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notes_on_real_life

Today's number: Eight billion

I don't like to reduce the hard work of the much respected and to a single number. Their annual Green Budget is after all 299 pages long. (It is nothing to do with environment incidentally, it's green in the sense of a green paper).

Twenty pound notes and coinsBut I know that most of you will not be reading those pages, and good journalism is often about boiling things down.

So I'm happy to boil down the green budget into one number: 拢8bn.

That's the tax rise needed by spring 2009.

The tax rise is required for the Chancellor's self-imposed fiscal rules. He needs it to ensure he meets his sustainable investment rule. And also to get the key measure of borrowing into surplus (the current balance, the measure used to assess the "golden rule".)

The IFS did not advocate tax rises last year, but over the course of 2007 it's become evident that the government's finances are far shakier than former Chancellor Gordon Brown expected at the time of his last budget.

In fact, the books now look 拢7bn worse than a year ago. And that, it should be said, occurred before any economic slowdown had time to bite. Corporation tax and stamp duty revenues have already been disappointing.

So what's to be done?

Well, the Institute for Fiscal Studies is the most respected source outside of government on the public finances - and in recent years has had a rather better record than the at predicting the need for extra money.

Each year it looks at the books, and today it said it thinks taxes need to go up by that 拢8bn, or the equivalent of about two pence in the pound on income tax if the economy performs more or less as Alistair Darling expects.

If the economy takes a serious dive, vastly more will need to be done.

This may not seem like a great time to hit households with extra tax - after all, the American government is allowing itself to borrow more in order to stimulate its economy.

But the IFS suggests that interest rates should be left to do the work of stimulating the UK...while the government needs to sort out its fiscal position.

In fact, the best reading of the IFS work is that the re-balancing that needs to occur for consumers - who will probably need to save more and borrow more carefully - applies also to the government.

The Chancellor and his predecessor have allowed themselves to assume that in years ahead, the good times will roll and money will flow in to the exchequer.

In fact, it seems the good times have just passed. That means both households and government have to adjust their expectations and spending accordingly (hence the impending economic slowdown).

It's just unfortunate, if the IFS is right, that the consumer and government cycle are so well synchronised. It might have been preferable for the two to be offsetting each other in the economy cycle, not supporting each other.

The real budget is expected in March - the Chancellor can update us on his thinking.

So far, the government has recognised that its medium term fiscal position needs some attention and has been restraining the growth of public spending as a result. But the IFS makes clear, a whole lot more needs to be done on top of that.

It's worth stressing that having boiled the IFS Green Budget down to an 拢8bn tax rise, that's not a prediction of what will happen - just their statement of what ought to happen.

notes_on_real_life

Cathartic recession?

Is there such a thing as a "cathartic recession"? A recession that purges the demons of excess from the economy and punishes the badly-behaved for their sins?

I'm not sure there is. But I unwittingly found myself in an argument with the former US Treasury Secretary Larry Summers on the subject.

I asked him whether central banks should be modest about how much they can hope to achieve and whether they might sometimes have to accept that economies slowdown.

My question was motivated by a sense that there's a limit to the imbalances an economy can accumulate to keep itself running at a good speed. (You can hear the interview on Saturday's Today programme).

Maybe I shouldn't have raised the topic.

He certainly put me in my place, arguing that the very question betrayed an adherence to one of most cruel, fatalistic and mistaken beliefs of the economics profession. It was the view held in 1929 he said.

He's once of the brightest economists around, Larry Summers and one of the most articulate. (His forthright views have got into trouble on more than one occasion). And his views need to be taken seriously.

As it happens, I don't actually believe in cathartic recessions, but his vociferous denunciation of them invites us to think carefully about exactly what it is we should believe of the economy at the end of a bubble. We might be right to tolerate a slowdown as part of a process of sensible rebalancing while also having to avoid a deep recession that wastes the potential of the population and needlessly makes people poorer than they should be.

My view is that the correction of imbalances probably involves some slowdown and we should live with that. Larry Summers' view (I think) is that we should not talk that way, because it will soon lead us into tolerating or creating the needless cathartic recession.

After he had finished with me, Professor Summers said he had been inspired by my questions (the sheer stupidity of them) to give a talk on this very subject.

It's good to know that my interview was so inspirational.

notes_on_real_life

The importance of love

Sometimes it's the "Davos fringe" which provides the most stimulating discussions.

To that end, I just enjoyed a constructive 15 minute diversion from the sub-prime blues, chatting with an American anthropologist called about love. (You should be able to hear it on Friday's Today programme).

She is addressing a couple of sessions here and her message is essentially that love is very important to all of us. But she's not echoing the usual John Lennon type calls for world leaders to reject war, and find love and peace. She has performed brain scans on lovers of different types to see what effect it has on us.

I won't tell you everything she has to say, except the two practical tips she offered me. First, don't get married in the first euphoric phase of a romantic attachment 鈥 wait for the love to settle down. And secondly, once it has settled down, to keep it alive do novel things together and don't let it become routine.

As we recorded our conversation on a rather unromantic sofa in one of the lobbies, I noticed that people sitting nearby were listening in.

John Lennon would probably have been pleased.

notes_on_real_life

Economic nationalism

I only arrived in Davos a few hours ago, but I've had three conversations and they've all ended up coming back to the same kinds of issues 鈥 protectionism and free trade, economic nationalism and the shift of economic power in the world.

If you'll forgive the name-dropping, two of those conversations involved George Soros and Henry Kissinger, who I actually spoke to before I arrived. (You can hear Soros online and Dr Kissinger will be broadcast on Thursday's Today programme).

But my not-very-representative sample of three conversations is clearly not altogether off-agenda, because I notice that David Cameron is here this evening, giving a speech on the subject as well.

"The heroes will be those who held their nerve and stood up for free trade" is his line, (while commending John McCain for doing that in the US election campaign).

It is not surprising the issue of trade has come up.

First, the US election has displayed some signs of gentle (or not so gentle) economic nationalism.

Secondly, it is 鈥 as you might have noticed - an interesting time in the world economy, and there might be a temptation for countries to retreat into the language and diplomacy of "looking after their own workers".

It might make sense at a selfish level for individual nations to put up trade barriers - although few economists would concede even that 鈥 but it rarely makes sense for the whole world to look after their own workers, because what we gain by protecting our workers, we lose by others protecting theirs.

Anyway, I expect the general issue of America's response to the rise of the emerging economic powers to absorb quite a few people here.

I'm not going to suggest it will dominate the Davos coffee-bar conversations of the investment bankers and private equity guys, but it does have a resonance at the moment.

notes_on_real_life

Bubble bursting?

We escaped the last big bursting of a bubble - the - with a relatively light US recession. On that occasion, the world economy found its way back on track fairly quickly.

And that time, it was activist monetary policies - ie the slashing of interest rates that appeared to save the day. No wonder the has chosen to repeat the formula today.

But this episode seems more serious than the dotcom one however, and it probably won't be resolved quite as easily.

Why? Because in 2000, we only managed to soften the landing from the crashing of the stock market bubble by creating a housing bubble. That supported American consumer spending, (enabling Asia to carry on exporting).

Alas this time there are no more obvious bubbles to create.

So today's cut in interest rates will struggle to support consumer spending at the levels necessary to act as a motor to the global economy.

Indeed, fiscal policy will struggle to do that either.

If you want to know the challenge facing the world, it is summarised by the American savings ratio - the proportion of disposable income saved by American households.

Back in 2000 and 2001, it was about 2%. It has now drifted down to zero (if not actually negative this year). That figure at some stage will probably have to drift up to something more normal, around 5%. As American consumers save more, the US imports and spends less.

The rest of the world feels the effect.

Now the fact that the American consumer motor is unable to power the world economy anymore, does not mean the world economy has to endure a long breakdown. We just have to replace the engine.

That means the world really needs spending in Asia to rise, to offset the slowdown in the US.

At the moment though, it's looking hard to see how Asia can pick up the baton as quickly as the world needs.

Which brings us to today.

The potential for a serious slowdown in global spending is spooking the markets.

But the markets themselves now threaten to exacerbate the very downturn of which they are so scared.

The Fed is spooked by the markets, so no wonder the Fed felt it needed to take drastic action. Even if it isn't going to work as well as it did in 2000, it might at least prevent markets and the economy driving themselves ever deeper in to a quagmire.

small_change

To spend or not to spend?

If you were a benevolent, omnipotent deity, governing the UK economy at the moment, what would you do?

Assuming that is, you can鈥檛 cheat, and help us all by creating a new set of oil fields or offering us free car insurance.

Would you drive consumers into the shops to spend more to boost the economy?

Probably not.

Consumers are saving well below their long run average. We probably need a consumer slowdown of some kind, and we need to wean our economy off the growth that depends on consumers constantly increasing their debt to income ratios.

But while a slowdown is desirable, an abrupt or dislocating halt to all spending is not.

It goes back to and the so-called 鈥減aradox of thrift鈥. Saving is good, but if we all try to save too much simultaneously, we all end up in an economic quagmire as spending dries up, incomes contract and the economy shrinks.

ShoppersSo the question that arises out of is whether the slowdown is now going too far for our own good? Today鈥檚 figures were far worse for the shops than expected; worse indeed than the survey from the earlier in the month implied.

It is true that in the last three months spending rose by 0.4% and so there are no grounds for panic. (In fact, that 0.4 per quarter amounts to about 1.5% a year, which looks about ideal if you want a gentle slowdown).

The problem is that the decline in the three monthly growth rate has been very rapid, and it could turn negative or seriously negative fairly quickly.

And we need to be aware of the discounting that occurred. For example, buried deep in the data that we got today is the astonishing fact that in household goods stores, prices in December 2007 were more than 8% below their level in 2006. There hasn鈥檛 been any deflation like that in recent memory.

So if I were a deity looking after the economy, I would not be programming British shoppers to do their patriotic duty and spend money but I would be ensuring they spent something.

If the power of the consumer to rescue the economy is limited, what else could the almighty do for us? What other options are there for protecting the economy against the risk of a deep slowdown?

He or she could encourage the chancellor to loosen fiscal policy i.e. spend and borrow more and possibly cut taxes? That鈥檚 what the Americans are talking about today.

That is an idea for an economic rescue. It鈥檚 pure Keynes in fact, another of whose massive contributions to economics was to point out the power of fiscal policy when other policy tools are failing.

But in Britain today, you would probably say that the slowdown is not yet bad enough to merit any special action plan. And there is the small matter of the Chancellor鈥檚 Golden Rule. The rule might be breached if the government deliberately went out to spend and borrow more.

In fact, the British government is not that dissimilar to British consumers in having overstretched itself in recent years. With a deficit of about 3% of GDP this year (a year in which the economy has grown strongly despite all the financial market problems) the room to loosen fiscal policy is not really there.

So what else is there that could be done to help the economy? Probably the answer in the UK is for our deity to push down sterling.

That should have the effect of promoting exports, inhibiting imports, and thus reducing the country鈥檚 manifestly unsustainable trade deficit. At the same time, it would cushion the country from an excessive slowdown, by allowing households to save more while foreigners take up the slack and buy our goods instead of us.

If a weaker sterling is what the almighty would prescribe for the UK, it is of course what the invisible hand is already delivering to us too. The pound has had a strong year against the US dollar, but don鈥檛 be fooled by that. Against the euro, it has tumbled, and carries on tumbling.

And that means what an economically-literate deity would be striving for in the UK this year is re-balancing away from consumer spending, towards trade and exports, with the minimum possible slowdown in the process.

Unfortunately, the process of a significant economic re-balancing is never smooth.

And this one is no exception. Exports will struggle to offset the decline in consumer spending; exports may not take off at all if our customers in the rest of the world face financial troubles of their own. And we still have the problem that there may be a some inflation embedded into the economy 鈥 in which case we won鈥檛 be able to let sterling fall too far for fear that it will raise import prices in doing so.

So I鈥檓 afraid that this will be a difficult year even if it goes well. There鈥檚 little point in hoping that government or consumer spending can change that.

Even if we put ourselves in the lap of the gods, we won鈥檛 avoid some kind of slowdown in 2008.

small_change

How interest rates work

This is an article dedicated to Kevin Hawkins.

He is the director general of the , and probably the most effective trade association representative I have encountered.

He is a wonderful communicator, who avoids the kind of studied, cautious, mealy-mouthed jargon of many public figures. He鈥檚 always feisty and never apologises for representing the interest of his members. He鈥檚 earned his OBE, and when he stands down from the BRC soon, they (and I) will miss him.

I鈥檝e heard him talk about supermarkets, minimum wages and chickens.

But in the field of macro-economics, there is one message that Kevin Hawkins delivers regularly and repeatedly: that it鈥檚 time for the Bank of England to cut interest rates.

He appears to do it month after month. For the BRC, it鈥檚 almost always time to cut interest rates.

Shoppers on Oxford Street, LondonWe鈥檝e been through a decade of incredibly robust consumer spending, and yet I can never remember him asking for a rate rise to tame the excesses of the consumer.

In making the case that rates need to fall, Kevin is perfectly representing the desires of his members and I make no criticism of him.

But how relevant is that call in 2008? How successful will those interest rate cuts be at helping the shops?

A little diatribe on the economics of interest rates is useful here鈥

Interest rate cuts have an effect in stimulating an economy by directly or indirectly making someone, somewhere, spend more than they otherwise would.

That extra spending increases demand and ensures that we all carry on with work to do, without us having to slash our prices or our wrists.

There鈥檚 always a dilemma about whether cutting rates threatens inflation - that鈥檚 the essence of the decision the MPC has to make each month.

But there is an interesting secondary question to ask of interest rate cuts when they occur. Which spending is it that they are expected to encourage? How will lower rates work their magic on the economy?

In principle, there are only three main components of spending that much matter to monetary policy: consumer spending, business investment and exports and trade.

Taking the three in turn, we consumers are encouraged to spend by lower rates in a number of ways:

- they change our incentive to borrow and save,
- they change the income available for spending for some of us and
- they affect the price of our houses, thus affecting our perception of how much spending we can afford.

When rates are not driving consumption, they affect business investment in a number of ways too. Lower rates tend to cut the cost of capital, which companies use to pay for investment.

As far as trade is concerned, lower rates work through sterling. They mean people are less inclined to park money in Britain; they buy fewer pounds (after all, they earn less interest on them) so sterling falls, and that promotes exports (as well as discouraging imports).

The Bank of England, when making a decision on rates, doesn鈥檛 have to care much about which of these mechanisms transmits lower rates into economic action; all have the effect of stimulating the economy at the cost of potentially raising inflation.

People working at a factory in ChinaNow in the recent past, consumer spending has been the active ingredient in the economy 鈥 the years of easy money have encouraged consumers to borrow and buy. And we needed consumers to do that in order to soak up the huge supply of manufactured goods coming into the global market from China.

Those days were good for consumers, and for the shops.

But many people - including some of the retailers themselves - appear to work on the casual assumption that if consumer spending is now drying up, all that is needed is for rates to go down to a level at which it takes off again.

That may have been right in 2001. It may not be right for 2007.

The reason is that saving in the UK is still relatively low. At 3% of household disposable income, we are saving at half the long term rate.

Do we expect or want interest rates to drive saving even lower? After all, we have many problems in the UK, but a reluctance for consumers to shop is not one of them.

Fortunately, consumers will decide for themselves whether they want to spend or whether they want to stop. And consumers will look beyond interest rates.

If house prices fall for example, we might all feel we overdid it last year, and choose to be more cautious now.

That means even if interest rates fall this year, they may not do much to stimulate the economy by promoting consumer spending. They might prevent an abrupt and disruptive halt to consumer spending, but I wouldn鈥檛 necessarily think of it as likely (or even desirable) that they do much more than that.

To summarise - if the game is up for consumer-led growth, there may not much the Bank of England can do about it.

So does that mean the economy is doomed? Possibly. Lower rates might promote business investment, but in truth, businesses are not normally much inclined to invest if there are not going to be customers for their products.

Burt there is one remaining thing rate cuts can achieve: they can lower the pound and help exporters sell more. The Americans have pulled off this trick to some extent (although there is a long way to go). The British may follow.

That would be good for the economy (if it is not too inflationary); it would keep us in work, while at the same time allowing us to sort out our personal finances.

Shoppers outside Marks and SpencerThe only problem is that improving our trading position would do almost nothing to help Marks and Spencer, other retailers or estate agents.

Indeed, a lower pound can hurt British retailers, who often source from overseas and find their imported goods more expensive. It squeezes their margins.

Kevin Hawkins is probably right to call for rate cuts - the economy probably needs them and will probably get them.

He may be disappointed to find they do little to help his members.

vital_statistics

Setting prices

What determines a price in a market?

Competition? Regulation? The whims of politicians? Illegal collusion between suppliers?

Looking through history, you'll find examples of all four playing a part in setting the price that consumers pay.

But these days we tend to think competition is the best of the lot.

And as a result, for gas and electricity, we introduced it. We got the regulator out of price-setting, we left politicians to do other things. And we have strict laws against cartels and collusion.

For several years it gave us low energy prices and we never complained. But now we are apparently unhappy.

My instinct is to assume that we consumers are an inconsistent bunch. We like competition if it delivers low prices, but grumble if it delivers the bad news that prices need to go up.

But in fact, it isn't that simple鈥 there are issues in energy markets.

If you eye-ball the graph of the wholesale price of gas and the retail price over the last three years, you wouldn't think another retail price hike is now due. In fact, if anything, it looks as though we might have expected bigger cuts in prices early last year.

Wholesale gas accounts for about half the cost of domestic gas, and you'd think that retail prices are not massively out of line with where they were three years ago, but they will be if prices rise again.

Which raises the question: is competition failing? Are we being ripped off?

Well, a good rule of thumb is that competition doesn't usually fail, it just operates a little clumsily. And its imperfections have long exercised economists.

In this case, it all comes down to the word "oligopoly". It's a lovely word, and applies to many many parts of the economy - including energy. Oligopoly is defined as a market dominated by a smallish number of suppliers. And it has spawned a myriad of different theories as to how prices are set in practice...

One theory that goes back to the 1930s - one that A-level students might recognise as the curve theory - observes that in oligopoly, prices are often sticky.

In essence, suppliers don't like to upset things by pricing aggressively. It's not that they are crooked or anything... it's just market logic. If you cut prices to gain new customers, you'll fail as other suppliers will soon cut prices too, and so no new customers will come. Ergo - don't cut prices unless someone else does.

In energy markets, this could be the case, reinforced by the fact that most of us can't be bothered to switch supplier anyway. If one company cuts prices, the others will have plenty of time to follow them before their customers get off their backsides and make an effort to switch supplier.

In this world, companies will also be reluctant to raise prices because their competitors might not follow. Or competitors might delay rising for a few weeks to follow with their own price rise, hoping to gain some switchers in the meantime.

Being a price-hiking first-mover is an uncomfortable position.

It's the possible asymmetry of competitors' reactions to an initial price cut or price hike that might account for price-stickiness. Companies will only raise prices when they have to as their costs are too high. All one can say is that given the frictions in the energy market, it would be odd if prices weren't a bit sticky, especially sticky downwards.

Of course, the real issue facing us is not whether competition is perfect; it isn't.

It's whether you want to improve it with occasional divine intervention from regulators or MPs. Unfortunately, over the long term, in a complex market, that's a very tall order. You can get the price wrong if you try to influence it, and in the long term if there is free entry into a market, oligopoly can work more competitively.

Best advice - if you're paying too much, don't write to your MP - shop around.

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