The Coalition Agreement and Inflation Report disappoint and the rally in gold’s price is disturbing

After writing my article yesterday about my concerns for the UK economy and in particular the UK fiscal deficit there was a lot of news on this subject. The new Conservative-Liberal Democrat government published a manifesto cum statement as to its plans and objectives going forward and we also received the Quarterly Inflation Report from the Bank of England. In case there was any doubt that moves were needed we saw Spain respond to the euro zone crisis by announcing quite substantial budget cuts for this and next year. As our economic situation has remained more stable we still have a window of opportunity to move ahead of events unlike Spain which has been forced to respond to a crisis but I fear that the window is beginning to close.

The new UK coalition agreement

This document starts with a brave statement

Deficit reduction and continuing to ensure economic recovery is the most urgent issue facing Britain,

If one examines the statement one would therefore be expecting specified and detailed spending cuts and some tax rises. Sadly you will find little of this in this document. However you will find some public spending pledges and some tax cuts! So the document will at face value actually worsen the deficit. Even after the election it would appear that our elected politicians remain averse to revealing the truth.

What did we get?

Deficit Increases

A promise to increase overseas aid costing around £4 billion a year

A promise to bring in the Liberal Democrats personal tax allowance of £10,000 per person “over time”. If this was staggered in over four years then it would cost just over £4 billion for each year and a total of £17 billion a year when implemented fully.

Around £3 billion a year reduction in employers National Insurance (the “jobs tax”) compared with Labour’s existing plans.

Higher state pensions at a cost of around  £2 billion a year as the earnings link will be reinstated.

More funding for school pupils to cost between £2 and £2.5 billion a year

A jobs package which will cost around £500 million a year.

Deficit Reductions

A plan to raise aviation taxes including charging by plane rather than by passenger expected to raise some £3 billion a year

Plans to raise capital gains tax from its current rate of 18% to the rate of income tax which is expected to raise £2 billion a year.

A completely unspecified plan to make spending cuts of £6 billion this year “subject to advice from the Treasury and the Bank of England on their feasibility and advisability.”

A plan to end Child Trust Funds.

Comment

It does not require many mathematical skills to realise that what has so far been announced makes the deficit worse and not better. This is hardly an inspiring start. I hope that there is plenty of work going on in the background pinning down some spending cuts as we need them in the tens of billions or markets will start looking at places like Spain and comparing their forecast deficit path with ours.

On the tax side I can merely repeat what I said at the time of the Budget in my article of the 22nd March that raising Value Added Tax to 20% would start to put a hole on the deficit. It would raise something in the region of £12 billion a year. It was also be inflationary but as I write below it does not appear that our monetary authorities are too concerned about inflationary upside surprises.

It also raises the thought in my mind that our politicians do not trust us with the truth yet. The new Budget due in late June will be interesting to say the least.

Bank of England’s Quarterly Inflation Report

The bottom line of this report is that the Monetary Policy Committee (MPC) is unconcerned about inflation trends and feels that going forward it is more likely to be below than above target. It is however worried about growth as it feels that the sovereign debt crisis may spill over into the general economies of the world and impact on the UK. Of course we may yet have our own sovereign debt crisis. The Governor also found time to praise the new governments (so far rather vacuous plans) to cut public spending by £6 billion this year.

Is the Bank of England any good at forecasting inflation?

The best guide to this is to look at what it said in the past. So I have been rereading the May 2009 Inflation Report to see what it predicted for now as an indicator of forecasting performance by the MPC. They produced inflation fan charts looking at the probability of inflation outcomes based on expected market interest rates and base rate which are supposed to cover 9 out of ten outcomes. At the moment we are outside them! Yes we are in what I call the UB40 zone (to explain their biggest hit had one in ten in its title). So the MPC has gone to a lot of trouble in its fan charts to cover as much as it can and was still wrong. I would remind you that this is not its central forecast which at around 1% has turned out to be something which would be likely to lead policy in the wrong direction.

Comment

One can see from this that the MPC’s record over the past year in forecasting inflation has been very poor. This is not inspiring as this is one of their jobs, but there is a worse corollary. You see they set their monetary policy based on this and in May 2009 they were expecting an inflation undershoot when in fact we have an inflation overshoot. So policy has been set inappropriately. I am surprised that there is not more of a debate about this but I feel that many other economists made the same mistake and so they are unwilling to draw attention to this problem as they feel embarrassed themselves.

I have written many articles on what I feel are the failings of the Quantitative Easing experiment in the UK and have a section in this blog devoted to it. But if we go back to May 2009 we had only bought £125 billion of the total of £200 billion we eventually spent. So you could argue that the last £75 billion was purchased on the back of incorrect forecasts.

The other alternative is to argue that the MPC is less concerned about rises in inflation than it claims to be. You do not have to be cynical for this as there is an argument that inflation is one of the ways out of high private and public-sector debt problems as it reduces the real value of the debt. Should they actually believe this then as their role is to control inflation then we have found the real cynics!

The rise in the price of gold

If there is anything which provokes a dispute it is the rationale for gold and the reason or reasons why it has value! A month or two ago I notice that Willem Buiter an ex-MPC member and to express a personal interest a tutor of mine from the LSE advanced the view that it had been a 6000 year bubble. This lead to a debate which concluded that as it can be used (and sometimes is) as an electrical conductor then the base for its price should be the copper price as if it got cheaper electronics would use gold rather than copper.

Apart from its obvious use for jewellery and adornment gold provides very little that other metals do not and as its price is way above what any use might suggest this leaves two explanations in my view. It is considered a store of value and a hedge against inflation and it appears that a bit like fiat money (with which it is often contrasted) it relies on belief in its own value. It also has one crucial difference with fiat money in that its supply is limited. There is debate over the exact amount but it is believed to be between 160,000 and 166,000 tons in total. Just to be clear that is all the gold that has ever been mined and annual production is about 1% of that. So here we have a clear difference with fiat money ( and part of the inflation hedge argument).

At the moment we do have inflation fears in the world although the world is currently in a polar situation where there are perhaps as many expecting disinflation and depression as inflation. If you look at markets recently we have fear and uncertainty. So I guess that it is not a surprise that the gold price has risen recently. Personally I feel that the recent euro zone bail out was a trigger for the gold price to rally as we saw the European Central Bank (ECB) start a path that in the case of the US Federal Reserve and the Bank of England led to the monetisation of debt. This was a big change for the ECB which had previously criticised such moves and some of its members are clearly unhappy with this.

An interesting corollary of the change in the role of the ECB from something like the Bundesbank to a more Anglo-Saxon/Japanese philosophy is that a lot of the recent gold buying appears to have come from Austria and Germany. Perhaps something driven by a genuine increase in uncertainty and inflation risks which the recent policy has caused.

Conclusion

My view is that at this moment in time the rally in the price of gold which is particularly marked against the Euro but true against most currencies is that people are uncertain and to an extent afraid. I do not forecast either rallies or falls in its price from here but do suggest that its price has become a measure of what people feel about the world economic situation and what it is telling us is not good.

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10 thoughts on “The Coalition Agreement and Inflation Report disappoint and the rally in gold’s price is disturbing

  1. Glad to see that you are now evidently prepared to be more critical of the MPC and its continued disastrous failure to fulfill its sole remit, Shaun. (Perhaps part of its problem has been the clandestine political interference; but that would not explain its continued similar stance now, except by habit? Of course the other key factor is that the MPC’s members were all hand-picked by Brown, and thus were essentially pronounced left-wing economists?)

  2. Thank you for a very interesting blog once again. I too was surprised that there were no details of forthcoming substantive cuts in the Coalition Agreement apart from the mention of CGT increases and the plane tax (thanks for clarifying its impact, I wasn’t sure what it would be although I guessed it would be an overall increase).

    What puzzles me is what benefit there is to the politicians to hold back at this stage. You suggest that they don’t trust us, the public, but surely there’s no longer any need to be coy, and it would please the markets to hear the details pronto, so is there any economic argument for delaying? My only thought is that maybe it is a politically motivated judgement born of the Conservatives’ and LibDems’ differing views on timescales, so they are talking of prompt action this year to try and steady the markets’ nerves but actually taking baby steps to placate the LibDems’ fears about too much, too soon?

  3. The oil that lubricates any coalition is pet project spending and tax concessions. This is a generation of leaders that just don’t grasp that the market eventually makes these decisions for you.

    Is the Chancellor of sufficient gravitas to face down the happy couple with a harsh emergency budget? I think he isn’t.

  4. I think there are a lot of other issues to be considered, not least there is maybe only a handful of people who have seen the actual books for UKPLC, and lets hope the off balance sheet stuff is quantified. If they are worse than anticipated, and given the control exercised over the likes of the MPC and even the BoE that would seem to be the case, then a lot of work needs to be done, pre going public, to retain the fragile market confidence we have at the moment.

  5. I couldn’t make any sense of this when I heard it on the news.

    The plans to reduce government expenditure are already in place as a result of the activity of the previous government. I know that my local county council is cutting £1 million of expenditure by closing a secondary school in Shrewsbury.

    Early on in the election I also heard a Labour minister in the Health Department say that they were going through budgets to reduce expenditure.

    This work, done under Labour, will underpin some of the budget next month.

    • Hi Sean and welcome

      It is true that there were some budget cuts planned by the previous Labour government. But they did not remotely address the size of the problem we have and whilst individual instances will happen ( and unless there are population changes to justify it closing schools would certainly not be at the top of my list) Labour needed to do much more to achieve its own targets and the new goverment has promised to go further than those…

  6. We’re not being told are we?

    What you have to do is dig around local council websites for the committee meeting sections and look at the medium term financial plans.

    The Director of Resources at Shropshire Council was prepared to be quoted in the local newspaper only two weeks ago that savings of up to 25% may have to be looked for over the next five years.

  7. The perceived value of fiat currencies is based on the belief that the issuing authority will not print more of the currency than debt is being paid down or repudiated and that there are products that one would be able to buy with that currency now or in the future, and the interest rate compared with the possibility of default. Quite a lot to factor in.

    The perceived value of gold is based on the belief that women will always love shiny things. Simples.

    The probability of worldwide inflation drastically increases when almost no currency is safe from inflation. With modern banking I can put my money in say Euros rather than Pounds at low cost but as the low inflation alternatives become fewer it becomes harder and harder to do so. Eventually I no longer have the choice of moving my money from currency to currency, the risk of hyper-inflation falls because my capital can no longer take flight, and the main obstacle against an all-government inflation race disappears.

    • Hi Jonathan: surely the other aspect is the net interest rate yield you can achieve in any particular currency? For example, at present the Australian base rate is 4.5 %. Provided that the currency inflation rate is slightly lower than the net yield you can receive then you will not have a potential loss, unless the currency risk goes against you.

      The idea of a real independent central bank, with the remit of independently setting base rate to control inflation, which reduces credit and to some extent reduces the monetary Velocity of Circulation, was supposed to avoid inflationary loss with fiat currencies? For example the Bundesbank performed very effectively as an independent central bank prior to the Euro, but the ECB is not doing so because politicians have taken over control. That was supposed to be the same philosophy with the BoE and the MPC, but due largely to political interference that has failed dismally.

      The problem surely is that politicians can never properly control government spending; they always have a propensity to spend more than they raise in revenue. If they control base rate and the money supply they will always be tempted to balance a significant portion of their deficit by using inflation. They do this by issuing more money form of one kind or another, so as to debauch the currency in a non-balanced Keynesian manner, and by holding base rate significantly lower than inflation, which exacerbates the bad effects of inflation on an economy, but eases the pain which would otherwise be experienced by the significantly indebted?

      So provided you can switch to a currency like one mentioned above you will not lose in net terms, except due perhaps to currency risk. That after all is surely also part of the basis of the so-called carry trade? Ultimately the Swiss Frank has always acted as the sort of currency which is a haven in times like this.

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