The Public Spending cuts (rises?) are announced and the Monetary Policy Committee is split 3 ways

Yesterday was a day where many markets simply reversed what they had done the day before. For example the Dow Jones Industrial Average in the United States rose by some 129 points to 11,107 and European equity markets followed this trend. It was as if Chinese interest rates had not risen and “foreclosuregate” had not worsened. Oil rallied by some 3% and the US dollar began to fall again. Indeed overnight the US dollar fell to a new fifteen year low of 80.84 versus the Japanese Yen, giving me a wry smile as I saw a research note which said that Japan’s intervention had gone reasonably well on the grounds that it has weakened against the Euro. It was published just in time for the new high against the US dollar for the Yen! Oh well back to the drawing board….

There were rumours overnight of more monetary easing by the Bank of Japan which led to a sharp fall in its value at one point to 81.82 but it did not last and is now at 81.08, although it is sustaining a weaker level against the Euro at 113.24 which is where in was in late July early August. Of course the weakness against the Euro is partly caused by Euro strength and it is pushing towards 1.40 versus the US dollar and has just pushed above 1.13 versus the pound.

With the Yen under pressure again it is perhaps not a surprise that the Japanese Nikkei 225 equity index failed to follow the performance of other equity markets and in fact fell by 5 points to 9376. This means that the notional spread I follow between it and the Dow Jones has now risen again to 1731 points or 18.5%. Well might this be looked upon with woe in Tokyo.

The US Foreclosure Scandal: Now other government agencies are looking to sue the banks as well

I reported on Friday about the deepening foreclosure or repossession scandal in the United States and added to this yesterday by pointing out that a letter to Bank of America threatening legal action had been signed amongst others by the Maiden Lane subsidiary of the Federal Reserve Bank of New York. So the US central bank has added a its authority to the claim, such as it is. Well according to the Wall Street Journal other US government organisations are joining in.

The federal regulator overseeing Fannie Mae and Freddie Mac hired a law firm specializing in litigation as the agency considers how to move forward with efforts to recoup billions of dollars on soured mortgage-backed securities purchased from banks and Wall Street firms.

So the situation continues to develop even if markets sometimes ignore it. According to the Wall Street Journal estimates of the repurchase demands sent to US banks vary between US $24 billion and US $179 billion so there is still doubt over the scale of the problem.

I saw in the Financial Times a reference to this article from CNN news.

Rampant fraud in the mortgage industry has increased so sharply that the FBI warned Friday of an “epidemic” of financial crimes which, if not curtailed, could become “the next S&L crisis.”

The crucial point is that it was dated the 17th September 2004! I will leave you to draw your own conclusions as to what was actually done about it…

UK Public Spending Cuts

There is some debate over the exact break-down of the cuts announced yesterday by the Chancellor George Osbourne but in general they turned out pretty much in overall terms to be as promised in his Emergency Budget back in June. I pointed out yesterday my view that the ring-fencing of the NHS and overseas aid is a policy error and will lead to inefficiency. Today I wish to look at the economics of the estimates as the most important factors behind them are the estimates for inflation and economic growth that are used.

To illustrate my point let me give you the figures for total managed expenditure for 2010/11 which was £696.8 billion and the estimated expenditure under the new plans for 2014/15 which is some £739.8 billion. So expenditure will in fact rise by some £43 billion,which is not quite the cuts screaming from today’s newspaper headlines is it?

By the time you allow for the Chancellor’s growth and inflation forecasts you get a different picture where our public expenditure falls from around 48% of Gross Domestic Product to 41% if events unfold as he hopes. The Office for Budget Responsibility feels that growth will be around or slightly above 2.5% over the next few years and official forecasts of inflation may be above 2% in the short-term but are invariably assumed to fall back to it.

So in essence the Chancellor is only with his £81 billion announcement of cuts is only reducing the rate of growth of public expenditure and is in fact relying on economic growth and inflation to do the job of reducing the size of the public sector for him. So here is the real danger for his plans if growth or rather ironically in this instance inflation under-perform.


It may be reasonably obvious that such forecasts depend on growth but not quite so obvious that inflation has benefits too. Clear examples of this would be the VAT take which is boosted by inflation and as many thresholds are currently not being indexed or if they are only indexed by the rather inadequate CPI measure then fiscal drag has a beneficial impact too. So governments benefit from inflation in many ways but their subjects usually do not. It is one of the reasons I expect our inflation performance to continue to disappoint there is a clear moral hazard in that our government benefits from higher inflation as it not only gets more taxes but also benefits from the real size of its debts being reduced.

The Public Finances deteriorated just before the Chancellor spoke

Before the Chancellor spoke we got news that the recent improvement in public finances has slowed and may even be reversing which must be worrying for him. The Office for National Statistics makes it hard to find the figures which exclude financial interventions but I have tracked them down on its statistical bulletin and we borrowed £15.6 billion in September 2010 which was more than the £14.8 billion of 2009. Seeing as we are supposed to be retrenching and recovering these were not reassuring figures.

As a more technical issues regular readers will be aware that I do not like the official use of the word temporary. I hope that the UK financial interventions will be temporary but I no more than anyone else do not know so and accordingly I always try to use figures which include it. I suspect their lack of enthusiasm is based on the fact that it worsens our public debt to GDP ratio by some 7.4%.

The Monetary Policy Committee Minutes

These revealed yesterday that the MPC is openly split in three directions. Adam Posen voted for more Quantitative Easing ( I analysed a recent speech of his on the 29th September which explains his and my views), and Andrew Sentance voted for a rate rise to 0.75% as he has done recently and the other 7 voted for no change. In the minutes there is a hint that Mr.Posen’s views may get some more support over time but only a hint.

Some of those members felt the likelihood that further monetary stimulus would become necessary in order to meet the inflation target in the medium term had increased in recent months. But, for them, the evidence was not sufficiently compelling to imply that such a course of action was necessary at present.

Mervyn King speaks

There had been a speech from the Governor of the Bank of England on Tuesday which I referred to in passing yesterday and I want to touch on a couple of important points from it. The Governor has developed the habit of being a decent judge of world events but a rather poor one of UK events so he would be much better suited to say a job at the IMF. However if we look at his analysis of the UK we got the following.

Firstly we got the usual reverse mea culpa i.e it wasn’t my fault. “In searching for a solution, some ask who is to blame. But that misses the point”. This fits slightly oddly with the praise he gives himself for his remarks in the earlier part of the last decade…
But then we got some real gems and the emphasis is mine.

I find myself in the opposite situation having to explain that there is too little money in the economy. But, in the wake of the financial crisis, and the sharp downturn that followed the amount of money in the economy as a whole – broad money – is now barely growing at all. That is restraining activity and pushing down the outlook for inflation.

So we are back to the output gap theory again and he indicates one of 10% in this speech. If he actually believes this theory then as inflation is above target and above its previous target by a wider margin then any recovery would surely only push it higher. But this theory seems to have become something of a belief or religious experience which is clung to whatever the evidence.

This was followed by something which was deliberately misleading I feel.

In 1998, before he joined the Bank, Charlie Bean estimated that the normal variation in the economy would lead inflation to be more than 1 percentage point away from target for around 40% of the time. And in the past three years, inflation has been more than 1 percentage point away from target in 17 months, or 47% of the time.

It must have slipped his mind to point out that all the variations have been in the same direction or higher than 1% over the inflation target he is supposed to aim at. That is not quite my definition of volatile, as volatility is reduced if the moves are in the same direction.

He likes acronyms so he introduced a new one.

So the next decade is likely to be a sober decade – a decade of savings, orderly budgets, and equitable rebalancing.

The savings part sits rather oddly with the recent interview given by Charlie Bean to Channel 4 which I discussed back on the 28th September as he appears to want people not to save. Perhaps they could give a joint interview and it might be best if it was given to someone who is not prone to laughing at discrepancies.


16 thoughts on “The Public Spending cuts (rises?) are announced and the Monetary Policy Committee is split 3 ways

  1. “So expenditure will in fact rise by some £43 billion,which is not quite the cuts screaming from today’s newspaper headlines is it?” and “…his £81 billion announcement of cuts is only reducing the rate of growth of public expenditure and is in fact relying on economic growth and inflation to do the job of reducing the size of the public sector for him.”

    You are dead right! These are not overall cuts at all. Just as I suggested some while ago would be the reality, the truth is that this government is relying on generating higher inflation as being the principal means of reducing the deficit. The failure to reduce certain sectors of Public expenditure in supposed austerity, such as Foreign Aid, but instead to increase it, has to be seen as unbelievable.

    The real deception is the complete failure to admit and come clean about what the intention is, and that the BoE is not independent at all, but is being used to execute the government’s strategy by theft (i.e. debasement). As Keynes wrote: “Lenin was certainly right. There is no subtler, no surer means of overturning the existing basis of society than to debauch the currency. The process engages all the hidden forces of economic law on the side of destruction, and does it in a manner which not one man in a million is able to diagnose.”

  2. Dull Recovery Under Negative Konditions.
    (Please excuse my spelling!)

    [audio src="" /]

  3. ” Our results highlight the way that monetary policy and policies toward financial stability are linked. When the financial system as a whole holds long-term, illiquid assets financed by short-term liabilities, any tensions resulting from a sharp pullback in leverage will show up somewhere in the system. Even if some institutions can adjust down their balance sheets flexibly, there will be some who cannot. These pinch points will be those institutions that are highly leveraged, but who hold long-term illiquid assets financed with short-term debt. When the short-term funding runs away, they will face a liquidity crisis.” ( Adrian and Shin 2009 Staff Report Fedreal Reserve of NY).

    Mr Shin is growing on me as an expert with his finger on the pulse. He advised the BoE, unfortunately maybe not at the moment. He points to the role of markets taking over the role of supplier of credit from traditional depository banks. It just strikes me that short term money rates have marginal effects in an illiquid market, as today. As such the transmission mechanism which the MPC are debating is becoming dislocated from credit generation, isnt it? Heads against brick walls comes to mind.

  4. I’m no economist, I just about get the basics but it seems obvious to me that the real problem has only been partly addressed, deferred really. G.O admitted that debt interest will be 60Bn by 2014, and that the deficit will be approaching 100% of GDP. The decline actually hasn’t been halted, geometric collapse through debt interest will still happen unless further action is taken. So what and when? King is worried about low money supply growth (at only 2%, was 11% 3 years ago, as I understand it) in a time when the economy has a cappuccino froth of spurious value assets floating around on it and he wants to pump in another Q.E of 50Bn or so, which because of bank and corporate hoarding creating low velocity will do very little…. until surely the dam bursts and yes, stored inflation must surely take off. Someone explain to me how any other result is possible.
    The point already made about currency debasement plus low velocity and enforced money supply growth has me running for real assets and avoiding paper….how long before others wake up and do the same, confidence slumps and we get high inflation for several years until a true rebalancing occurs?
    I was told off on this site, a few months ago for suggesting the BofE had wilfully mis-interpreted its mandate and was out to destroy assets through inflation. I still hold that view and am sat here just shaking my head slowly in a very Gromit like way….ho hum.

    • Hi Allan
      The estimation of debt interest is another variable that can be manipulated. As it is something that we do not know and it also depends on other factors that we do not know it is easy for confusion to reign. Or rather for spurious accuracy to reign….

      If we assume that this programme begins to get our national debt under some sort of control there is still the danger of long-term interest rates rising. For example as problems have hit her Ireland’s are currently a bit over double ours and Greece’s are treble and any sustained duration of interest rates like this would do a lot of damage to any debt/fiscal deficit numbers.

      With banking problems still in evidence around the world our continued reliance on a large banking sector troubles me and I am still not sure that our property market has rebalanced much.

      If you were told off it was not by me.

  5. I think the inflation argument is self-evident now as more and more of the great and good openly admit as much. What I don’t get is the projected growth figures and everyone glibly saying the private sector will take up the slack in public sector jobs? We have decimated the manufacturing sector yet all these new businesses are going to start up and make exportable goods? I wonder if these people actually believe what comes out of their mouths?

  6. Hi Sean,

    I think that it would be interesting if you could provide an analysis of the money multiplier theory, in particular money circulation. I believe that the government is following several paths: propping up the property market so that banks do not go into meltdown for a second time and debasing the currency so that industry is deemed more efficient.

    I have believed for 9 years that the Remimbi is undervalued. However, for us to become competetive the Chinese exchange rate needs to rise significantly; but this needs their property and overheads (taxes) to rise. All of the problems that we face arise out of this problem, as currencies try to rebase themselves to become competetive. Unfortunately, the Chinese government is after global domination so will not currently allow this to happen, especially during the period that they are buying up all of the world’s raw material resources.

    So far as the money multiplier, I think that if we debase our currency, then Nissans produced from Sunderland will only go up slightly (imported material inflation) but static wage inflation will reduce the overall cost. As such, we will buy more Nissan’s within UK and employment will increase. If these additional wages are spent in the local community then it should result in increased employment.

    My big caveat – that I would like you to address is the fact that the UK has a high propensity to import, meaning that the money multiplier is extremely low!

    How about an analysis of what percentage more we should pay for products produced in the UK that would produce full employment and therefore be available to reduce our taxes to compensate for the additional cost.

    A historical example: Ten years ago, when my daughter was born, I bought an expensive TV assembled in Wales and bought cheap Chinese Plastic “rubbish” toys for my daughter. Recently I purchased a plasma TV, but made in China. We need for these jobs to come back to the UK and without import controls, these need to either be currency debasement based or National pride based.

    I believe that if we fostered a sense of national pride – something that we do not have – the money multiplier would increase and unemployment would cease to exist. As an extreme example, no diriver to willingly let a non UK car into the traffic ie exclude BMW, Mercedes from yellow boxes.

    What do you think? And how can we organise this campagn?

    Mugh regards


  7. I thought I had already posted a comment/question, but don’t see it this morning. Maybe its daft, but if spending in 2014/15 is £740bn and current Government receipts are of the order of £500bn then at 2.5% growth (compound) these will rise to not much more than £550bn by 2014/15 – leaving the deficit largely unaltered in cash terms.

    It doesn’t look as if growth is going to do much to sort things out.

    As for inflation, price inflation is one thing – and already going on: but I don’t see how price inflation on its own can boost revenues. If people are strapped for cash then they are likely to concentrate spending on essentials and cut discretionary spending: in which case VAT revenues would not rise in line with prices and could fall as a greater proportion of spending goes to low rate products.

    Meanwhile, income tax receipt can only rise in line with wage inflation which is currently running at a much lower rate.

    f this is wrong (and in some ways I hope it is) I would be really interested to learn how either mechanism, growth or inflation, can actually bridge the deficit gap in the time available.

      • Someone posted these figures on another blog:
        The Treasury records the following:
        Year 2007 – 2008 Tax receipts £549bn
        Year 2008 – 2009 Tax receipts £534bn (2.7% fall on previous year)
        Year 2009 – 2010 Tax receipts £515bn (3.5% fall on previous year)
        And predicts the following:
        Year 2010 – 2011 Tax receipts £548bn (6.4% increase on previous year)
        Year 2011 – 2012 Tax receipts £584bn (6.6% increase on previous year)
        Year 2012 – 2013 Tax receipts £622bn (6.5% increase on previous year)
        Year 2013 – 2014 Tax receipts £662bn (6.4% increase on previous year)
        Year 2014 – 2015 Tax receipts £700bn (5.7% increase on previous year)

        So if those figures are to be believed a major turnaround will be happen this financial year. In fact we’re going from – 3.5% to + 6.4% right now.

        How can this be?

  8. Thank you KG. That’s really interesting and appears to reflect a view I have of mathematical models: namely, that they are no good for telling what is going to happen – but useful for testing the sensitivity to critical assumptions.

    In this case the critical assumption is the growth rate (of Government receipts) and for the books to balance by 2014 this has to grow by roughly 6.5% – 7%. I achieved this conclusion in 20 minutes on an xcel spreadsheet (a bit cheaper than the Treasury models).

    The question is, then, how you can get a 7% increase in revenues. 7% economic growth (p.a.) would do it: or 7% increase in tax rates. The 14% increase in VAT could contribute some of this but given that VAT contributes only 17% odd of total revenues there’s still a long way (roughly two third of the way) to go!

    If the remainder is all down to growth, then the implied growth rate each year will be something like 4.6% – being growth in taxable incomes and national insurance contributions. We’ll see!

    • Hi Chris
      Just to reply in more detail to your comment as I promised I can reply in one word. Inflation.

      It helps on its own with national debt to GDP ratios although to get technical only to the extent that you have conventional bonds. Also it is more true to say that nominal GDP is taxed than real GDP so inflation will boost tax receipts particularly when thresholds are not raised as long as there are some wage rises..

      As to your counterpoint that we might hit a threshold where people spend less thenyou might be right and that would be an offset. Personally I hope not because we have enough problems as it is!

      Also I agree with your point about mathematical models except to add they usually tell you what is unlikely to happen…aka their prediction

  9. KG’s figures show the madness of our predicament. If the tax revenue is to increase as suggested we will have to see an economic boom starting now as business growth will need to be phenomenal to produce these tax revenue figures!

  10. What exactly is the MPC attempting to achieve with further QE?

    Gilt yields are already close to rock bottom. Driving them lower still will add nothing to people’s propensity to borrow. Loan demand is constrained because people are deleveraging – they see an uncertain future and as such believe the prudent course is to pay down debt and save more. This is a rational response to the present circumstances.

    The psychology of the situation is this: the longer that monetary policy remains un-normalized, and the greater the non-conventional measures undertaken, the more the message is being sent out by the MPC that the outlook remains difficult and uncertain for the foreseeable future. With such an outlook, why would businesses choose to borrow money to invest, or consumers obtain loans to bring forward their consumption?

    Furthermore, the market’s response to further QE is currency depreciation. No doubt the MPC considers this a good thing, but the reality is that demand for the UK’s exports is proving to be inelastic with respect to Sterling weakening. There is no export boom.

    Worse, the currency weakness ensures that an ever greater amount of business costs and household budgets are consumed by essential imports, such as energy, food and other commodities. Facing escalating costs, the rational response is to further batten down the hatches: reduce planned investment, defer consumption and hoard cash reserves in vehicles immune to currency depreciation (i.e. commodities).

    In an environment such as we have, where people are rationally choosing to deleverage, attempting to generate negative real rates will do nothing to spur either consumption or investment capable of productive returns.

    As you have pointed out, in his recent comments, the Dallas Fed’s Richard Fisher has indicated he seems to grasp that the US Fed’s actions may be being counter-productive to their aims (not that I expect his views to carry much influence within Bernanke’s Fed). One can only hope that some enlightenment dawns upon the MPC’s members, and quickly, before the damage they cause becomes too great. I am not hopeful, and sadly expect the worst.

    • Hi Trevor and welcome to my blog.

      I have written often on the subject of QE and have a whole section devoted to it. Just to give a taste I did for a while count the variations on the MPC’s explanations of it but I am afraid I tired of the game at 27 and became of the view that they were like buses and another one would soon be along. One time when I suggested this on here another one came the next day…

      As to gilt yields this is my old stomping ground so to speak and I feel that the lessons learnt from the over-funding in the Thatcher era were forgotten by our current MPC and many other economists. It may come as a surprise to younger readers but we did go through a period where rather than buying our own gilts we issued too many. So we have had the reverse of QE and the results were patchy at best. Accordingly I always expected patchy results at best from QE and find it very frustrating that the effect of disintermediation which became clear then has apparently been forgotten in the meantime so that its apparent effects on the velocity of money are now claimed by some to be a “surprise”.

      With my view on likely inflation I think that index linked gilts are out of line with conventional ones in a strategic sense although tactically they are expensive, life is never meant to be easy! For example the surge in conventional gilts this year has been something of a surprise although there was a market theory I studied as an undergraduate which had some predictive power of this and a technical analyst friend of mine said his charts were pointing to it.

  11. Hi again,

    Thanks for your more detailed response. Clearly, on income tax if tax threholds don’t rise and there is wage inflation then revenues will increase: but if wage inflation is much less than price inflation (as currently) then the revenue increase will follow the former. A bit more head scratching suggests that the Treasury figures cited by KG must be factoring in Alistair Darling’s 50% tax rate on £150,000+ and the removal of tax allowances on £100,000+: and probably a freeze on thresholds – and even then its a stretch.

    On the debt to GDP ratio – that’s more a macro-economic statistic than a balancing of the books.

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