UK must cut state spending - or be racked with gilts

Last week, we learnt the UK’s CPI index grew by only 1.8pc in June. Given this column’s hawkish stance, I suppose I should be happy inflation is now below the Bank of England’s 2pc target.

Instead, the way this news has been spun, and the media’s willingness to swallow that spin, fills me with despair.

Inevitably, I suppose, the CPI’s dip below target has been presented as “yet more evidence” the UK faces a Japanese-style “lost decade” of deflation. The only escape, we’re told by City economists and their pet commentators, is for the Bank of England to keep printing money and the government to rack up ever more debt in order to extend yet more unconditional cash to our bloated banking sector.

This, of course, allows the stone-faced bank executives who caused this crisis to once again pay themselves huge bonuses. Now, though, said bonuses are being financed not by profits gleaned from over-hyped capital markets, but by taxpayers – namely you, your children and grandchildren.

Politicians are now talking about cuts. So gallingly obvious is the need for restraint that even Peter Mandelson last week admitted state spending will be be reined-in. But all the main parties – in cahoots with their banking friends – insist such actions are for the future. So, for now, the UK’s fiscal and monetary policy remain wildly expansionary – with the wealthy few gaining from that largesse while the general public shoulders the costs in terms of higher taxes and high future inflation. If such a state-facilitated wealth transfer took place in a country with hotter weather, we’d purse our lips and call it kleptocracy.

Why is it suddenly a good idea to spend our way out of recession and print money? The debate over the Bank of England’s “quantitative easing” scheme - or QE - has been practically non-existent.

Those benefiting from QE – and the associated recapitalisation of insolvent, failed banks by the backdoor – have instead endlessly repeated the mantra “we simply must beat imminent deflation”. In that context, the June CPI number bears closer examination – because it has about as much to do with deflation as Gordon Brown does with fiscal prudence.

The credit crunch has been in full swing since the summer of 2007. Yet June was the first month during that two-year period in which CPI inflation even fell below target, let alone risked going negative.

That’s despite the fact that CPI grossly understates inflation. And had VAT not been cut last December, even the CPI would still be at 3pc – with the Bank writing a public letter explaining why inflation is so high.

The deflationists know this summer is the high-water-mark in terms the validity of their argument. That’s because it was in June and July 2008 that oil prices spiked above $140/barrel – and lower fuel prices in the same months this year drag down the CPI.

During the next few months, though, these base effects will rapidly reverse. That’s because oil plunged during the second half of last year – hitting $32 by December 2008. With crude currently above $60, and the futures market pricing-in a steady rise, it won’t be long before instead of being 50pc cheaper than the same month last year, oil is 100pc more expensive. However the numbers are rigged, that will push up the CPI.

This “inflation V. deflation” debate, though, is about far more than the methods being used to bail-out our failed banks in an opaque and deeply misguided manner. It is at the heart of the UK’s future financial stability – and whether we can avoid the ignominy of being unable to roll-over our sovereign debt. Such a catastrophe would be second only to the Two World Wars in terms of fiscal damage – and a bigger blow than Suez to the UK’s national prestige.

Yet such a gilts strike looms. The danger signals are flashing. Since QE began in March, 10-year yields have risen as gilt prices have fallen – despite the fact that the Bank has spent £112bn of funny money buying almost half the gilts the government has issued. And QE was supposed to stimulate the economy by bringing yields down!

Over the coming year, more and more recession-hit Western countries will be selling swathes of sovereign debt. But the UK is set to borrow twice as much in 2009 as France and Germany and over three times more than Italy.

That's why our political leaders must now state, extremely firmly, how we're going to cut spending and slash borrowing totals – and start the painful process of doing so. If we wait for an election, and endless reviews, the market could easily lose patience. And if UK firms and households are suffering from a lack of affordable credit now, the situation after a gilts strike would be many, many times worse.

CHINA'S ROW WITH RIO - NO FLASH IN THE PAN

The UK economy will shrink 4.2pc in 2009, according to the International Monetary Fund’s latest forecasts. America’s output will fall 2.6pc, while the global economy will contract 1.4pc. But nobody seems to have told China.

New data suggests the Chinese economy expanded by a head-spinning 7.9pc between March and June this year, up from 6.1pc in the first quarter. Retail sales last month were 15pc higher than in 2008. Despite a global recession, the world’s third largest economy powers on.

Faced with such incredible numbers, I’d make three observations. The first is that the main Shanghai stock index is now 106pc above its mid-November low. But investors eyeing such gains must remember Chinese shares are extremely volatile.

Stringent capital controls mean Chinese investors have limited choices. For the vast majority, the only alternative to a negative real return in a state bank is the local stock exchange. So as China’s vast workforce gets richer, more and more savings are being channelled into local stocks. That’s great news for foreign investors willing to take a long-term view. But, in the short-term, China’s share-trading mania leaves its market vulnerable to regular and violent mood swings. Such a swing is now overdue.

My second thought concerns the danger of Chinese inflation. That may sound odd given that, for most of the last decade, cheap Chinese exports have helped dampen Western inflation.

Chinese exports are now getting dearer, though, as its manufactures force margins wider. More fundamentally, the People’s Republic is in the midst of a massive credit expansion – again, in stark contrast to elsewhere.

As the authorities crank up the Chinese economy, some 1,500bn yuan (£134bn) of loans were extended last month. Average monthly credit growth during 2009 has so far been three times higher than last year. In a rare display of dissent, a Chinese Parliamentary Committee just warned about the inflationary dangers of this “extraordinary credit growth”. Arguments about “China’s exported inflation” will be the subject of numerous future columns.

In recent years, of course, Western inflation has anyway been aggravated by China’s burgeoning demand for raw materials, which has pushed up commodity prices. As Chinese growth continues, and becomes evermore energy-intensive, that trend will become more prominent.

China now accounts for 34pc of global steel use – up from only 5pc 30 years ago. In June, Chinese car sales were no less 36pc higher than the same month the year before. As Chinese workers get richer, and adopt modern lifestyles, the country’s commodity use will soar.

That’s why China’s espionage row with Western mining giant Rio Tinto is no one-off. Bad tempered disputes over China’s commodity-mining rights will also be the subject of numerous future columns.

Liam Halligan is Chief Economist at Prosperity Capital Management