The US Trade Department reacted by saying that the report would actually confirm that “European subsidies to Airbus dwarf any subsidies that the United States provided to Boeing”. This statement refers to an earlier 2010 ruling which Boeing accused Airbus of receiving $20bn in illegal subsidies.

The Yanks may have a point because if you average out $5bn over the last few decades this only comes to the price of one large body aircraft per year. This is hardy enough money to do any serious research and development.

This latest WTO dispute is the largest in its history. The arguments go back 6 years and have their foundation in an old 1992 trade agreement that was abandoned by the US Government. There is everything to fight for as the aircraft market is worth $1.7 trillion. In recent years the fight has become tougher as new Chinese and Brazilian aircraft have started to compete in this market.

There is also a wider impact of this dispute. The WTO will release its official findings in a few weeks, around the same time as the US Air Force are going to decide on who will win the $25-50bn contract for refuelling tanker planes. Both Airbus and Boeing have their political allies but the report may shine a negative light on just how Airbus have been able to undercut competitors in the US market. Image from Smarter air charter

In all, December saw a 103,000 gain on payroll employment, compared to 297,000 the month before. It was a blow, because the recent ADP survey had suggested we would see so much better.

There was some good news in the figures: US unemployment rates fell to 9.4 per cent, from 9.8 per cent the month before, and that was a 19-month low.

Alas, there is a view that once unemployment benefit for those who have been unemployed over a long term is reinstated, a number of people who are not currently registered as jobless will suddenly come forward, pushing the official estimate of unemployment up.

Paul Dales, Senior US Economist at Capital Economics said: “The labour market may well improve in the first half of this year, as activity is supported by the second fiscal stimulus. But that boost will fade later in the year. Overall, the US economy is still not creating enough jobs to generate a sustained and meaningful fall in the unemployment rate. As such, the Fed is unlikely to call a halt to its asset purchases ahead of time.”

Economic theory has this concept known as Okun’s Law. This suggests that for employment to increase by 1 per cent, GDP needs to grow by roughly 2 per cent (Fed chairman Ben Bernanke is one of the experts on this particular theory). But demographic and productivity changes mean the story is more extreme, and it has been calculated that the US economy needs to grow by around 2.5 per cent for there to be any increase in employment at all.

In other words, the equation looks like this: growth in employment is half the growth in GDP, once that growth exceeds 2.5 per cent. So, this implies that in the long run the US economy must expand by more than 3.5 per cent a year for there to be any improvement in employment at all.

See: Sticky unemployment – Okun’s Law

Companies are awash with cash, it seems. We are not talking about dynamic little entrepreneurial businesses, of course. They need cash and banks ain’t providing it. Rather, it is the big corporates. They are so awash with money they are not sure what to do with it. These are the very same companies that don’t want to borrow from banks, thus supporting the banks’ assertions they are willing to lend, but no one wants to borrow. It seems the only way your bank will lend you money at the moment is if you don’t want it.

So what will companies do with all their cash? Chances are they won’t save it; interest rates are way too low for that. If they try putting their hoardings in deposit accounts, shareholders will scream out in fury. So that means one of three things: a year of big dividends and share buybacks; a surge in investment; or a rise in merger and acquisition programmes.

At the tail end of last year, the FT’s Martin Wolf was about as bullish as one can recall, thanking central banks for their foresight in rescuing us all from financial disaster.

And this week, the latest purchasing managers indices (PMIs)have revealed a fine tale, with the UK PMI from CIPS/Markit hitting a new 16-month high; the index tracking employment only falling slightly from last month’s highest ever reading; and new export orders reaching their highest level since April when they hit an all-time high. In the US, the PMI has hit a six-month high, but bear in mind six months ago it was suggesting US manufacturing was booming.

And yet, data out at the tail end of 2010 revealed that while US annualised growth was 2.6 per cent in Q3, final demand (that’s demand after removing the effect of stock re-building) was up just 0.9 per cent. In other words, much of Uncle Sam’s stellar growth may have been down to the inventory cycle, and thus won’t continue.

And while it’s good to see manufacturing companies apparently taking on more staff, the Chartered Institute of Personnel and Development (CIPD) – who seem to be the experts on the UK job market – have forecast that public sector employment will fall by 120,000 and private sector employment will fall by 80,000, pushing UK unemployment up to 9 per cent.

One thing is for sure: while 2011 may be good for equities, for households it will be awful. It seems likely inflation will greatly outstrip wage rises. In fact, recent data suggests it won’t be until around 2015 before average households are as well off as they were in 2009.

So, if consumers are going to struggle, and the public sector is set to feel the axe, growth can only come from investment and exports.

Exports are looking promising, but the nagging doubt remains that US debt and euro woes will lead to sterling rising against the euro and the dollar. This could kill off hopes of an export recovery.

And if demand is so low, why should companies start investing? Surely you only invest if you think you can sell more products.

Maybe the problem is that wages have been cut by too much. Companies have cut costs, and for individual companies this makes sense, but for the macro economy this could mean demand will be insufficient for companies to generate the growth they require.

So we look towards the East, hoping demand will come from China and India. But here there is promise, for it might.

Last December, it was told here how China may be approaching the Lewis Turning Point, when the country runs out of workers to migrate from the countryside into the towns. If this is so, wages in China will probably rise, and then in turn we may see wages in the West rise too.

The last decade or so has seen global savings outstrip investment, creating cheap interest rates, but creating a problem of insufficient global demand – leading to downward pressure on wages. This could be set to change, although it will take two or three years before this effect is felt.

See: The world’s most populous country is running out of workers – what are the implications?

http://www.investmentandbusinessnews.co.uk/china/the-worlds-most-populous-country-is-running-out-of-workers-what-are-the-implications/12147

and: Interest rates set to rise as economic tectonic plates shift – is this good or bad news?

http://www.investmentandbusinessnews.co.uk/economic-growth/interest-rates-set-to-rise-as-economic-tectonic-plates-shift-is-this-good-or-bad-news/12136

Steven Spielberg may have shown remarkable prescience with his famous 1975 film, apparently prophesying the events of Sharm el Sheikh, but not even he could have produced a film fit enough to tell the story of the protectionist attack that could be pending.

In China, it seems bubbles are inflating faster than you can say DA DUM.

In the US, the wall of protectionism is homing in: DA DUM DA DUM
There is even talk of yet another round of quantitative easing: DODODO.

And yet there is no need for the scar-comparing Richard Dreyfuss and Robert Shaw to save us. On this occasion, common sense can save the day.

Look across the surface of the Chinese economy, and the shark fin that is a property bubble glides into sight.

According to Ambrose Evans Pritchard, writing in the Telegraph: property “prices are 22 times disposable income in Beijing, and 18 times in Shenzen, compared to eight in Tokyo. The US bubble peaked at 6.4 and has since dropped 4.7. The price-to-rent ratio in China’s eastern cities has risen by over 200pc since 2004.”

No wonder some are drawing parallels with Japan twenty years ago. The Japanese government deliberately kept the yen cheap against the dollar, creating a massive backlash amongst US politicians. But when Japan finally acceded to Washington’s demands and the yen rose, property prices in Japan crashed, and nigh on twenty years of economic growth were lost.

Then there’s Uncle Sam. The last few days have seen three bits of news to scare the willies out of you. First, Uncle Ben has been making noises suggesting he is considering yet another round of quantitative easing. Secondly, the latest report on US jobs was a big disappointment. Payrolls rose by a tiny 39,000 after a 172,000 jump the month before, and unemployment rose from 9.6 to 9.8 per cent. And finally, the third bit of news revealed that Barack Obama has elected to extend George Dubya’s tax credits by another two years.
Why is it all so scary? Well, it seems that Uncle Sam is all over the place. The US fiscal debt is rising to horrendous levels. Democrats won’t agree to spending cuts, Republicans won’t agree to tax rises. We end up with a kind of horse trading creating even more debt. President Obama has agreed to extend the tax credits for high income earners in exchange for Republicans agreeing to extend federal unemployment insurance.

You could say that US economic policy making is in a mess, but then you could say the Amity Island mayor, and now the Egyptian tourist industry, made a mistake by saying the waters were safe. In fact, Spielberg’s fictional character, and the Egyptian minister who seems to have chosen to mimic him, made errors on a catastrophic scale, and so it is in the US.

Meanwhile, the money created by the Fed is pumping yet more dollars into China, and in order to maintain the exchange rate with the yuan, the Chinese central bank is forced to create money. And so it is that the Chinese money supply expands. According to Bloomberg, analysts reckon China’s money supply expanded by 19 per cent in November on the year before.

China is being forced to react. Interest rates are set to rise. But whether China is capable of deflating its bubbles without letting the yuan appreciate, is another matter.

The fear is growing that as Uncle Sam sees how hopeless its attempts to kick start the economy are becoming, he will instead opt for protectionism, pushing up tariffs on its imports from China.

Bizarrely, Capital Economics thinks the threat of this could be a good thing, and that Chinese authorities will react to this growing danger by finally acceding to US demands and allowing its currency to rise.

The parallels between China today, and Japan 20 years ago, are obvious. No wonder many are predicting the bursting of China’s bubble.

But we are not so sure.

There is a deep and fundamental difference between China today and Japan twenty years ago. Look at it this way. It could be said there are two types of growth. Growth that occurs during a period of catch up, when an economy is closing the productivity gap with mature economies. Then there is the growth that occurs once an economy matures. At this point, growth is reliant on innovation.

Japan’s problem from 20 years ago is that it caught up, even raced ahead, and then the potential for growth fell. It was similar in Europe and the US in the early 1970s, when productive potential defined by past innovation had just about been fully used up. In the 1970s growth slowed, but demand kept rising, so in Europe and the US we got inflation. In Japan, as the growth slowed, property prices kept rising, and then we got the deflation of Japan’s asset prices.

It is not like that in China. She is still years away, maybe decades, from catching up with the West and Japan to become a mature economy.

Sure, the Chinese property bubble will probably burst. But this will not be the calamity it was in Japan in the late 1980s.

But we now know that not even the US and European consumers combined have sufficient resources to soak up the extra production that comes with Chinese development. The potential for China’s growth to continue is still huge, because there is still massive untapped potential. But this growth can only occur if demand rises in tandem, and China, it appears, is the only country in the world big enough to provide this extra demand.

And that’s the great irony. The US threatens China, but actually, both US and Chinese interests are the same.

Who knows why the shark attacked swimmers off Amity Island. But it appears the causes of the attacks off Sharm el Sheikh may well have been manmade – with the tipping of animal carcases the most likely culprit; Mossad involvement, surely the least likely.

But in the Chinese–US row, the ones who are most guilty are the politicians, and maybe it is them we should have harpooned.

Except he, or is that she, is doing no such thing, and Uncle Sam is simply paying the downside for its big upside. But expect fireworks, however, as US politicians find another reason to blame the rest of the world for their ills.

Blame is a good game to play. It’s good to blame others for your misfortune. The US has run up huge debts, and it’s good to blame China for having the gall to lend it money.

The reality is the US has huge debts because no one is willing to pay their dues. The Democrats want European-style healthcare at a time when the population is ageing, and the Republicans want tax cuts, or at the very minimum won’t agree to tax hikes, such as reversing George Dubya’s tax cut.
And can you believe this one – there is actually an economic theory that Barack Obama caused the recession, even though it began when George Dubya was president.

The theory goes like this: markets, and even those people that economists seem to think have perfect knowledge – consumers, thought Barack Obama would become president and then in turn mess things up, so in anticipation of this they saved more, and as a result the US fell into recession.

It just goes to show you can concoct a theory to prove just about anything you want, if you try hard enough and blind yourself to your theory’s failings.
In his book, Crisis Economics, Nouriel Roubini said: “Many politicians and policy makers seem blithely unaware of how little leverage the United States has with countries financing our twin fiscal and current account deficits. They tell China it can’t buy American companies, and they threaten to take protectionist measures if China doesn’t revalue its currency. That’s very quaint – and foolish. In effect, China is underwriting US wars in Afghanistan and Iraq, never mind the bailout of the financial system and any costs associated with reforming healthcare.”

Roubini frets about what will happen when the dollar loses its mantle as the world’s currency. After talking about the fallout that may occur as a result of the burgeoning crisis in the Eurozone, he says: “These tremblors will shake the global economy. But they’re minor compared to the ‘big one’ – a rapid, disorderly decline of the dollar.”

But for the time being at least, the dollar remains the world’s currency. And for as long as this remains the case, the Democrats and the Republicans can continue to play the fiddle while the fiscal deficit burns. But if they don’t change, then when that day dawns that the dollar loses its hegemony, all hell will break loose. “If the United States were an emerging market,” says Roubini, “it would have long ago suffered a collapse of confidence in its debt and currency.”

But there is a price to pay for having the world’s currency.

It turns out that the two banks which benefited the most from the Fed’s emergency loans were Barclays and the Swiss bank UBS.

Of course, the loans were only overnight, and the Fed has been repaid.
No doubt some in the US will see this as evidence once again of how the US keeps bailing out the rest of the world. The truth is, dollar hegemony is effectively funding US practices that would have brought any other economy to its knees.

For seven months in a row, US core inflation has been below 1 per cent. Month-on-month data has been flat for three months.

In October, the annual rate of core US inflation was 0.6 per cent. However, because of the way the data has moved in the past, it would take another nine months of flat month-on-month price changes before the annual rate of US core inflation hits zero. Bear in mind, however, that the weak dollar has been pushing up on US prices, so the fact that core prices are looking weak, when the imported goods are rising in price, is truly alarming.

The headline rate of annual US inflation is much higher – 1.2 per cent in October, although again, when you consider how weak the dollar is, this remains worryingly low.

It seems the problem in the US is subtly different from the UK challenge. In the US over the past 12 months, average hourly earnings have increased by 1.7 per cent. But given that inflation is so low, that means that workers are seeing a real improvement in their hourly compensation relative to inflation.

In the UK, by contrast, average earnings including bonuses rose by 2 per cent in the year to September. Over the same period, the retail price index rose by 4.6 per cent.

But, although hourly compensation may be above inflation in the US, personal income growth is not. In fact, US personal income fell by 0.1 per cent in September. Real disposable income fell by 0.3 per cent.

There is no mystery behind falling US inflation. In fact, the only real mystery is why UK inflation is remaining so stubbornly high.

The US and the UK enjoyed an orgy of spending lasting over a decade right up to the moment of the credit crunch. In the UK, consumer spending went mad in the late 1990s, and while growth in consumption slowed in the noughties, the fact is, in order to make up for the excess that had come before, it should have contracted. It was house price inflation during the noughties that stopped the consumer spending correction. With US house prices now doing a good impression of a lead brick falling off a cliff, and with UK house prices teetering, it just doesn’t seem possible that consumer spending can do anything but fall next year.

Throw into the pot the impending retirement of the baby boomers, and the need for those in their forties and fifties, and indeed early sixties, to save a lot, lot more, and the prospects for consumer demand in the US and the UK are looking decidedly ropey.

It is no surprise that QE is not working. The Fed can keep printing dollars, US households just don’t want to spend.

But what we are seeing, however, is a flight from cash by investors.

Economic theory says that when interest rates are low, people will want to spend more. But that’s not how it’s working. Portfolio managers, on the other hand, are ditching cash. They are avoiding cash as if it were scorching hot.

This in turn is pushing up on some asset prices, incuding bonds and equities.

So, here is your question for today. If consumers are reining back, meaning falling demand, but asset prices are rising anyway, is it sustainable?

“The stock market has forecast nine of the last five recessions,” or so the economist Paul Samuelson once said. But the big question now relates to whether Samuelson’s idea works in reverse. In other words, are stock markets as poor at predicting recoveries as they are recessions?

Of course, the Dow enjoyed very impressive rallies after the crash of 1929, leading many experts to forecast the end of the downturn. And yet the leading US stock market index did not pass its pre-crash high until 1954. By contrast, it took just two years for shares to recover from the 1987 crash.

There is a difference between those two famous crashes, of course. I929 marked the beginning of the Great Depression; and historians are still puzzling over the 1987 fall, with some even arguing it was something of a statistical quirk.

Last night the Dow hit 11,435, the highest level since 8 September 2008, and the FTSE 100 hit 5,863, the highest level since June 2008. The two indices are still way down on their all-time highs. The Dow peaked in October 2007 with a score of 14,164, and the FTSE 100’s highest level was set on 30 December 1999 with a reading of 6,930. (Incidentally, the pre-dotcom bust high for the Dow was set on 14 January 2000: 11,722.)

But what is a little strange about yesterday’s movements, or at least superficial analysis makes it seem strange, is that gold, normally seen as a safe refuge in times of crisis, hit a new all-time high, and the yield on US and UK government bonds fell quite sharply.

But actually, there is a good reason for the seemingly contradictory movements. It all boils down to those horrible two words, quantitative easing, or QE.

The Fed revealed plans on Wednesday to create $600bn worth of new money over the next year or so. The move was anticipated by just about everyone. Or at least, markets knew more QE was on its way, but in fact the consensus was for an even bigger stimulus. So that does make the market reaction a tad odd. After all, it’s supposed to price-in changes it expects. But then again, sometimes momentum on its own can be enough to push markets up.

Observe through the prism of QE the seemingly contradictory movement with securities that are supposed to do well in times of boom, rising with other securities that are seen as a safe refuge also surging, and things make more sense. After all, the Fed wants to drive up bond prices by buying these securities, and thereby make equities look cheap. That is the main purpose of QE. If equities surge, we will feel better off. Pension deficits will shrink, and may eventually turn into surpluses. As a consequence, companies will be able to afford to invest more, pay out bigger dividends, or even up the wages of their staff. At least that’s the theory.

But then again, if we were to say QE is not very popular, it would be an understatement along the lines of saying “folks around here are unenthusiastic about suffering another world war.”

And in the build up to the Fed’s revelation of more QE, and indeed in the aftermath, analysts queued up to explain why they felt the measure would be ineffective. In fact, it is actually quite hard to find fans of this particular measure outside of the central banks in the Big Apple and the Big Smoke (London).

Oh, apart from George Osborne, that is, who seemed to suggest that we should praise him for his fiscal policies because as a result of the measures he has taken, the Bank of England is more likely to introduce more quantitative easing. He said: “Fiscal credibility allows the MPC to do what it has to do, raising interest rates, lowering interest rates or using any other monetary policy tool. It gives them flexibility.”

But the US political scene is less clear cut. Thanks to the results of the midterms, Republicans now control the House of Representatives, and are likely to vote down any attempt by Barack Obama to introduce fiscal stimulus, meaning that if you want to stimulate the economy, QE is the only game left in town.

But actually, there are other reasons for market exuberance. Markets were cheerful earlier this year, too. After all, the US had been enjoying pretty impressive growth figures. But then, come the spring, bad news started to emerge. The data that seemed particularly to spook the markets were the purchasing managers indices from CIPS/Markit in the UK and from ISM in the US.

You may recall, back in the spring the PMI for UK manufacturing hit a 15-year high. The index tracking new export orders hit an all-time high. In the US the story was similarly bullish, with the PMI for manufacturing hitting 60.4, the highest reading since 2004. The indices tracking services were up, too. And then things went pear shaped, falling steadily, with the new export order index for UK manufacturing at one point suggesting contraction was under way. The steady decline in these key barometer indices fuelled fears of a double-dip recession. But this week, the October versions of the various PMIs were out, and they looked good. The PMI for UK manufacturing enjoyed its first improvement in seven months. The CIPS/Markit report tracking services had the headline index hitting its highest level since June. The US equivalents of these reports also pointed to a rebound.

Perhaps the most promising piece of data relates to jobs in the manufacturing sector, with the CIPS/Markit report suggesting jobs are being created at the joint fastest rate since the mid 1990s.

Hand in hand with the more promising economic data, company results are up too, and while a cynic might question why equities are rising so fast, it needs to be borne in mind that forward p/e ratios, that’s projected profits versus current market cap, remain quite modest by historical standards.

There are two big snags, however.

Before the economic crisis descended on the world, there were two underlying problems which don’t seem to have been solved.

Firstly, we had global imbalance. Here there is some room for optimism, and in China at least there are signs that consumption is beginning to take off, leading to the world’s economic growth engine being more evenly balanced, and thus more likely to become a source of consumption for the rest of the world. But in Europe, the same old problems are dominant. Germany still sells more than it buys, and the likes of Ireland and Greece still seem to be heading for oblivion.

Secondly, we have a problem that is rarely discussed but which is incredibly important.

During the boom, the elixir that is economic growth did not fully soak through the system into people’s wages. The boom saw a disconnect between economic growth, and growth in household disposable income. Moving forward, it looks as if household disposable income may be set to fall. Indeed, this process has already begun on both sides of the Atlantic. And if households become worse off they will spend less; eventually corporate profits will fall, and output will contract. Right now, the economic system is not porous, wealth is not trickling down. And until it does, the great crisis of 2008, or would that be the great crisis of 2000, will not come to a complete end.

For more on declining household affordability, see: The US and UK economy may be growing, but households are suffering a nasty hit

Investment and Business News is a succinct, erudite and informative roundup of today’s top news stories on business and the economy, with analysis thrown in. Sometimes amusing, frequently contrarian, often thought provoking, and always informative, Investment and Business News is free. To subscribe, click on the subscribe function at the top right hand corner of this page. By the way, did we say it’s free?

Consumer demand is everything for the economy. It matters not what companies invest, or what asset prices do; if consumers are not buying stuff, then everything else will eventually grind to a halt. There is no debating this. Production and investment, and buying frenzies and investment crazes, count for nothing if, beneath it all, consumer demand is not there to support the activity.

It is obvious. In the UK, VAT is founded on this principle. One business sells to another and charges VAT. The business that buys this product claims the VAT back, adds a bit to the product and sells it on to another, and charges VAT. And so the process continues until we reach the end of the line, the consumer. This is where VAT is charged but not claimed back. This is where value is no longer added, and the consumer pays the tax on the entire production process. All production will eventually soak through the economy and reach the consumer.

And yet the importance of the consumer gets forgotten. During the boom of the noughties, consumers got forgotten as GDP soared, but in the UK, discretionary disposable income shrunk. In the US in 2007, corporate profits as a percentage of GDP hit an all-time high, pushing up equity prices, but the rise in profitability did not filter through to consumers in sufficient quantities. Growth was propped up during this period because consumers ran up ever greater debt, which was never going to be sustainable. In the noughties, the fruits of globalisation and new technology were not distributed from company coffers to consumers. Recession should have occurred sooner as a result, but instead, rising consumer debt delayed the inevitable correction, making it far worse when it finally came.

But the consumer is in trouble again. In both the UK and the US, households are becoming worse off, and next year are set to become even poorer as wage rises lag behind price inflation. Data out this week from the US adds to this tale of woe. For more, see today’s piece: The US and UK economy may be growing, but households are suffering a nasty hit

And as this column keeps saying, don’t forget the retirement of the baby boomers. The baby boomer generation across the developed world needs to spend less and save more. There is no alternative, this must happen, and it will happen.

And yet, despite problems for consumers, asset prices keep soaring. The yield on US and UK government bonds has dropped to silly levels. The Dow is flirting with a year high. It hit 11,188 last night, against 11,205 in April which in turn was the highest reading since before the collapse of Lehman Brothers. (And if you are interested in such things, it is now 544 points off the pre-dotcom crash high.)

This begs the question, why are equities so high, while consumers are so hard up?

There are two answers to this question.

First of all, it’s down to QE. Certain central banks are buying bonds, pushing the price of bonds up, making equities seem cheap, pushing their price up too. This is precisely what the Bank of England and the Fed want to happen. They are hoping that higher asset prices will make households feel better off, and encourage them to go out and spend. But why would consumers do this when their disposable income is so stretched and when house prices are looking so vulnerable? This begs the question, are the central banks in the UK and the US fuelling an asset bubble?

The second answer to the question why are equities so high, throws a different light on the subject. Maybe equities have been rising because US corporates are making more money. Indeed, if you look at the forward p/e ratio for S&P 500, that’s to say market cap versus what markets expect profits to be next year, the ratio comes out at 12.7, a perfectly reasonable level.

But then again, how is it possible for corporates to be making more money when the person who will ultimately buy the fruits of corporate production, the consumer, is so hard up?

The obvious answer is that US company valuations are justified because the US can export its way forward. Well, this may prove to be right, but at the moment this view does smack somewhat of wishful thinking.

But the issue becomes more interesting when we look at a fascinating gem of information to come out of the US yesterday on what money is doing. Yesterday, it was told here how the velocity of money circulation, that’s the speed at which we spend, is rising, bringing with it fears of inflation. See: Velocity matters, so is the money supply really in such a state?

Well, here is a piece of news that at least on the surface supports the velocity of money proposition: according to the American Association of Individual Investors, holdings of cash in the US are at their lowest level since March 2000.

So, if we are holding less cash, presumably this means we are spending much faster. QE may be ineffective in terms of boosting the broad money supply (that’s the money supply including such things as credit), but if we are spending money more rapidly, QE is still boosting the economy, and may be creating an inflationary effect that neither the Bank of England nor the Fed have fully factored in.

But then again, as was said in today’s piece, The US and UK economy may be growing, but households are suffering a nasty hit, while the US and the UK economies expand, households in both economies are becoming worse off.

It seems to us that QE is not shoring up inflationary problems for the future, simply because the money being created is not reaching households. Instead, it is fuelling an asset bubble. This is why the likes of Nobel winners Paul Krugman and Joseph Stiglitz say QE on its own is ineffective, and instead, governments need to control how the money that is created is spent via fiscal policy. The results of the US mid terms mean this won’t happen.

The last time holdings of money were so low was in March 2000. Back then the rises in the velocity of money did not herald a new era of inflation. Instead, it was a symptom of the fact we were in bubble territory. Dotcoms crashed. Instead of inflation, we apparently got NICE, non-inflationary, consistently expansionary. In reality, what we got was a bubble, because the wealth created did not pass down the chain to the consumer, but instead funded lending and then boosted house prices. Today, the assets that are booming are different, but something similar is happening, and tears will follow.

Investment and Business News is a succinct, erudite and informative roundup of today’s top news stories on business and the economy, with analysis thrown in. Sometimes amusing, frequently contrarian, often thought provoking, and always informative, Investment and Business News is free. To subscribe, click on the subscribe function at the top right hand corner of this page. By the way, did we say it’s free?

In the UK, wage inflation is lagging behind consumer inflation. In the three months to August, the annual growth rate for pay including bonuses was 1.7 per cent, against 3.1 per cent for consumer inflation, and inflation measured by the retail price index of 4.6 per cent.

But even that puts a positive gloss on things. The truth is, average wages are only as high as they are because of government spending. During the same period, average pay in the private sector rose by just 1.2 per cent over the previous year. In other words, your average private sector worker is becoming worse off to the tune of 3.4 per cent a year, relative to the retail price index.

But things are set to get worse. Next year will see VAT rise, and wage hikes in the public sector will stop, maybe even go into reverse. The job losses caused by the austerity drive will put pressure on wages. Meanwhile, VAT will rise next year and benefit payments will fall. During the recession, the fall in interest rates meant that the average household, after allowing for debt repayments, was no worse off. But interest rates can not fall further. Next year, it seems your average household will have significantly less disposable income than today.

According to a report from Fathom Consulting, households across the length of the UK are being protected from financial ruin by low interest rates. Danny Gabay from the consultancy was quoted in the Daily Mail as saying: “We are in a situation that I am very worried about. Too much money has been lent against assets which have fallen in value but those losses have not yet been fully recognised. We are being kept alive on a near-zero interest rate drip and we can’t move forward.” See the Mail piece: Millions caught in cheap home loans trap: Financial expert’s warning over families under threat from interest rate rises. http://www.dailymail.co.uk/news/article-1326040/3m-households-caught-cheap-home-loans-trap.html#ixzz14DI2XiUy

The truth of the matter is that we are told inflation is an inevitable consequence of QE, and interest rates will have to rise. But if rates were to rise, then the consequence of that in the current environment would be that a complete catastrophe would descend on households, and demand would crash, creating a Japanese-style lost decade or longer of falling prices.

Meanwhile in the US, data out this week showed that personal incomes fell 0.1 per cent in September, while household disposable income dropped 0.3 per cent. Consumer spending was up, but only by a tiny 0.1 per cent, while in the third quarter the US savings ratio fell from 6 to 5.3 per cent.

So, if consumers are being hit so hard, why are bonds and equities doing so well, and why are the economies of the US and the UK still growing? To find out why, see today’s main article: Will quantitative easing fuel the next bubble?

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Pessimists say that the inevitable result of the spending cuts will be a surge in unemployment, and the UK will head back to recession as a result. The out and out pessimists say a downward spiral will be created as a result of the cuts, and the rise in unemployment will lead to less consumer spending, lower corporate profits and that as a result business spending will fall too, and then things will get nasty.

The optimists say corporates are scared of the public deficit, and if they can be convinced George and his crew are serious about cutting back, they will open up their corporate wallets and spend, moving into the vacuum created by government cuts, but creating more sustainable and productive jobs in the process.

The ITEM Club falls into the optimistic camp, but maybe not quite as unequivocally as suggested by the various media reports out this morning. The Ernst & Young forecasters reckon that consumers are cashed out. They are out of puff. That inflation is set to exceed wage increases for the time being. And while the ITEM Club reckons consumer spending will remain healthy until the end of this year, perhaps creating a pretty good Christmas for retailers, it is far more gloomy about the prospects for the High Street in 2011 and for the following few years.

Its optimism applies to corporate Britain: “Large non-financial companies are generally in excellent financial shape,” says the ITEM Club. And it reckons, or maybe it would be more accurate to say it hopes, Britain’s large corporates will spend. That they will eat into the cash reserves they have built up. And while small businesses find that squeezing money out of the banks is akin to squeezing blood out of a stone, big business is not similarly cursed. So the theory goes that larger corporates can raise money, and they can then fund a new wave of investment.

Peter Spencer, the head of the ITEM Club, not to mention an economics professor at York University, says that corporates have benefited from globalisation. He sees exports and investment taking up the slack, as government and consumer spending wilts.

For an overview of the ITEM Club forecasts see our “recent and forecast growth” economic snapshot section.

Meanwhile, 35 top men and women in business, including Andy Bond and Charles Dunstone, who respectively are the chairman at Asda and Carphone Warehouse; Ian Livingston, Chief Executive of BT; and Gordon Frazer, who is the top man at Microsoft UK, have written a joint letter to George Osborne urging him to cut as much as he is able. The letter said: “Everyone knows that when you have a debt problem, delaying the necessary action will make it worse not better … The cost of delay is enormous … In the end, the result of delay would be deeper cuts, or further tax rises, in order to pay for the extra debt interest … if the markets lose faith in the UK, interest rates will rise for all of us.”

The letter suggested that if the UK delays in making cuts, then this delay will cost the exchequer around £100bn.

Here are a couple of observations.

Economists are almost as unpopular as bankers. They did an appalling job at predicting the economic crisis, and most people would believe a chief exec at a large successful British company over an economist. So when the likes of Paul Krugman and Joseph Stiglitz, both former winners of the Nobel Prize in Economics, argue against cuts, and CEOs at blue chip companies come out in favour, most people are inclined to believe the company bosses. But that does not necessarily mean CEOs are always right and economists always wrong. The letter to the Telegraph said: “Everyone knows that when you have a debt problem, delaying the necessary action will make it worse not better.” But not everyone realises that when you are talking about the economy, basic rules of common sense can be wrong. The problem right now is that business, consumers and the government, are all making cutbacks simultaneously. And when everyone does this, the result can be a fall in demand, a fall in prices, and as a result the more we save, the higher our real debt.

The second observation is this. Peter Spencer talked about the strength of corporates, how corporate profits as a percentage of GDP have been rising, and how corporate Britain has done well out of globalisation. Meanwhile, corporate Britain writes to the Telegraph to call for government cuts to be as extensive as possible.

But is it not possible that this analysis is back to front? Corporate profits as a percentage of GDP also surged in the US during the 1920s, peaking in 1929. Common sense says the problem we had in the noughties was that debt got out of hand. But it could be equally true to say savings got out of hand. Corporate savings rose too high. And that much of the proceeds of the noughties boom went into balance sheets or was paid put as dividends, and bypassed workers.

And if the fruits of globalisation are not being adequately distributed, or if wage growth does not keep pace with GDP growth, we can then get the problem of demand lagging behind supply.

In fact, figures from Ernst & Young back in 2007, the same Ernst & Young which owns the ITEM Club, showed that discretionary disposable income for households in that year had barely risen at all over the course of the decade. See: You have never had it so good – well actually you have.

 Maybe the only reason why we avoided a recession many years earlier than we did, was because consumers ran up debts.

So it may be that the debt bubble was a symptom of a deeper problem, not the cause of the economic crisis.

And the ITEM Club may well be right, and corporates may start spending. But equally, they may not. And therein probably lies the key to economic prospects for the next decade or more.

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