers in the industrial regions of the UK do not enjoy anything like the same life expectancy as professionals or other classes or employees…To force someone who has done a lifetime of toil on building sites, farms or in factories to work until they are 66 is completely unacceptable.”
According to the ONS: “Within the UK, life expectancy varies by country. England has the highest life expectancy at birth, 77.7 years for males and 81.9 years for females, while Scotland has the lowest, 75.0 years for males and 79.9 years for females. Life expectancy at age 65 is also higher for England than for the other countries of the UK.”

And that’s the problem, it’s a case of horses for courses. Some people don’t want to retire until they are old indeed. Others, employed in sectors that require hard physical labour, may feel 65 is too old. Still, with horses, some of us want to be put out to grass, others think it is unfair. But what we can say is that the herd of mammoths in our bedroom won’t keep quiet for much longer.

The markets appeared to like it. Okay, the FTSE 100 was down slightly yesterday, but this was probably unrelated. The index has risen sharply over the last two weeks, so yesterday’s mild falls are pretty insignificant. Sterling rose one cent against the dollar and the euro, but, again, the movements were so small that one can’t really read much into them at all. More significantly, the yield on ten-year UK government bonds dropped from 3.51% to 3.46%, the joint lowest yield in some time. But it was the comments from the credit ratings agency Fitch that are the most significant. David Riley, who is in charge of sovereign ratings at the agency, said of the plans in the Budget to cut government debt: “if delivered upon, will materially strengthen confidence in UK public finances and its AAA status.”

It is unavoidable that growth will falter in the short term as a result of this Budget. But that is not necessarily a criticism. In a way, you could say Osborne wants growth to be slightly lower this year and next. After all, it wouldn’t be painful otherwise, now would it. This Budget is about trying to improve the economy over the longer term. By reducing debt, interest payments on repaying our debt will fall eventually, so that eventually taxes can drop. By trying to shift the economy’s balance towards exports and investment, it is hoped that the UK will be more stable, and future growth won’t be at the expense of another bubble.

The big problem isn’t so much with the Budget. Rather it lies with the groundswell of opinion across the world, and the somewhat short-sighted view taken by markets. Markets failed us in the noughties, and seemed quite inept at seeing the crisis in the making for what it was. We keep hearing things like ‘no one saw it coming’, but this is not true. Plenty of publications, including this one, warned of a crisis in the making, and judging by the feedback we received from readers at the time, our views had common parlance amongst the public. The markets, by contrast, seemed unable to see it.

They can’t see it now. Once again they are proving inept.

As for George Osborne, to express our criticism it is first necessary to say what was wrong with Gordon Brown.

Brown’s followers say the recession was down to factors beyond his control. That the cause of the budget deficit was an international meltdown in markets. But these people forget the standing that GB had during his years as chancellor. Gordon brown stood centre stage in the great failure of the noughties. He, and his biggest fan come friend Alan Greenspan, and his second biggest fan the IMF, were the most influential economic policy makers in the world. They loved Gordon because his views were pretty much smack on what they thought. And they were all wrong.

Gordon’s policies did not cause the international crisis, but he was a part of an international consensus that got it hopelessly wrong.

Alas, it seems George Osborne is similarly cursed. The spirit of his Budget was in keeping with the spirit of the international consensus. And just like in the last decade, the consensus is wrong. The ultimate result could be disaster.

But before we say why, here is a brief rundown of some of the specifics and whether they are a good or a bad idea.

VAT increase is bold move, but danger lurks

To be honest, the increase in VAT was as close to a no brainer as you could get. The snag with increasing tax is that sometimes the effect can be less tax revenue. Economic theory calls it the Laffer Curve. Increase income tax, or capital gains tax, then people’s behaviour changes, they won’t work so hard, they pursue tax avoidance with renewed enthusiasm, high earners may move abroad, others just stop taking risk. Tax receipts fall. VAT is different. Sure, there might be an increase in people working for cash in hand, but in the scheme of things this is not significant. We all have to spend money in the shops at some point. The increase in VAT will raise money.

It is a little ironic, because Alistair Darling’s big idea to kick start the economy during the recession was a cut in VAT. The move drew wide criticism, and was very expensive. But what it did do was inject money into people’s pockets. And in that sense it may have been quite effective at boosting growth for a while. (By the way, economic theory says a tax cut designed to boost the economy has no effect because people have perfect knowledge, and realise tax will have to rise to compensate for the cut in the future so they leave the money they save for the tax cut in the bank. But we know Darling’s VAT cut did lead to a rise in consumer spending, and thus we know at least one piece of economic theory is bunkum.)

VAT is usually seen as a regressive tax, because it penalises the poor as a proportion of their income more than the rich. On this occasion this criticism may not be valid, as Mr Osborne did introduce measures to compensate for this effect.

It does of course make some Lib Dem politicians, and even David Cameron, look stupid because before the election they waxed lyrical about why an increase in VAT was a bad idea. Their excuse that government finances were worse than thought, or that market conditions had changed, were just excuses. If they had any kind of competence in economics at all, they should have known before the election that VAT was going to rise. They didn’t tell us the truth, because, well, because in the words of Jack Nicholson from the film, ‘A few good men’, they thought we “couldn’t handle the truth”, and we would then vote Labour.

What the VAT rise does do is to help re-balance the economy away from spending. For too long the UK was reliant on the High Street for growth. So we bought our advent calendars for dogs, and the High Street saw a boom that was simply absurd.

In that sense the rise in VAT is a good idea.

The counter argument is that the real problem of the noughties was that workers were not getting a sufficient share of growth. The growth in corporate profits outstripped growth in wages, therefore the only way demand could meet capacity was via debt. This argument would suggest lower, not higher VAT is what the UK needs.

Incentive to work

Gordon did have another failure. Not only was he a part of an international consensus that got it wrong, he was the architect of a benefits system that was horrendously complex and destroyed the incentive to work. By playing around with the benefit system, reducing some benefits, including housing benefits, child tax credits for families earning more than £40,000, freezing child benefit, reducing benefit for lone parents when their children go to school, and playing with sickness benefit, Osborne has helped himself to a large stick to try and beat the unemployed back to work.

The rise in personal allowance is the carrot to complement Osborne’s stick.

We would prefer more carrot and less stick, but in essence we think his ideas are about right.

Certainly the lack of incentive to work has been a factor in keeping people off the job market, and this in turn costs the Exchequer billions every year.

There are two snags. Cut benefits and you are likely to see a rise in crime. Secondly, it matters not how great are the incentives to work if there is no work available. Indeed, some argue that high benefits in a recession are essential in order to maintain demand for goods and services.

Help the poor

Osborne has balanced out his VAT rise, to help the poor with an increase in child benefit for low income families, help for pensioners and extending personal allowances. Public sector employees at the low end of the income scale will get pay rises.

On balance, the Budget was surprisingly mild for people at the low end of the income scale, given the massive hits to be suffered by most people.

Soft on banks

The Chancellor imposed a bank levy, in line with a similar levy imposed on the same day in France and Germany.

Of course, banks are not so important to the economies in France and Germany, so the fact they implemented a similar policy is something of a so-what development. The City will lose some of its competitiveness as a result of the Budget, but this will be partially cancelled out by the cuts in corporation tax.

On balance, given the rhetoric from Vince Cable before the election, the banks have got off lightly.

Encourage investment

The cuts in corporation tax will, over time, be quite significant. The rise in the threshold at which employers pay NI will encourage investment and employment in the private sector.

The fact that businesses are seeing taxes fall at a time of austerity does indicate how serious the chancellor is about re-balancing the economy.

One possible doubt relates to the fact that corporate profits have been rising faster than wages for some time. This would suggest that, actually, the economy needs higher, not lower corporation tax. But we realise this is a radical argument, and in any case the argument about the relationship between wages and profits is more relevant in Germany and China, than it is in Britain

Encourage entrepreneurs

For entrepreneurs this was a good budget. They will now be able to sell their business for £5m, and only pay 10 per cent tax. (In his last budget Mr Darling put the limit at £2m.) The small companies’ tax rate will be reduced to 20 per cent, and rules on employers NI contributions for new businesses are being softened quite significantly.

CGT

Capital gains tax (CGT) is to rise from 18 to 28 per cent for higher tax payers. The move has come in for some criticism.

Firstly, some say the rises don’t go far enough. Why should CGT be less than income tax? The counter argument seems to be that had this tax rate risen higher, tax receipts would have fallen.

Don’t forget, a few years ago you paid CGT at 40 per cent.

Others say the chancellor should have offered some kind of taper relief, so that CGT is less for people who make long-term investments. Under the new rules, CGT on shorter profits, made for example from derivatives, will be the same as CGT on profits that are arguably better for the economy.

Spending cuts

Spending cuts are to be massive, and it is surprising that more has not been made of this across the media. Most departments are to cut spending by a whopping 25 per cent.

There is no getting away from this, job losses will result. The question is, will these jobs be replaced by new ones in the private sector?

Conclusion

Expect it to hurt for a few years. It will take time for the economy to re-balance. Export sectors are not going to start hiring straight away. Don’t expect a sudden explosion in investment.

The danger lies in the possibility that the re-balance never occurs.

We are concerned that all governments, except for the US, are banging the same drum, the drum that says fiscal cuts. Such global austerity drives are without precedent. It always worries us when a consensus emerges and the counter view is ignored.

This proved to be a problem in the last decade, it may be a problem now. Five years ago, warning about debt or predictions of a banking crisis were laughed at. Now it is those who say we need to carry on spending that are laughed at.

If the UK was acting in isolation that would be fine, but we are not, and that’s the problem.

Keynesian economics has become a joke. This is tragic. Keynes’s big ideas concerned what to do in a depression. His ideas have never been adopted. Except, it could be argued, during the Second World War, when UK government debt hit 250 per cent of GDP and his policies were adopted by mistake.

For 25 years after the Second World War, Keynesian economics was the only economics there was. The result was something of a disaster, at least for the UK. But Keynes never did argue for spending just to smooth out the economic cycle. It is doubtful the great man would have agreed with the use of his ideas during the 1950s, 1960s or 1970s. Indeed, some economists argue that Keynes was not a Keynesian.

Right now is the only time since Keynes’s ideas were published that has mirrored the period in which he developed his ideas.

But Keynes was also concerned with what should be done in times of global imbalances. He wanted to force trade surplus countries to buy more. Those ideas are precisely what the world needs now.

The big danger with Osborne’s plan is that everyone else wants to do something similar. And when every country tries to spend less, invest more, import less and export more, the result is economic depression.