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stars_and_strife

Dollar thrill

For virtually my last excursion on this trip, I get into the dollar printing facility in downtown Washington DC.

evandollar.jpgAlthough we only get up close to one of the printing machines inside, it's still quite a thrill. Here I am with a pile of unfinished $100 banknotes.

There are only two of these facilities in the US, though they are capable of producing millions of notes a day. And it seems very different to the equivalent operation in the UK. We Brits print banknotes out in Debden in Essex, and have contracted it out to the private sector.

Here in the US it is a government operation right in the heart of Washington next door to the Holocaust Museum.

Now, the staff at the Treasury Department's Bureau of Engraving and Printing were very efficient and cooperative in allowing us in. They get nothing out of it (after all, they don't need TV publicity to sell their product).

But I detect a small amount of disappointment that we are using the facility as a backdrop to talk about the falling value of the dollar in the international currency markets.

I can understand why they might think the story is negative 鈥 people generally prefer strong currencies to weak ones. And the weak dollar reflects some of the current problems in the US economy (international investors have less enthusiasm for investing in the US).

And it is clear the BEP staff are like other Americans in becoming more aware their currency has fallen. In a country as big as this, people would be entitled to forget the value of their currency to foreigners, and yet people keep mentioning it.

They even make reference to the strong euro - a marked shift from previous trips, which sometimes left me with the impression the euro had barely dented the public consciousness.

But people here should not feel so negative about it. A weak dollar is not just a symptom of the problem; it is also possibly a solution. It provides a positive story in that it is helping the US adjust to a new phase in the economic cycle that places emphasis on exporting rather than importing, saving rather than borrowing.

In fact, the people who might need to worry most about how things are going are the Europeans.

Their currency is rising sharply against the dollar, and as a large proportion of the world ties its currency to the dollar, the euro is rising against other currencies too.

This is a bit of a pain.

There are a number of trade imbalances in the world, none more important than the trade deficit of the US. When that deficit is reduced, there has to be a reduction in some other countries' surpluses.

One option, which seems much the most desirable, is that the unsustainable US deficit is resolved by a reduction in the unsustainable surpluses of China and other Asian countries.

But the rising euro might mean that the US deficit is just transferred to Europe. The problem passed on, not solved.

It won't matter much to the Americans whether it is solved or transferred 鈥 either would be nice. But to create long-term stability, the rest of us should probably hope that the Chinese currency is allowed to rise further against the dollar, to ease pressure on the euro, stemming from the dollar's fall.

Of course, we are not going to get a complete end to the US deficit; and we are not going to get a US-sized deficit in the euro-zone, any more than we'll get US-sized portions of food.

But that is still quite worrying for Europe's economies, which for all their strengths, lack labour market flexibility. If there's weaker growth, it can quickly escalate into real economic woes.

I've spent a week here now, have spent the budget and am apparently expected to return home tomorrow. Maybe it is a good time: if we want to examine America's economic problems, Europe might be a good place to get a view of them.

stars_and_strife

Prompts v causes

I spoke to a second-hand car dealer today. A nice chap called Mike Navidi out in Arlington, just close to Washington DC.

evan_caroutlet.jpgApart from enjoying the chance to be simply amazed at how cheap his cars are ($12,000 for a neat-looking Mustang on the forecourt) I wanted to know how easily were finding it to get car loans.

I was a bit surprised to hear that he still writes loans all the time, even for sub-prime customers, and that they rarely get turned down.

That could be seen as reassuring.

The great worry at the moment is that the credit crunch in the financial sector will lead to real economic problems as banks stop lending anymore. (That's what I was talking about in the blog yesterday in fact).

But my car dealer implied that's not been affecting him. It's not the credit crunch constraining credit.

So surprised was I, that I spoke to a second second-hand car dealer to get another opinion. He told me the same thing. He said you wouldn't get a sub-prime mortgage now, but you can still get a sub-prime car loan.

However, Mike Navidi was adamant about something... that even though credit was available, he's not selling so many cars. Not because people can't get loans, but because they don't want them.

This might turn out to be important. It might be that the credit crunch is not pulling the economy down by reigning in the supply of credit; it could be that it is simply the trigger to remind consumers that they need to reign in the demand for credit. After all, their balance sheets have suffered in the wake of housing market falls.

In this sense, one might view the credit crunch not so much as causing the problems, but as prompting them. A subtle distinction, I know, but an important one all the same.

A "prompt" launches something that you might have expected to occur anyway at some point.

A "cause" brings something about that would not have otherwise happened.

I'm not sure whether the credit crunch will turn out to cause problems or prompt them. It's worth us being wary of both, and it is possible it can cause and prompt at the same time.

But I'm perhaps increasingly thinking that the credit crunch has activated a big economic shift that was already waiting to happen, as unsustainable economic trends unravelled.

That has an interesting implication: we shouldn't just focus on the credit crunch, we should also look at the economic fundamentals.

And it also implies that although the credit crunch itself was not really predictable, all the big things apart from the credit crunch that are going on right now, could have been foreseen.

• Falling house prices in the US

• A falling dollar, leading to an improving trade balance

• Potentially slower consumer spending in the US

• Higher than expected sub-prime mortgage defaults

Just because we didn't know what form the crisis would take when the economy moved out of its unsustainable phase of low consumer saving and trade imbalances, does not mean we couldn't have known there would be big adjustments.

Being interested in why the world has apparently been taken by surprise at a turn of events that were to some extent inevitable, I asked the chief economist of the International Monetary Fund today, Simon Johnson, what he thought.

Of course he rightly made the point that no-one predicted the intensity of the credit crunch.

But he also made the point that there are lots of pieces of the crisis that you could have predicted individually, like the falling dollar, or falling house prices, or high oil prices, but not the confluence of different things that are going on simultaneously. (You should be able to hear part of that interview on Radio 4's PM programme, on Wednesday evening at 5pm).

For example, Mr Johnson argues that you might have predicted high oil prices, but not at the same time as a housing market correction. It's unusual to have a US recession threat preceding an oil price hike.

He might be right on these points. But the truth remains that when big economic shifts occur they sometimes tend to be a bit messy. And when things get messy, everything tends to get messy at the same time. Things that look unrelated, like the value of the dollar and the direction of house prices, suddenly seem related after all.

We probably ought to have known that.

We can be forgiven for not forecasting the time and the precise trigger for economic adjustment. We can't be forgiven for not realising that adjustment had to come.

stars_and_strife

Dow vs ABX

I'd say that the success of business television ( and the like) in the US, is built on one fundamental insight by those producing it: if you can make it sound like sports coverage, then it feels engaging.

And we all know that Americans love their statistics - in sport, obviously. And in finance too.

Yet one of the problems in covering the sub-prime debacle is that the usual scoreboard measuring US financial health is the Dow Jones Industrial index. And although it has had its ups and downs this year, it really doesn't tell a very interesting story of near financial meltdown.

We need another way of scoring the financial sector, to better reflect the way the game is going.

With that in mind, I today went to get a lesson on the ABX indices. These have had some recent prominence in the financial pages and get mentioned on CNBC, but I'm surprised they haven't made it much beyond. Because if you think a financial crisis of the magnitude we have endured deserves graphs diving in a downwards direction, then the ABX is what you want.

There are lots of ABX indices actually, so take your pick. You can .

I had them explained to me today by Robert Pickel, chief executive of the . And I made sure we had a photo of a couple of the graphs so you can get the general idea.

Essentially, there is one index for each vintage of sub-prime mortgage backed assets; and there is one for each level of risk. So for example, there is one index for AAA ultra-safe sub-prime assets, from each half of both 2006 and 2007.

Graphs

In the picture with my fingers in, you are looking at the performance of AAA securities, from the second half of 2006. In the picture without my finger, you looking at BBB- of the most recent vintage.

I won't go into much detail, suffice to say that the index is always constructed to perform like a bond price, so that par value is 100. Expected defaults in the assets underlying the index lead to prices below 100 (but you can't read the value of the index as a percentage default rate; it's more complicated than that).

But there are two fascinating things about ABX.

First is the rating of those AAA ones. They were worth about 100 until May and you can only describe the performance since then as a crash.

Yes, a crash.

And secondly, it is noteworthy that the 2006 mortgages seem to perform better than the 2007 ones. The longer the sub-prime boom went on, the more reckless was the lending and the higher the expected defaults.

So the first AAA index from early 2006 is worth about 90 now; a pretty awful performance for a AAA rated product. But the most recent sub-prime AAA securities are trading at 67.

Now I'm not index mad. But I do like an index to reflect the story, and the stock market is not doing that.

Obviously long term, the fate of the entire corporate sector of the US - encapsulated in share prices - matters more than the fate of one kind of sub-prime asset-backed security market.

But in the short term, it is the exotic paper that is driving things. Why?

Because of the degree of bank exposure to sub-prime mortgage assets. When stocks fall, wiping hundreds of billions of dollars off share prices, the people who own shares are poorer. So, that happens from time to time.

But when hundreds of billions of dollars of losses are being made by banks (or their off-balance sheet profit-centres), well that affects their capital, and their ability to lend. And as banks lend a big multiple of their capital, when the capital falls only a even a small amount, their lending can fall a lot.

And when lending falls a lot, the economy can stumble. Just as it did in the great depression for example.

Of course, when the stock market wakes up to that possibility, it might fall a lot more than it has, and then it to will tell the tale of what's going on.

But at the moment, it is our relatively new friend the ABX to watch.

stars_and_strife

What next for US economy?

Where will the American economy go next year?

Perhaps it'll help you answer this if I tell you that last year it grew 2.9%; this year it is set to grow 2.1%.

Rather than get caught up in the decimal points of forecasts for next year, think about three scenarios.

a) next year's growth number is significantly below this year's;
b) next year's number is about the same as this year's; and
c) next year's number is larger.

The argument about the economy's prospects at the moment is between those three options: there are those who think there's downward momentum; those that think the slowdown currently occurring will be contained and those who think it will be a small temporary phase before the economy reverts to the norm.

evan_us_2.jpgNow, talking to folks out on the streets 鈥 from market traders to students 鈥 I find a variety of views about the economy. But it is conspicuous how many people are upbeat about things, and assume there is little reason to get very worked up.

And even more interestingly, the same is true of the professional economic forecasters.

The optimists may be right. I can't stress that enough. I am still surprised however, there are so many of them.

According to the ever-useful Consensus Forecasts the average forecast for next year is that US growth improves marginally to 2.3%.

But that underplays the optimism. Half the forecasts out there are plainly built on the assumption that by the second half of next year, the US is back on its old upward trajectory.

The most optimistic of the professional forecasters is The Conference Board, a large and respected non-profit business think-tank. It expects US growth to re-bound to 3.0%. Bear Stearns thinks the US will grow 2.7%, as does Fannie Mae (the government-backed private mortgage guarantor organisation) . The National Association of Home Builders expect the economy to grow by 2.5%.

If any of them are right, you would say that is quite a result, given everything that is happening at the moment.

Only two forecasters think the economy will slow-down very significantly. The Economist Intelligence Unit and Merrill Lynch. And no-one appears to be predicting a recession.

Now, I am not one to criticise forecasters. But I can't help but feel there is a bit of anchoring going on.

You know what anchoring is? It is a tendency to produce numbers that are close to ones that are already in your head.

Famously, it has been shown for example, that if you ask people the percentage of African countries that are members of the United Nations, you will get higher estimates if you first ask people whether it is more than 65%, than if you first ask them whether it is more than 45%.

Experimenters that get people to look at totally arbitrary numbers 鈥 like social security numbers 鈥 and then to guess something quite unrelated, tend to find a bias. People with higher social security numbers come up with higher results.

Bizarre I know, but well documented. (Indeed, the discovery of this tendency was part of the reason won a Nobel prize.)

Now I think the fact that growth has tended to be around 3% in the US in recent years, might be anchoring expectations. It's not quite the same as using social security numbers to make predictions. But forecasters are undoubtedly subject to the same kinds of cognitive mistakes that the rest of us are, and they might simply lack imagination in thinking about the many different paths the US economy could conceivably follow.

Why else would forecasters be so happy about the prospects?

Joseph Stiglitz (who I mentioned yesterday) puts it down to the fact that Wall Street forecasters have to be professionally upbeat to sell stocks. They are not liars, they just live in a world where you learn to believe what suits you. (Similar considerations might be alleged of
those forecasters tied to the housing industry).

But actually the Wall Street forecasters are not always the most optimistic at all; they are scattered throughout the distribution.

So no I don't think in general that explains it. I think anchoring is the answer. Anchoring to the idea that normal service will soon be resumed.

And it might be. But in general, economies almost always revert to their long term trends in the long term, but exhibit far more volatility in the short term. And the long term is longer than six months.

It's quite rare for a downturn as serious as the one now underway to be over by next Christmas, given there are with so many unresolved problems in the banking and housing sectors.

stars_and_strife

Made in America

Having arrived here a couple of days ago full of thoughts about the falling dollar and the improving state of American trade, it is fascinating to observe at first hand that perceptions of low quality in Chinese products are the issue that seems to be driving consumers away from imports.

Recent recalls of badly designed toys and toxic toothpaste seem to have driven a surge of interest in the "Made in America" label. Websites such as usmadetoys.com offer lists of US products that don't
bite or poison you. offers an eco-friendly four tips on buying lead-free toys made in the US. Or look at the poll on Chinese goods on the , a presidential candidate.

The mass media is talking the issue up. I was surprised to hear advice offered this morning that one advantage of buying goods online is that if they are recalled, you will automatically get an e-mail telling you, without you having had to register your purchase.

Does that really happen so often?

It's fascinating that fear of foreign goods is taking hold just as the trade position of the US has turned a long-awaited corner. In September, for example, the trade deficit in goods and services was $57 billion, (or "a lot" as we say in English).

But it was still 12% smaller than the September before.

Something is changing. Imports were up by 5%. But exports were up by 14%.

This is of course exactly what the US economy needs. If the country is going to avoid recession while hard-pressed consumers save more now their houses are not increasing in value any more, exports have to be part of the answer. And reduced imports will help as well.

What is good for the US may not feel good to the rest of the world of course. In many respects we have become more used to the US as a customer not a competitor. Suddenly the US bites back, lets its
currency fall and starts improving its trade balance, by worsening everyone else's. But it is only fair - the US needs to improve its position more than anyone else. Its deficit last year was over 5% of its whole GDP.

So how far can improving the net trade position, help the US sort out its difficulties?

I've been speaking to several economists on this. One thing they all agree on is that the US does not do enough trade for it to be the piece of GDP that underpins the rest of the economy. Big countries do not need to trade as much as small countries, because residents have more choice from within their own jurisdiction to choose to trade with.

But that being said, trade is a small but volatile portion of GDP. It can grow or contract more than the personal consumption typically does, for example. (Those exports growing at 14% for example). So let's not diminish the role for trade too quickly.

I think there are two other challenges for the US in trying to improve its trading position.

First is the idea the problem of oil. As that gets more expensive, the US deficit has to export more just to stand still, and pay for its oil.

Secondly, does the country have the capacity to export? Once you have stopped making things, and have learned how to source them elsewhere, it takes quite a bit of time to re-build that capacity. Growing exports at 15% per year, year after year, will be no mean feat.

evan_2.jpgI spoke to yesterday (pictured). He's well known as the former (and controversial) chief economist of the World Bank, a Nobel prize winner and author of Making Globalisation Work. He is sceptical of the idea that the falling dollar will improve the trade position and bail out the economy, and he uses the interesting argument that America's "new economy" exports, in sectors like software are ones where the falling dollar will do nothing to improve things.

The argument goes like this 鈥 Microsoft have already priced their software as profitably as they can in each overseas market. And selling intellectual property is not like selling automobiles: the cost structure of software is far less sensitive to the level of the currency. Microsoft won't be stealing market share from the Europeans because the dollar has made it more competitive.

It's an interesting argument. The new economy is not about toys made in America; and the new economy may not respond in the old ways to the traditional price signal of the exchange rate.

If Professor Stiglitz is right, growing exports won't be helping out much. It'll have to be shrinking imports if anything, that will sort out the trade deficit.

Which I suppose is where the Made in America fad comes in. When the exchange rate fails to solve a problem, you can always rely on fear of badly made foreign products to help.

stars_and_strife

Black Friday

evanheathrow.jpgI've arrived in the US for a 10-day look at some of the economic jitters here. And guess what: I find I have arrived in New York on Black Friday.

That term is apt to mis-interpretation. Black Friday is not another bad hair day in Wall Street. It's the term used by American retailers to describe the day after the Thanksgiving Holiday, seen as the semi-official start of Christmas shopping season. (It isn't really the start, by the way: the decorations do go up earlier.)

The name Black Friday is reported to derive from the 1970s, and comes from either the bad traffic conditions prevalent, or from the fact that retailers expect this day to mark the season of the year, in which they expect to go into the black.

It is a bit of a tradition. To my amazement, the shops open at about 5am; some in fact are beginning to open on Thanksgiving itself. Queues build up round the block, the shops offer so-called "doorbuster" deals. It's all great fun.

Now, the shops will look busy today, and there is already a lot of hype around the great deals on offer. But the big question is whether this year's Black Friday will really be black for retailers. Can they possibly enjoy strong trading in the frazzled economic conditions of the time?

It's a question of importance to the whole world.

For years, we've grown dependant on American consumers as the world's spenders of last resort. They've kept Europe out of recession, allowed China to industrialise, and prevented global deflation.

But at the same time, they've not been looking after their own futures. The savings ratio in the US (the proportion of households' disposable income that is not consumed) has been in a long-term decline since the early 1980s. In the most recent data, it has dipped negative 鈥 yes negative. It means they are "running on empty" as they say. It can't go on.

This year surely has to be the one where the long-awaited turn occurs.

Why now? It's simple. For the past decade, Americans have seen their wealth increase without them having to save: first, their shares went up, and when they stopped rising in 2000, their houses went up.

That gave people a sense of wealth that appeared to justify saving less.

But with the housing market in serious decline, people will have to save if they want a pension. Not just sit and watch the pension materialise out of nowhere.

So the question for the shops over here, and for the world's manufacturers, is how big and how fast will the adjustment in US savings be? Here are three options.

• Will Americans just raise their savings to back inside positive territory for example? That would still be an adjustment for us all, because world spending growth has been boosted in the recent past by that small decline in US savings.

• Or will Americans slowly raise their savings back to a normal historical level 鈥 5 to 10% of income, say? That would represent quite a big adjustment for the world economy. Remember the US is 25% of global spending, and US consumer spending is probably about 20% of the world's total demand. Saving 5% of that, is like a 1% reduction in global demand.

• But the third and least attractive option for the world is that Americans over-compensate. They might see their house price fall, and think "not only am I not getting richer anymore, I am actually getting poorer". In which case instead of simply reverting to normal and saving 5 to 10% of income, they might choose to make up for lost ground and save 10 to 15% instead, at least for a few years.

We won't know which of these three courses the economy will follow by the end of Black Friday, but this season's shopping might provide the first clues.

I'll hope to get some early comments on the retail scene on 大象传媒 TV news programmes early next week.

small_change

On devaluation

This week marks 40 years since . (You may have seen some of the archive coverage over the past couple of days.)

How appropriate that we are marking this anniversary now, one of the most famous episodes in British economic history.

Of course, there are lots of other notable episodes in history - the 1931 devaluation, the 1949 devaluation and the 1992 devaluation all come to mind.

But 1967 has a special place. It was the one that saw Harold Wilson famously draw the distinction between the falling value of the pound abroad, and the stable value of the pound at home - the pound in your pocket.

He was sort of right in that distinction incidentally, but not quite right. Devaluations only work when they make people feel a little poorer. Because whatever they do, they have to stop us spending quite so much on foreign goods by making them more expensive.

Now this is a good time to reflect on devaluations because next year we might see our currency fall quite sharply again.

To see the similarities between the sixties and now, we have to understand what a devaluation does.

Back then, we worried a lot about the trade deficit, and devaluations were seen as a way of improving our trading position. The falling pound raises import prices and cuts export prices.

But there's another way of describing the effect of a devaluation, more relevant to our economy today. Falling currencies are the best way an economy can reorient itself from away consumption towards saving.

In fact, the trade deficit is often just an expression of too much spending and borrowing... and not enough saving.

Falling currencies, rising savings and increasing exports are often all part of one and the same thing.

A country that saves more probably has a falling currency. Why? Because if we all choose to save, we lend money to foreigners rather than borrowing it from foreigners, so we buy foreign currency to lend - the pound falls.

You can think of a falling currency as either helping the trade deficit, or increasing savings. They're often the same thing.

Now that's what our economy needed in the 1960s, and it's what it might need now.

Back then, we couldn't afford to keep spending, so we had to increase exports to keep the economy moving. Today, the same is true. We've borrowed and spent enough. If we ask who then can buy our output, it's foreigners. That'll probably take a lower pound now, as it did then.

Of course, the pain of successive devaluations means we have now decided not to join any fancy currency fixing schemes - we'll fix the pound against the price of eggs using an inflation target. Not against the price of Dollars or Deutschmarks.

But just because we don't have a fixed rate pound to devalue, doesn't mean the pound can't fall anymore.

notes_on_real_life

Captain's update

Some quick thoughts on the ...

The economy is an aeroplane, and the captain (Mervyn King) has come across the tannoy with a rather complicated message. In essence, he said - "there's a bumpy ride ahead for the economy, but with a couple of rate cuts next year and a bit of skilful piloting, the economy can come through by 2010". I.e. - we'll be landing on time.

It's an interesting announcement by the standard of these things, but buried within it were a number of sub-lines, each of which deserves mention on its own.

Nightmares

Firstly, the governor wasn't ruling out some rather unpleasant scenarios. The plane shouldn't crash, but it could be a very bumpy ride indeed.

Personally, I'm glad he did not sound complacent on these possibilities.

My own personal view is that the famous fan charts the Bank publishes to present its economic forecasts offer a slight sense of false reassurance. They visually anchor one's gaze on to the most likely scenarios, when more attention should be given to the unlikely but far serious scenarios.

After all, there is unlikely to be a major plane crash today, but I nevertheless think the world's airlines should be very alive to the possibility.

But at least the governor's words were not designed to produce unjustified reassurance. He recognised the nightmare by which an economy can get trapped in a vicious circle of house prices tumbling, consumers slowing their spending very sharply, and the economy spiralling down with job losses and collapsing confidence.

And at the press conference, talk of recession was not dismissed as silly; an effort was made to show how the Bank's apparently benign forecasts do in fact allow for the possibility.

Spillovers

A second interesting message was that the Bank noted the spillovers from the credit crunch to the real economy have so far been rather modest. The governor spoke of a dichotomy between events in the city, in the housing market and in London, and the rest of the economy which has so far carried on producing much as before.

Or, to use my plane analogy - so far it's only passengers in first class that are feeling the bumps.

Mr King even pointed out that the financial sector in the city is perhaps a smaller part of the economy than generally supposed. Maybe that's why the rest of the economy has thus far escaped lightly.

Dilemmas

The third message I took from the press conference was the complexity of steering the economy through the turbulence it is now entering. Higher inflation next year, and slower growth. It's a tricky combination - it's the problem I described yesterday.

Using one control to keep the economy flying at the right speed, at the right altitude and in the right direction is a formidable task for any pilot.

notes_on_real_life

Why inflation matters

Inflation is up to 2.1%. That may not seem a very big deal.

And as we have a symmetric inflation target of 2.0%, 2.1 is about as close to good news as you could imagine.

But in these fragile times for the financial sector, my own inflation preferences are decidedly asymmetric. At the moment, anything above target severely complicates the management of the economy over the next two or three years. Here's why.

In essence, the argument is that dealing with one problem is far harder than dealing with two. Just as doctors find it harder to give a heart by-pass to a patient with renal problems, a central bank finds it harder to deal with an economic slowdown and falling asset prices, while there's inflation lurking around in the system.

But this argument is particularly important at the moment, as most of the indications suggest the economy is at an interesting turning point. The Bank of England needs room for manoeuvre right now.

To understand exactly why, one needs to follow the chain of events that is likely to occur.

After several years of strong consumer spending underpinned by rising house prices and growing consumer debt, house prices will probably stagnate at best and consumers will probably start to retrench. The turning point has been a long time coming, but it seems to have arrived.

These things happen and do not, on their own, constitute a problem. If we buy more cars than we need in 2006, we buy fewer than we need in 2008. If house prices rise too much in 2006, they fall back to where they should be in 2008. Indeed, I would personally argue that one might see the current economic turn as good news rather than bad.

However, falling house prices and declining consumer spending do become a real problem if they leave the economy with too little spending to keep everybody employed. In that situation, the downward momentum can become self-reinforcing. The slowdown leads to job losses, which lead to further house price falls and further
slowdown, and more job losses.

This is where the central banks come to the rescue. They can prevent that downward spiral by cutting interest rates and stimulating spending.

They probably won't stimulate consumer spending as consumers won't borrow and spend more, whatever the level of interest rates, if they feel they have already borrowed enough.

So the role of the central bank in this situation is to stimulate exports by cutting interest rates and allowing the pound to fall to make exports more competitive.

That leaves the economy a perfectly good escape route from its obvious challenges. The central bank can ensure that at a difficult time the economy continues to grow, workers stay in work, consumers improve their finances and save more. All because exports rise.

But here's where inflation can get in the way.

If the pound falls, domestic prices tend to rise, which obviously adds upward pressure on inflation. If inflation is already above target, the central bank can't allow that to happen.

At a time when we need to extricate ourselves from a difficult situation, we may not have any way out. And we get back into the downward spiral of declining demand and rising unemployment.

The pre-existing inflation can end up being the equivalent of the locks holding the fire escape doors shut. In the end most macro-economic management issues come back to inflation. This is because you can convert many macroeconomic problems - like unemployment and falling house prices - into inflation problems if you want to by printing money to stimulate demand.

This means that as a simple rule, most problems are curable in the absence of inflation, and few problems are curable in the presence of it.

There are still grounds for debate on whether inflation is really a problem at all at the moment. Remove energy, and our rate is on target. And one of the economists I rate most highly, Graham Turner, thinks the Fed may be acting far too cautiously in cutting rates, fighting a non-existent battle against price rises. He was an astute of the Japanese economy over the 90s and knows a thing or two about asset price deflations in leveraged economies.

I'm personally agnostic. I just don't know whether inflation is back or not. I've written before about how the "China effect" which has kept our inflation low is surely a temporary one (although a very long temporary), and the current inflation news from China is discouraging.

Moreover, I certainly don't believe in excluding the fastest rising prices when assessing underlying inflationary pressure at home. 2.1 is 2.1 in my book.

But we'll see whether underlying inflation is at or above target over the next year, as the economy undoubtedly slows.

However, there is one general lesson to be drawn from recent experience: it is that flexibility around the symmetry of an inflation target might be helpful.

If things go as crazy as they have over the last few years, with asset prices booming and the economy and consumer spending strong, we would probably have done well to have erred on the side of keeping inflation below target. That would have ensured there is almost no risk of it being above target, so that when this crunch moment inevitably arrives we can stop the drama turning into a crisis.

notes_on_real_life

Oil prices

Imagine. $100 dollars. It is a lot for a barrel of oil. In fact, it's way up there.

Since the 1860s, when people stopped killing whales for oil and dug it up in Pennsylvania instead, the price has averaged a little over $25 a barrel in today's money. We're at four times the long term average price.

Oil rigAnd as recently as 1998, only nine years ago, oil - on some measures - dipped below $10 a barrel. Although in today's money, for the year as a whole the price was more like 17.

It's clear that $100 a barrel is very high. Although it's worth saying, it's still not a record.

1864 was in fact the most expensive year for oil. It was over $104 in today's money. Notwithstanding that record (and most of us in the media will ignore it when talking of record highs in the next few weeks - we'll be using the high of $104.7 reached in 1980 after the Iranian revolution) we can at least say an impending $100 barrel is getting historically significant.

One does have to wonder why the price fluctuates so enormously鈥 it makes the housing market look stable.

Well, there are several oddities that drive the oil market.

Geo-politics is one - Iran has a tenth of the world's oil reserves, so you can't ignore what's going on there for example.

Geo-economics is another factor - the falling dollar means oil prices are not rising in euros and pounds as fast the dollar price suggests.

Finance matters too - the oil price doesn't just depend on oil, it also depends on bits of paper called derivatives that are bought and sold by people trading in oil. That can exacerbate price movements.

Each of these might be adding 10 or more dollars to the current price of oil. But you can't pin the price or the volatility of the price just on those.

The economics of supply and demand ultimately play the largest part, the demand of China in particular at the moment. As a rule, its economy is growing much faster than its oil consumption, but that still leaves its oil consumption growing very fast.

And there's a simple rule about commodities - a small gap in supply and demand can lead to a big swing in price.

After all, if there's 1% too little oil in the world for current demand, the price needs to rise. But there's no reason to think the price needs to rise by just 1%. It needs to rise enough to persuade 1% of the users to switch - and that can be a lot more than 1%.

But the point of volatile market is that it swings both ways.

The longer we have higher oil prices, the more we can economise on oil - by switching to smaller cars for example. And the more oil that gets produced 鈥 a small excess of supply over demand - and the price can plummet.

The lesson of history, is that when oil prices soar up to record levels, they usually then fall back down.

notes_on_real_life

On the buses

Here鈥檚 a multiple choice question. Try and answer it before you read on.

What effect do you think it has, if a British bus company employs a bus driver from overseas?

a) it takes away the job of a British bus driver?

b) it increases the number of bus drivers we have?

c) it undercuts the wages of British bus drivers?

d) it reduces bus fares for British passengers?

A lot of people will probably choose (a), so let鈥檚 discuss that first.

Much of the recent coverage of migrants in the labour force has been written in a way that implies there is a fixed stock of jobs, so the more that migrants take, the fewer there are for native Brits.

A that says 鈥淏ritons lose out on jobs and housing鈥 or a describing how 鈥淭he number of British nationals in work has fallen in the past two years as 540,000 foreign workers have replaced them and taken all the net new jobs in the British economy鈥 can easily give the impression that the labour market is a kind of musical chairs with only so many places to go round.

Economists are sceptical of this view of the world 鈥 they call it the 鈥渓ump of labour fallacy鈥. In essence, they argue that if a migrant takes a job, they may well create a job that would otherwise not have existed too.

Buses in trafficFor example, they may fill a gap that no-one British was available to fill. They may demand a lower wage, creating a job that would otherwise have been unviable. Bus company employers would certainly argue this is the case, and point you to answer (b) in our question above.

Even better, if a migrant bus driver allows a bus to operate that would otherwise remain idle, then many other jobs could potentially be created for people who could then travel to new workplaces more flexibly and easily.

In practice, we do not know whether the labour market effect of any particular new migrant employee is to create many other jobs, to create the one job they themselves fill, or to create no jobs at all, and hence to displace one domestic worker.

We can鈥檛 be sure, and it is likely that some migrants displace, others don鈥檛.

But if pushed, I would tend to adopt the simplifying assumption implied by a fully functioning, competitive labour market, that on average migrants create exactly as many jobs as they fill. If 1.1 million migrants are employed, there are probably 1.1 million extra jobs.

It鈥檚 only an assumption, but it鈥檚 not a bad one. And perhaps I can defend it by using an analogy. If migrants eat 8% of our food, it would be silly to think that in the absence of migrants, the native British would eat 8% more.

Far more realistic is the idea that the supply of food adapts to the demand of migrants. Similarly, it is realistic to assume the demand for labour adapts to the supply of migrants. That鈥檚 where a competitive labour market gets you.

That deals with options (a) and (b) in our bus driver multiple choice question, but many of you might have been inclined to adopt option (c).

It is very plausible that competition from migrant bus drivers undermines the wages that British bus drivers can attract. Indeed, one reason why the presence of migrant bus drivers can create new jobs is that they make it cheaper to hire bus drivers.

And businesses are pretty open about admitting that the low cost of migrant labour is one of its attractions.

But if you are right to tick option (c), don鈥檛 you also have to tick option (d)? After all, if there are more buses driven at lower cost, one would imagine that competition or regulation would create lower bus fares too.

And that鈥檚 important.

If the presence of migrants on the buses pushes down wages and fares, it pushes up the spending power of everybody using the buses. So the bus passengers鈥 real wages 鈥 their wages after inflation 鈥 tend to go up.

You might tell where this is going. A second simplifying assumption. Like the first, it is reasonable if one assumes fully frictionless and competitive markets. It says that on average the presence of migrants has no effect on the real wage level of the British workforce.

The wage cuts of some workers are offset by the real wage gains of other workers.

In fact, if migrants were dispersed uniformly across the economy (which of course they are not), all of us in work would lose a bit in facing more competition for our own job, but would gain a bit in being able to buy other things more cheaply. Net it all out and we are back where we started.

My two assumptions are a bit extreme in their simplicity, but they are not extreme in their implication. They end up with a rather simple conclusion: that migrants are neutral.

They don鈥檛 do the harm that some think, nor the good that others like to pretend. They expand the population, the workforce, employment and national income by more or less the same proportions. The rest of us get on with what we do.

Or, to put it another way, my assumptions imply that the employment rate and incomes of a country with 30 million workers are probably about the same as an otherwise identical country with 31 million workers.

Of course, in reality, I am assuming away all the interesting things migrants have to bring. They have different skills, work in different industries, use housing in different ways to the rest of us, and take up the scarce space of the UK.

To draw a more realistic picture we would need to engage in detailed empirical study as to what the actual effects are, not the supposed effects.

When more sophisticated economists perform more rigorous work, using more complex economic models, they invariably come to the conclusion that migrants modestly benefit the domestic population on average. But that does not preclude them hurting some particular groups.

However, I鈥檝e taken 1,029 words and have yet to answer the multiple choice question I started with.

As is so often the case in multiple choice questions, none of the four answers are quite satisfactory. I would say, (e), all of the above. In the short term, (a) might be true, but in the long term, (c), (b) and (d) come in to play.

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