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Tuesday, 28 May 2013

Public money set to be used to cover shortfall in private-finance projects

Promised £3bn to invest in infrastructure and stimulate economy may all be used to plug gap in overhauled PFI scheme

A £3bn investment in infrastructure promised by George Osborne to stimulate Britain's flat-lining economy "could be entirely consumed" by problems with his overhauled Private Finance Initiative, according to economists.

Public funds will be required simply to make up a shortfall in the hoped-for private finance for three large investment projects, each worth £1bn-£2bn, said Mark Hellowell, of Edinburgh University. "It looks as if much of the extra public capital expenditure that the chancellor talks about is in fact substituting for the disappearance of planned private capital."

In opposition, Osborne slammed the PFI as an accounting wheeze beset with "perverse incentives", but late last year he reinvented it as "PF2", a rebrand and refinement which seeks to entice new investors into the market by limiting their financial exposure and keeping more risks with the public sector. Before the recent increase to public capital spending was announced, Whitehall had been looking to PF2 to finance a raft of major infrastructure projects. Subsequently, however, several of these have come unstuck.

After Michael Gove's move to ditch Labour's school rebuilding plans in 2010 ran into the wrath of parents and teachers, the coalition made a partial U-turn and announced that it would upgrade the institutions in most urgent need, through a PFI-style "priority school programme" worth around £2bn. This month the Department for Education let slip that private finance of that programme had been scaled back by £1bn. The department was forced to make an immediate allocation of £300m of its own money to cover 27 schools, and hopes that June's spending round will agree sufficient public funds to cover the rest.

In March, the government conceded that an intended £1bn public-private partnership to finance the rolling stock for the Crossrail project running through central London would now be entirely footed through Whitehall's own capital budgets.

In the same month, the Ministry of Defence backed away from the planned use of private finance for its Future Force 2020 scheme for soldiers' accommodation, with the defence secretary, Philip Hammond, allocating £1bn from his own budget to fund the proposals instead.

With no central list of all the schemes going ahead or being cancelled, the total cost to the public finances of plugging gaps in private finance cannot be known for certain. But Hellowell said that "in the worst case the extra capital spending the chancellor talks about could be entirely consumed in addressing the gaps left by a failing PF2".

The government has conceded that a £1bn public-private partnership to finance rolling stock for the Crossrail project in London will now be entirely funded by Whitehall’s capital budgets.

Jonathan Portes, of the National Institute for Economic and Social Research, warned that problems with PF2 could undo action the government is taking to boost growth: "To the extent that its claimed additions to public investment simply substitutes for investment that was planned to be financed 'off balance sheet' via PFI, it will have no significant macroeconomic impact at all".

A Treasury spokesperson defended PF2, insisting that the model "will provide more flexibility, transparency and better value for money". The spokersperson said "five batches of schools projects at a value of around £700m" were going ahead. The government was "committed to using private finance where it delivers the best outcome for the project", but recognised "that there is 'no one size fits all' solution to the delivery of complex infrastructure projects".

Chris Leslie, Labour's shadow financial secretary to the Treasury, said: "George Osborne has already invested billions less in infrastructure than the plans he inherited, meaning house-building is at record lows and the construction sector is in decline. Now it looks like the relatively small amount of extra funding in the budget will simply offset the shortfall in private finance."

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Article source : http://www.guardian.co.uk

Was jittery Thursday a foretaste of another global economic crash?

The sharp slide in share prices was either a blip in the road to recovery or a sign that the unwinding of quantitative easing will lead to disaster. Our writers argue it out

Central banks may be pumping billions of dollars into the world's financial markets through quantitative easing, but by artificially inflating the prices of stocks and bonds they're just storing up an almighty crash for the future.

That's the argument of City bears, who warn that while last week's slide may be reversed in the days ahead, the sharp fall in share prices that spread from Tokyo to Wall Street and London was a foretaste of the reckoning that will inevitably come, once QE starts to be unwound. "This is a liquidity-fuelled rally in stock prices. It's clear that the world economy has not been performing as well as stock prices say it has," said Neil Mellor of BNY Mellon.

Pessimists cite several reasons to be nervous about whether the rally that took share prices in the US to record highs before the blip can be sustained.

The first is China: a weak reading on the purchasing managers' index survey for the country – a barometer of its manufacturing sector – was one of the factors that fed Thursday's decline.

Growth in the world's second-largest economy has long been expected to slow from the double-digit pace that was the norm before the world recession of 2008-09. But there are serious concerns about the health of China's banks, which are thought to be sitting on a growing pile of bad loans. "It's clear that a lot of banks are in an awful lot of trouble," said Mellor.

Demand from China is critical for a number of major economies, including Japan, for which China is a huge export market, and Australia, which is heavily reliant on its natural resources. Any sign that the Chinese economy was slowing sharply, or worse still, facing a financial meltdown, would have knock-on effects right across the world's financial markets.

A second reason to worry is the eurozone. While the mood has been quieter since the Cyprus bailout was agreed in March and a rate cut from the European Central Bank boosted confidence, the crisis is far from over.

The eurozone economy remains deep in recession, and there is a long list of countries, from Slovenia to Spain, with unresolved problems that could spiral rapidly into a major crisis.

Third, Japan: markets have been supercharged in recent weeks by the radical policy of "Abenomics", named after new prime minister Shinzo Abe, which involves deregulation and a boost to public spending as well as the "shock and awe" quantitative easing announced last month.

Even if the policy works well, however, it is unlikely to be the overwhelming success that would be required to validate the 25% jump in share prices seen since the end of last year.

The final reason to be nervous is a more general one: as central bankers themselves have warned, extended periods of cheap money tend to create market distortions, as investors take the money and use it to fish around for better returns, in a "search for yield".

In the bond markets, for example, countries that would usually find it impossible to attract foreign lenders are finding investors falling over themselves to buy their bonds. Rwanda's $400m (£265m) bond issue in April was more than seven times oversubscribed, while middle-income countries such as Turkey, Mexico and Brazil have seen their borrowing costs slide. That's great news for the governments in question, but smacks of what Fed chairman Ben Bernanke recently referred to as "excessive risk-taking".

Whatever the outlook, "jittery Thursday", as analysts at City consultancy Fathom called it, underlined the fact that investors should brace themselves for a period of increased volatility.

"This bout of market jitters has laid bare the twin distortions imposed by a combination of near-zero interest rates and unconventional monetary policy, namely an excess sensitivity to small changes in the data and an unhealthy addiction to doveish central banks," they said.

People who buy shares are by nature optimistic. They make a profit when the stock market goes up, so they want it to go up forever.

Until last summer – after two years of crisis in the eurozone about the single currency – European investors were wary about the prospects for the global economy. The 2008 banking crash had been a disaster, as shares lost almost half their value on the big European exchanges. Then governments soaked up bank debt and themselves grew vulnerable.

But then European Central Bank chief Mario Draghi said he'd do "whatever it takes" to save the euro. That pledge, plus the renewed money-printing from the US Federal Reserve and the Bank of England, was a message that delighted investors. Since June 2012, the German Dax index has soared from around 6000 to almost 8400, before dropping back a little last week. The same story is told by the other major European exchanges, including the FTSE 100, which jumped from 5260 to a peak of 6723 earlier this week – a 28% gain in less than a year.

Japanese stocks fell sharply last week after an unexpected drop in a Chinese business confidence index

Some economists argue that stock exchanges are riding for a fall. They say fundamental building blocks of growth are missing. In the major economies, investment remains low and consumer confidence is lacklustre, especially while high unemployment is rising and wages are frozen in real terms.

However, there are three good reasons why stock markets, a few blips aside, will continue to grow for some time: central banks are scared; there is lots of money waiting to be invested; and returns on all other assets are low.

Many analysts blamed the sharp falls in stock market values last week on a hamfisted performance by Federal Reserve chairman Ben Bernanke, who initially gave little hint that the Fed's QE measures might be scaled down only to say later that several members of his committee thought the time might be ripe in the next few months.

The Fed has injected more than $3tn of freshly minted money into financial markets and is supposed to be increasing the total by $85bn a month until unemployment comes down to 6.5%. It is 7.5% at the moment. The hint that Fed funds would stop early sent markets into a spin, but it was not new. Bernanke had said the same in January.

And the Fed must stay the course because households and businesses across the US and Europe are still paying back debt from the boom years. Only central bank funds are keeping economies afloat. The Bank of England remains steadfast and the Bank of Japan is ramping up its QE programme. Bernanke will stick with his original plan.

Stock markets are also being buoyed by the huge reserve of funds sitting in the Middle East, in Asia, and in western pension funds. Fund managers want to bet the trillions they are keeping on the sidelines on the stock market, should it feel safe. Central banks will continue to make it feel safe.

The third driver comes from the low returns elsewhere. Sovereign wealth funds and pension funds have used large amounts of their spare money as loans to governments and big companies. But buying bonds earns them only a small return. Lending to the German government is such a privilege that investors lose money on the deal.

Strapped to these three rockets, the market can still soar. Of course, Spain could yet go bust or China grind to a halt. There could be a natural disaster, an act of terrorism or war. History tells us a bust is waiting down the track, but while the world economy recovers and governments and central banks maintain their pledge to keep printing money, we should expect prices to rise.

Article source : http://www.guardian.co.uk

Niall Booker hired as new Co-op Bank executive

It is hoped veteran HSBC banker Niall Booker will help nurse struggling Co-op Bank back to health

The Co-operative Group has appointed a veteran former HSBC banker as the new boss of its struggling banking business, which saw its investment rating slashed to junk status earlier this month.

Niall Booker, 54, spent 30 years at HSBC, quitting in 2011 after nursing the bank's sub-prime lending business back to health.

Booker replaces Barry Tootell, who stepped down as chief executive of the Co-op Bank when credit rating agency Moody's expressed concerns about the bank's capital position and even hinted that it might need taxpayer backing. The agency slashed the bank's investment rating by six notches and analysts have estimated that the Manchester-based bank could need to find up to £1.8bn to boost its capital cushion.

The bank, part of the wider Co-operative Group that includes supermarkets, funeral services and pharmacies, is in talks with Britain's financial regulator to agree on a plan to address the shortfall.

The group's new chief executive Euan Sutherland – who took over earlier this month – is expected to update the Co-op board on the talks at a meeting on Friday.

The Co-op bank has had a tumultuous few weeks. In March it unveiled a £600m loss, largely as a result of losses on bad loans and compensation for mis-selling payment protection insurance.

One of the UK's smaller banks, with 6.5 million customers and only 2% of the current account market, it had nevertheless planned to expand rapidly and was negotiating to buy more than 630 branches from Lloyds. Its ambitious plan, which would have given it an extra 4.8 million customers and a total of 942 branches, was welcomed by the government, which is keen to see new competitors to take on the existing big four banks.

But the deal fell apart, with the Co-op blaming regulators and the difficult economic backdrop. Two weeks later came the Moody's downgrade. Last weekend it emerged that the Co-op had halted all new lending to small business customers.

Sutherland, who was previously chief executive of DIY group B&Q, said in a statement: "The board and I are confident that Niall will add tremendous value, helping us work through the complex issues that we currently face as we work to reposition our bank."

There has been speculation that the Co-op might wind down the bank, but Booker's appointment was being viewed as a commitment to the business.

Booker, who is expected to split his time between London and Manchester, said: "There are no quick fixes here, but with the support of the Co-operative Group, our staff and our loyal customer base, I am confident we will be able to stabilise and develop the franchise."

The Co-op had planned to release the details of Booker's appointment this morning, when the stock exchange reopens, but news of his appointment leaked over the weekend. The group does not have shareholders, but does have bondholders.

Booker, a Cambridge graduate, joined HSBC in 1981 and has worked across retail and corporate banking businesses. He was chief executive of HSBC in India and of the bank's Middle East operations before being posted to the US.

HSBC was last year fined $1.9bn (£1.2bn) by the US department of justice for "stunning failures of oversight", which allowed drugs cartels and terrorists to launder hundreds of millions of pounds through its US and Mexican businesses. HSBC had earlier hit problems with its sub-prime lending business – which provided loans to high risk borrowers – and Booker was parachuted in to put the business back on an even keel. He left the bank in October 2011 and has been looking for a new role since then, said a Co-op spokesman.

Sutherland said: "With his strong background across the banking sector, covering both retail and corporate, he is the ideal person to lead The Co-operative Bank at this important time in its history. He clearly brings the strategic and operational skills that we need to help take the bank to the next stage of its development."

Booker's experience of working with regulators is also understood to have been key.On Monday the Co-op refused to say when it had approached Booker or divulge his salary. But a spokesman said it was likely to be more than the £522,000 earned by his predecessor, as Booker has also been installed as the group's deputy chief executive.

Article source : http://www.guardian.co.uk

Deloitte appoints official criticised over 'sweetheart' tax deals

Dave Hartnett has been hired by accountancy firm which faced tax avoidance allegations during his time as head of HMRC

The row over tax avoidance by multinational companies escalated on Monday night as it emerged that Dave Hartnett, until 10 months ago the country's leading tax official, has been appointed to a new position with a leading accountancy firm mired in the controversy.

Hartnett will work one day a week with Deloitte, the auditors for Vodafone and Starbucks, which faced tax avoidance allegations during his time as head of HM Revenue & Customs.

The appointment was approved by David Cameron and the advisory committee on business appointments last week, although Deloitte did not announce the high-profile signing.

The appointments committee added a list of six caveats to its approval letter, designed to ensure Hartnett does not share any information about how to avoid UK tax and to guard against potential conflicts of interest.

But tax campaigners and MPs criticised the appointment and suggested that although Hartnett cannot advise UK organisations, he could use his knowledge to strengthen the positions of offshore tax havens.

Hartnett, 62, will advise overseas governments on how to implement "effective tax regimes".

An HMRC lifer until his retirement, Hartnett was heavily criticised for agreeing a number of "sweetheart deals" with major corporations including Vodafone and Goldman Sachs in the UK.

Earlier this month, a judge found that a deal brokered by Hartnett with Goldman Sachs, which saved the US bank £20m in interest payments, was lawful but "not a glorious episode in the history of the revenue".

Mr Justice Nicol said the deal had been agreed by Hartnett to save the chancellor, George Osborne, from potential embarrassment, and criticised the fact that it had been done behind closed doors and without proper approval or reference to lawyers. Hartnett was said to have personally negotiated a deal with Vodafone, which saw the telecoms business pay £1.25bn of an alleged £6bn tax bill. Vodafone disputes this figure.

A spokesman for Deloitte said: "Dave Hartnett will work as a consultant to Deloitte advising foreign governments and tax administrations, primarily in the developing world. He has significant experience in advising such countries on the development of effective tax regimes, necessary to ensure their continued economic growth. He will not work with UK companies or with HMRC."

The new job comes four months after Hartnett was appointed as an adviser to banking group HSBC on financial risks and crime. The bank was fined $1.9bn (£1.3bn) by US authorities last year for laundering Mexican drug money.

Confirming his appointment, the advisory committee on appointments said it was noted that "whilst working in government, Mr Hartnett did have official dealings with Deloitte, and he also dealt with a wide range of major accountancy and law firms during his time in HMRC and the Inland Revenue before that".

Labour MP John Mann, who sits on the Treasury select committee and questioned Hartnett on several occasions, criticised the appointment. "It shouldn't be allowed. It is all-too-cosy relationships that is the problem at the heart of HMRC.

"It would be a strange government that would employ him considering the problems we've had trying to get our tax system in order, especially when he personally negotiated the deal with Vodafone.

"It gives the wrong message to a group of staff [at HMRC] who are already some of the most demoralised workers in the country."

Deloitte and the other "big four" accountancy firms – KPMG, PricewaterhouseCoopers and Ernst & Young – have all been criticised for using knowledge gained from staff seconded to the Treasury to help wealthy clients avoid paying UK taxes. Richard Murphy, of Tax Research UK, called the latest switch from the state to the private sector "the creeping control of the state by the big business elite".

He said: "We've had people who are very senior who have moved over to big business, but never the very top. He was meant to be the taxman's taxman."

He suggested that Hartnett may be called upon "to advise on tax avoidance in offshore locations".

The prime minister accepted the committee's recommendation that Hartnett be allowed to join Deloitte, but set a series of rules on what he can and cannot advise upon while working for Deloitte.

The rules laid down state that Hartnett should "not draw on any privileged information" from his time at HMRC. He must also not advise "any taxpayer that he has been involved with whilst at HMRC" and must ensure he "has no involvement in discussions with other fiscal authorities of UK's confidential tax policy".

He is also not allowed to personally lobby the government for at least a year.

Hartnett had a close relationship with Deloitte during his time at HMRC and met senior British partner David Cruickshank 48 times between 2007 and 2011, including meetings about Vodafone, one of Deloitte's clients.

Deloitte also signed off the accounts for coffee company Starbucks. The chain faced a backlash among customers last year when it emerged that it had, quite legitimately, paid no corporation tax in the past three years by channelling its revenues through Luxembourg and Switzerland.

Murray Worthy, a spokesman for UK Uncut, who recently brought an unsuccessful court case against HMRC for the sweetheart deal with Goldman Sachs, said Hartnett had been "welcomed with open arms by the people he was supposed to have been regulating".

Article source : http://www.guardian.co.uk

Monday, 27 May 2013

FirstGroup chief Tim O'Toole offered to quit with chairman over £2bn debt

Transport firm CEO, who was told by Martin Gilbert to carry on, spearheading courtship of big investors over £615m rights issue

FirstGroup's chief executive, Tim O'Toole, will this week visit its biggest institutional investors to secure backing for the troubled transport operator's £615m rights issue, as it emerged that he offered to quit instead of the chairman.

Martin Gilbert announced his resignation last week after the group concluded it could no longer continue struggling with its £2bn debt. Sources close to the company said O'Toole had, in a private conversation, told the chairman he would also consider his position, but Gilbert said he should carry on.

O'Toole will steer First through a £1.6bn programme of investment over the next four years – primarily in renewing its ageing bus fleet. After the west coast mainline fiasco, in which it missed out on the lucrative railway linking Britain's biggest cities, it would be natural to blame rail for its troubles. But the malady that has forced the firm's rights issue was incubated in the mode of transport it knew best: the bus.

The company, which bills itself the "world's largest public transport operator in private hands", began with a small municipally owned bus company in a far corner of Scotland. Formed from a management buyout under privatisation and a merger with south-west England's Badgerline, the new FirstGroup plc was little more than a decade later striking a deal that would make it the biggest player in key US markets – but at a cost that it is finally having to address.

Borrowing billions, First acquired US transport firm Laidlaw in 2007, and now provided 40% of school bus services across the States. But the takeover did not go to plan: attempts to reduce the debt to a manageable sum by hiving off the newly acquired Greyhound coach service to another buyer fell through. The school runs on a 54,000-strong fleet of the yellow buses did not generate the anticipated profits, and First's share price fell while the group's debt burden made the ensuing bumps in the road ever harder to absorb.

The services it runs in about 40 towns and cities in Britain also began to run into trouble. Passengers were deserting deteriorating, clumsily managed services, with routes slashed and fares pushed up, to the point that there were campaigns and protests against the operator in cities such as Bristol. Changes in government grants and support for concessions exacerbated problems in a bus business that had been generally regarded as a safe cash cow, leading to a profits warning last year.

These headwinds and growing questions over the group's debt partly explain why First bid so keenly for the west coast mainline – a bid so high that rival Sir Richard Branson, the Virgin boss, branded it "insanity", though O'Toole has consistently defended it since. Instead of securing the bandage of a lucrative rail franchise, First licked its wounds as the government paused the entire rail franchising programme, a delay that diminished options beyond the long-resisted rights issue – one being considered even when US railwayman O'Toole joined the board four years ago.

What First now describes as an "albatross" was debt that peaked at £2.6bn after the acquisition of Laidlaw. While the debt was being eroded – partly through selling assets – fears that rating agencies would downgrade First's creditworthiness to junk status, piling on financing costs, forced the group's hand.

Douglas McNeill, a director at investment firm Charles Stanley, said: "Pressing on without a rights issue wasn't doomed to failure, but it was risky: when you have a lot of debt you need everything to go well. You're vulnerable to events.

"Had they done it earlier when the share price was higher it would have been less painful, less dilutive for shareholders."

Those shareholders include at least 8,000 FirstGroup staff who have been part of a long-term share buying scheme, and would likewise have seen their nest eggs slashed by a third last week as the share price nose-dived for the second time in seven months. The RMT union said: "Low-paid guards and platform staff have been propping up the share price with a scheme that might see them losing all their money – and now potentially their jobs because of the chaos at the company." First dismissed the union's claims that the schemes had been closed or that jobs were at risk.

The one man who did lose his job, Gilbert, was a director of First running buses in Aberdeen when Sir Alex Ferguson was still managing the local football club, and has overseen a similar transformation in the scope and scale of the business as Fergie at Manchester United. Analysts believe one sacrificial lamb will be enough to appease shareholders, and O'Toole will have some breathing space.

A First spokesman insisted the rights issue, which should be ratified by shareholders on 10 June, is "good news: we can pay down debt, this is a licence to invest and grow, even if the share graph over 24 hours looks terrible – it's what analysts were expecting". McNeill concurs: on First's prospects, he is "optimistic – for the first time in a while".

Article source : http://www.guardian.co.uk

Property price rises stoke fears of a new housing bubble

House prices grew by 0.4% in May – the faster at any time in the past six years – figures from Hometrack show

Fears that George Osborne, the chancellor, is stoking a new housing bubble through plans to boost mortgages may be exacerbated by figures showing house prices grew faster in May than at any time in the past six years.

Prices rose 0.4%, the most since May 2007, driven mainly by the market in London and the south-east – although the rest of the UK also averaged a marginal rise.

Data from Hometrack, a property analytics firm, shows prices grew by 0.9% in the capital last month, and by 0.5% across the south-east.

The number of people looking to buy grew almost 15% in London over the past six months but the number of available properties declined, creating the biggest gap between supply and demand for more than four years.

The average time a sale takes in London is now one month – a third of the time taken in the East Midlands.

Outside London and the south-east, the picture was more mixed. Prices were static in four regions (the north-east; north-west; Wales; and Yorkshire and Humberside) and grew in a further four (East Anglia; East Midlands; West Midlands; and the south-west).

Richard Donnell, Hometrack's director of research, said: "While levels of demand have been increasing each month, the total growth in buyer numbers has been broadly in line with that seen in recent years. But it is a lack of housing to buy that is driving the acceleration in prices.

"High moving costs, uncertainly over the outlook for jobs and a lack of available housing to move to means homeowners remain unwilling to put properties on the market. This is only serving to limit supply further."

Donnell said he expected to see more "mini housing cycles" with more sellers entering the market but demanding unrealistically high prices. Currently, though, sales are going through at 93.9% of asking price – the highest since summer 2010.

Last week the average price of a home in London passed £500,000 for the first time, according to the property website Rightmove.

In his March budget, Osborne unveiled a Help to Buy scheme giving partial guarantees for billions of pounds worth of low-deposit mortgages, allowing more people to get loans without a big deposit, as well as providing government loans. But observers including the Royal Institute of Surveyors and the outgoing Bank of England governor, Sir Mervyn King, say the plans risk fuelling a new bubble and warping the market at the expense of new buyers.

Article source : http://www.guardian.co.uk

Britain is a lab rat for George Osborne's austerity programme experiment

There is no evidence – and never has been – that austerity works in the fashion promised by those who support it

What do you think about George Osborne's austerity programme? No, I am not trying to be funny. When the chancellor says he is tackling Britain's large budget deficit through a mix of spending cuts and tax increases are you more or less likely to go out and spend money?

The answer to this question appears obvious to most people. Austerity makes consumers and businesses more cautious. It leads to less spending in the economy and throws deficit reduction programmes off track.

That, though is not what Osborne thinks. It is not what the European Central Bank thinks. It is not what the Tea party in the United States thinks. It is not what most mainstream economists think. What they all believe is that any pledge by governments to cut spending imparts a warm glow to those toiling away in the private sector. Confidence blossoms because individuals and businesses expect healthier public finances to result in lower taxes. Businesses will invest and this will lead to higher consumer spending.

Conversely, any attempt by governments to spend their way out of a slump is worse than useless. Perfectly rational economic agents understand that higher public borrowing today means higher taxes tomorrow, and they will prepare for that dread day by reining in investment and spending. The economy will shrink rather than grow.

Let me guess what you are thinking? You are thinking that this sounds like complete mumbo jumbo and bears no relation to the real world. You think that expansionary fiscal contraction – the economic idea used to justify austerity – is a contradiction in terms. You think that there is not one shred of evidence to support the idea that government belt-tightening in a deep slump does anything other than to make that slump deeper and longer.

And you would be absolutely right. There is no evidence – and never has been – that austerity works in the fashion promised by those who support it so vehemently. Britain – used as a laboratory rat in order to prove that expansionary fiscal contraction works – is proof of that, as are the examples of Ireland, Greece and Portugal.

The UK experiment began three years ago when the coalition came to power. The timing could hardly have been better for the new breed of expansionary fiscal contractionists at the Treasury. The deficit was at a peacetime record, the economy appeared to be on the turn and, as an excellent new book by Mark Blyth* shows, it was the time when the brief one-year dalliance with Keynesian economics had just hit the buffers.

What happened was this. In the winter of 2008-09, following the collapse of Lehman Brothers, the world economy contracted at a rate not seen since the early 1930s. Governments decided this was not the time to sit back and do nothing: they got together and co-ordinated the biggest expansion of monetary and fiscal policy on record. The Americans, the Chinese, the British, all cut interest rates and announced stimulus packages. Even the fiscally conservative Germans joined the party.

The unprecedented intervention by central banks and finance ministries prevented a second great depression, but the healing process had only just begun by early 2010. At that point, the narrative changed. As Blyth correctly points out in Austerity: The History of a Dangerous Idea, the crisis began with the banks and it was only when states moved in to re-capitalise institutions that were on the brink of bankruptcy that a private sector debt crisis became a sovereign debt crisis. With the sole exception of Greece, the financial problems faced by western governments did not stem from the profligacy of the state but were the result of taxpayers picking up the tab to bail out the banks.

But this view was quickly challenged. Within months, as Blyth says, it was re-christened a sovereign debt crisis by political and financial elites. Why? In part, it stemmed from the ingrained belief that markets are infallible and governments can never do any good. In part, it stemmed from a genuine – if misguided belief – that government debt levels would explode to unacceptable levels unless austerity was introduced. In part, it was a way to ensure that the people who were actually responsible could shift the burden of clearing up the mess onto those who were quite blameless.

Those determined to push back against the Keynesian experiment came armed with economic evidence. The Italian economist Alberto Alesina made the case for expansionary fiscal contraction when he presented a paper to EU finance ministers in April 2010, citing examples of countries – such as Ireland in the late 1980s – where the approach was supposed to have worked. Jean-Claude Trichet, then president of the European Central Bank, was impressed. So was Osborne, who drew on Alesina's work in his emergency budget of 2010.

Vicious circle: the IMF says spending cuts are more painful when every country is retrenching at the same time and has urged George Osborne to boost spending

Blyth's book traces austerity back to its roots in the works of John Locke, David Hume and Adam Smith, but is particularly impressive in the section that takes apart claims that the last 30 years have provided examples of expansionary fiscal contraction working. Alesina's version of what happened in Ireland in 1987-9 is that an austerity minded government delivered growth by cutting welfare, taxes and the public sector wage bill, with the fiscal tightening offset by a devaluation of the punt. This explanation, however, fails to mention that Ireland's biggest export market is Britain, which at the time was going through the wild excesses of Nigel Lawson's ill-fated boom.

And so it goes on. Blyth has plenty of examples – Britain in the 1920s, for example – where austerity failed. He finds none – not even the recent case of Latvia – where it does what it says on the tin.

IMF economists have done a good job in challenging the claims of the expansionary fiscal contraction brigade. The fund found that the notion that spending cuts are less harmful to growth than tax increases – one of the chancellor's key claims – only holds true if central banks can compensate for the contraction with reductions in interest rates. When official borrowing costs are just above zero that is not possible. The IMF also says spending cuts are more painful when every country is retrenching at the same time, as now.

In short, it believes that austerity isn't working. It believes the US has recovered more quickly than the eurozone because of Washington's belief that growth leads to deficit reduction rather than the other way round. It says Britain's economic recovery is feeble and wants Osborne to boost spending on public infrastructure in order to offset the £10bn of tax increases and spending cuts he has lined up for 2013-14. So ask yourself one final question. If Osborne borrowed £5bn-£6bn to build houses and fix potholes would that be a good or bad idea? Most of us, I would suggest, would take the former view, which is why austerity has failed and why the economic thinking that underpins it is bunk.

Article source : http://www.guardian.co.uk