It’s been another busy few days. Quelle surprise – government finances are worse than we thought. News has emerged that during talks between the Lib Dems and the other two to form a coalition government, labour seemed unenthusiastic about the idea. Can’t think why, can you? And then there’s the French president, our good friend Nicholas Sarkozy, who said the EU itself was in danger of falling apart.

Read the article that follows for more on these stories. See End of EU warning, Greece blames the banks, and government finds black hole

But first, consider this one. If the UK is set to follow Spain into the economic dog-mire, explain some rather surprising news to come out of Spain on its inflation.

And so the austerity begins. In Portugal, VAT is rising by 1 percentage point to 21 per cent, there’s an increase in corporation tax, and income tax is going up as the country’s government tries to reduce its fiscal deficit from 9.4 per cent of GDP last year to 7 per cent this year and 4.6 per cent next. In Greece, the government is trying to enforce public sector wage cuts of 12.5 per cent; in Spain, the idea is to get pay down in the sector by 5 per cent. We all know about the unrest in Greece, but in Spain, where unemployment is 20 per cent, the resentment is growing; strikes, more strikes and then strikes seem inevitable.

As for the UK, we’ll let the headline in today’s Telegraph tell the story: “David Cameron declares war on public sector pay”. It seems Cameron’s big idea is to hit those people in the public sector who are on the highest wages and get the biggest bonuses. So that’s clever, civil servants earning over £100,000 a year are hardly like to go on strike. But don’t expect this to continue. The idea of making the rich pay for our debts is very seductive, but it ain’t going to happen, finances just won’t allow it.

But how about this for an idea? Debts are too high, right. Why not print money, and inflate our way out of danger? If our GDP rises by, say, 12 per cent in real terms, but by, say, 20 per cent in monetary terms, then our debt will become more affordable. And that in a nutshell expresses the big fear. Quantitative easing (QE) is step one on the road to paying off debt via inflation, and letting creditors, or if you prefer, those with savings, suffer by seeing the real value of their savings/investments erode faster than Gordon Brown rushing out of UK politics.

It is just that there are reasons why this fear is probably wrong. For one thing, much of the UK’s existing debt is in bonds which are tied to inflation. So if inflation rises, so does the yield on many UK government bonds.

For another thing, well, take Spain. Spain’s core inflation rate (that’s with food and energy taken out) went negative in April, falling by 0.1 per cent on the year before. The EU average was plus 1 per cent. Of course, the headline rate was 1.6 per cent.

It’s all a bit tricky. During the noughties we had low inflation in manufactured goods and high inflation in commodities. This diverse pattern may have confused central bankers and the markets, leading to certain policy errors.

But just bear in mind, the big bears of the UK reckon that everything that the likes of Greece and Spain are going through will be experienced here down the line. So we will suffer a fiscal crisis in a few months’ time as markets run scared of the UK’s ability to pay debts. Those same critics are typically the ones who say inflation is set to return to the UK with a vengeance as a convenient way of paying off debts. But if that is so, and we are set to follow Spain, why is it that deflation, and not inflation, is becoming a growing fear in the land of the Costas?

Of course, the UK has added inflation worries: namely the cheap pound, lower interest rates and QE. The European Central Bank has been dominated by inflation hawks. Maybe that is why Spain is now close to the deflation precipice.

 But it is worth taking a sideways look for a couple of paragraphs.

Some time ago economic theory came up with the idea of the Phillips Curve. This was meant to indicate a reverse relationship between employment and inflation, and that there was a trade off between jobs and inflation. Later on, the monetarists said that the real trade off was between expected inflation and jobs, and that as inflation rises, expectations of inflation rise, therefore in the long run there was no trade off, or if there was, then an ever rising rate of inflation was required to keep employment high.

In the long run, it may be more accurate to say that there’s a natural rate of employment. If employment falls below this level, we get deflation; if higher, we get ever growing inflation. But during the Thatcher era this natural rate of employment moved to the right. All of a sudden we could afford higher employment without suffering inflation.

It seems that in Spain, where unemployment is 20 per cent, and core inflation is now negative, unemployment is below the natural level.

We would like to suggest the same applies to the UK. That right now, there’s bags of scope for rising employment before wages and then prices going through the roof.

During the 1970s, growth in potential supply had perhaps been left behind by growth in demand. Globally, this is patently not the case today.