A month ago the world seemed obsessed with one thing: BP (see my post on the subject, Uncle Target , makes me a member of this cluster). However, now that BP seems to not have broken the world, attention can shift to other pressing matters. On this front, two issues have moved front and centre in the last few weeks: the results of the stress tests applied to European banks; and the related matter of the risk of "double dip".

I haven't posted anything on the stress tests. So, without having provided evidence for my views, the short version is this: the stress tests are a nonsense that did little more than encourage confidence amongst consumers, the financial cluster and industry more widely. They also afford governments and regulators an opportunity for some back slapping and self congratulation for a job well done. (At this juncture in my note we need the soundclip of the cartooned banker dragging himself to the master switch gasping "Must save world".)

To provide some substance to my view, one piece of evidence that is central to the argument that the stress tests are a nonsense is this: bank balance sheets were not tested for the scenario of a government defaulting on its debt. Whilst this has become a little less likely amongst European countries in recent months, aided by rescue packages alongside austerity packages, to act on the assumption that governments don't default seems naive.

Relate to this point, one event that materially heightens the risk of government default is a double dip recession. For this reason, many commentators want to wish the likelihood of event away. To be clear on this point, not for one moment do I wish a double dip upon economies, but to act as if the risk of double dip is nowhere in sight, and that consumers and investors should be brimming with confidence, strikes me as a perverse stance. Yet, in the article below, David Smith of the Sunday Times is clear on this point: "The more you say things are going to be horrendous, the more people will believe it." I'm not sure whether this statement should cause me to laugh or cry.

At what point will people, including Mr Smith, come to accept the world has been permanently changed? Twenty years of reckless spending and wild borrowing in the West; hiked social welfare levels in the face of increasingly greyed populations and ever-lower retirement ages; and a belief that money and wealth are the same thing and that both are available for modest effort had to end in a financial wreck. Picking through the economic debris hardly passes as fun for anyone, but sober analysis that recognises the hard yards are still top be made, and that these hard yards include later retirement, lower government spending and borrowing for investment and not consumptive purposes is what is needed.

Regardless, if you want a decent laugh or need a good cry, there's always the view that trees grow to the sky and that free lunches are abundant.

BLOODCURDLING TALK DOES MORE DAMAGE THAN CUTS

Ministers should stop exaggerating austerity measures. It dents consumer confidence, which could restrict the recovery
David Smith, Sunday Times

A nervous mood has de scended, not lightened by the banks’ bumper results or those exceptional figures a fortnight ago for economic growth in the second quarter.

Newspapers are full of talk of double-dip recessions and, oddly, stagflation, which puts me in mind of Lloyd Bentsen’s “I knew Jack Kennedy” putdown of Dan Quayle. I knew stagflation in the 1970s when inflation was 27% and the economy was deep in recession, a long way from where we are now.

As for a double dip, which some are desperate to see, including at least one Labour leadership candidate, it is highly unlikely globally — despite the slowdown in America — and very improbable for Britain in the absence of another financial shock.

Yet the nerves are there, reflected in a drop in consumer and business confidence. The latest purchasing managers’ index from the services sector shows that, while growth continues, business expectations have suffered a fall of about 10 percentage points since the spring.

There has been a similar fall in consumer confidence, as monitored by GfK NOP for the European Commission. It has dropped by eight points from pre-election levels even as the recovery has picked up speed and unemployment fallen.

Why might this be? Markit, which produces the purchasing managers’ index (it measures business-to-business activity), puts the blame on the government.

“Behind the weaker growth profile for the service sector is a failure of confidence to rebound from the record fall seen in the aftermath of the emergency budget,” said Paul Smith, an economist with Markit. “Expectations about prospects for the coming year appear to have down-shifted in response to the austerity measures announced in June.”

The fall in consumer confidence has a similar cause. Talk of austerity has dominated the coalition government’s short life.

Next, the clothing retailer, reported a “noticeable cooling” of demand since early May, when David Cameron and Nick Clegg strode into Downing Street.

In general, despite one or two wobbles, the coalition has done very well. Compared with the warnings about the dangers of a hung parliament ahead of the election, and nonsense about Britain sitting on a bed of nitroglycerine, things have been remarkably calm. Sterling is up and so are gilts.

The government had to set out a clear plan for cutting the budget deficit. Labour, had it been re-elected, would have had to carry out a more bloodthirsty spending review than it admitted.

The problem is not the policy but the way it is being presented, as I touched on in recent talks at the Institute of Economic Affairs and at the think-tank Reform. The spending “cuts” over the next four years, including those inherited from Labour, but not yet implemented, add up to £84 billion compared with previous notional plans.

None of this has yet been delivered. There are three stages to the public-spending process: set the envelope, negotiate cuts to stay within that envelope, then deliver the cuts. The first is easy. The second a little more difficult. But it is only during the third stage that you know whether you can do it or not.

The government is encouraging people to look towards the end of a process that will take several years. It is also generating its own scare stories. The more you say things are going to be horrendous, the more people will believe it. When the Treasury asks most Whitehall departments to come up with cuts of 40%, not only is the departmental response likely to be less than rational but the impression is created of an irresponsible slash-and-burn process carried out with great relish by the coalition’s young Turks.

Fun though it is for newly-appointed ministers to be so macho, it is also undermining confidence. Even some Tory MPs are uneasy about it, while their Liberal Democrat confrères can only watch as their poll ratings collapse.

Are not ministers just being straight with voters, telling it like it is? What would the alternative have been?

What I would do, and it is not too late, is remind voters, and departments, that we have been through the biggest spending splurge in our history. If there is a good time to diet, it is after a feast.

Then I would point out that even the government’s savage spending envelope allows for public-sector current expenditure to rise from £600 billion in 2009-10 to £711 billion in 2015-16, a cash rise of 18.5%.

Between 1994-95 and 1999-2000, current public spending in the UK went up by only 14.9%, a comparable rate of increase to that planned now. There was no talk then of 40% cuts or Canadian-style surgery on the public finances, but it was achieved — Britain went from a budget deficit of 8% of GDP to a surplus over five years.

I am aware, of course, that £36 billion of the spending increase to 2015-16 is taken up by additional interest on government debt. The Office for Budget Responsibility has also pointed out that so-called “resource” limits for departments in 2015-16 will be 12% lower than if they had merely kept up with inflation. For capital spending the gap is even greater — 30%.

That adds to the case for seeking bigger savings elsewhere. The big cash increases in the next few years are social security, £30 billion, tax credits, £6 billion, public-sector pensions, £7 billion, and contributions to the EU, £4 billion.

There are two dangers in huffing and puffing too much about cuts. One is that consumer and business gloom becomes self-fulfilling, restricting the economy’s ability to grow its way out of debt.

The other is that the government gets a reputation for savage cuts but fails to deliver, the worst of both worlds. That was the fate of the Thatcher government in the early 1980s. Surely history won’t be allowed to repeat itself. Ministers need to lighten up on the austerity message. Otherwise they will end up with an austere economy.

Rate rise fears 

Another thing unsettling people is that if the spending cuts and tax hikes don’t get us, higher interest rates will. Sir John Gieve, a former Bank of England deputy governor, set the cat among the pigeons at an event last week organised by Fathom Financial Consulting.

He warned against the cosy assumption of a 0.5% Bank rate indefinitely and said that, if evidence of recovery builds, the rate could hit 2.5% or 3% next year. Charles Goodhart, another former monetary policy committee (MPC) member, said he would like to do a Rip Van Winkle and not wake up until 2012, such are the MPC’s dilemmas. Rising grain prices add to these.

Some of this may be overstated. Next, to give it another namecheck, warned of an 8% rise in clothing prices under the impact of higher raw material costs and next January’s Vat increase. It knows its business but if clothing prices, which have dropped 1.6% over the past year, rise 8%, I will go into my local Next branch and eat its display of hats.

There will be a lot more of this when the Bank unveils its August inflation report this week, but there is one crucial point. Predictions of higher rates, like Gieve’s, are conditional on recovery.

Only if the economy grows confidently through the tax rises and spending cuts will the MPC feel emboldened to begin raising Bank rate towards normal levels. The idea it would deliberately tip a fragile economy back into recession is surely fanciful.