The Autumn statement promised to be a difficult time for the Chancellor. Latest borrowing figures for October, suggested an overshoot of £11 billion in the current year, against the July target. The ONS had reclassified housing association debt into the Government figures adding £4 billion to the borrowing total year on year.

The abolition of tax credits, at a gain of £4.5 billion, was under pressure politically. The decision to cut police spending appeared impractical in view of the Paris terrorist attacks. On the face of it, the chances of securing the £10 billion surplus by 2019/20 appeared remote.

By the end of the day on Wednesday, the Chancellor had produced not just one rabbit but a veritable warren of rabbits from within the pages of the Spending Review and Autumn statement. This is how he did it …

The OBR Revisions …
Osborne was assisted by a series of revisions to the revenue forecasts from the Office of Budget Responsibility. The OBR produced an estimated £27 billion of additional revenues over the forecast period to ease embarrassment. Not bad …

Higher receipts from income taxes, corporation tax and VAT were unveiled– some of which result from modelling changes to the NICs and VAT deductions forecasts.

Spending on debt interest was also lower in all years, reflecting a further fall in market interest rates plus the decision by the Bank of England to maintain the stock of gilts over the lifetime of the forecast.

Not only would the Bank repurchase gilts on expiry but the dividend coupons would be returned to the Treasury under the QE ‘money for nothing, gilts for free” scheme. Hence some 25% of the gilts in issue would be coupon free.

For the public finances, the measures ensured that public sector net debt continued to fall in every year of the forecast as a share of GDP. The budget reaches a surplus of £10.1 billion in 2019-20. The Chancellor was able to meet the legislated fiscal targets … in line with the estimates in the July statement.

The adjustments to tax credits ..
“I’ve had representations that these changes to tax credits should be phased in. I’ve listened to the concerns. I hear and understand them. And because I’ve been able to announce today an improvement in the public finances, the simplest thing to do is not to phase these changes in, but to avoid them altogether.”

Reversing tax credit cuts produced a £5.0 billion increase in welfare spending over the period. In the first year, the effect was a loss of £3.5 billion and not the £4.5 billion as first estimated. Over the medium term the loss is mitigated by the implications of the Universal Credit adjustments phasing in from 2017 onwards. The Chancellor will have his welfare cut before the end of the decade, so best to avoid trouble in the house in the short term.

New Revenue Options …
New taxes from the apprenticeship levy (£11.6 billion), higher council tax (£6.2 billion) and higher stamp duty on second homes and buy to let (£3.8 billion) assisted the achievement of the tax reduction plans.

The additional payroll tax for larger firms has largely gone unchallenged. It is not quite clear as yet how the apprenticeship levy will produce a full net income gain to the exchequer.

The magic of the changes in spending and income mean, net borrowing in 2015/16 becomes £73.5 billion, falling to £49.9 billion in 2015/17, £24.8 billion in 2017/18, £4.6 billion on the following year, producing a surplus of £10 billion in 2019/20. All this including the additional housing association burden.

So what of the economy …
Growth helps, the OBR assume an average growth rate of 2.4% over the forecast horizon, with moderate assumptions on employment, trade and inflation. Is the projection realistic? It looks like it! The OBR states “On our central forecast, we judge that the Government has a greater than 50 per cent chance of meeting the fiscal mandate and supplementary target.

“We expect the budget to be in surplus by 0.5 per cent of GDP £10.1 billion in 2019-20 and public sector net debt to fall by 0.6 per cent of GDP in 2015-16 and by bigger margins in subsequent years.”

Projected total debt £1.7 trillion falls to 74% of GDP by 2019/20, still a massive burden on the economy attracting interest charges of £34.6 billion in this financial year rising to almost £50 billion by 2019/20. Fully interested the annual interest burden would be £75 billion assuming gilt yields move back to pre recession norms and the Bank of England withdraws from the gilt market!

So is this the end of Austerity ?
Paul Johnson of the IFS sums up the Spending Review … “There is no question that the cuts will be less severe than implied in July but this spending review is still one of the tightest in post war history. Total managed expenditure is due to fall from 40.9% of national income in 2014-15 to 36.5% in 2019-20. A swathe of departments will see real terms cuts. This is not the end of austerity" ... but growth will help ease the burden of the Master of the House.

So what happened to Sterling over the last two weeks?
Sterling fell slightly against the Dollar at $1.503 from $1.520 and moved down against the Euro to €1.419 from €1.427 The Euro moved down against the Dollar at €1.059 from€1.065.

Oil Price Brent Crude closed at $46.25 from $45.10. The average price in December last year was $62.24.

Markets, steadied! The Dow closed at 17,8068 from 17,818. The FTSE closed up at 6,393 from 6,334.

Gilts - yields moved down. UK Ten year gilt yields were at 1.83 from 1.87. US Treasury yields moved to 2.23 from 2.24.

Gold moved to $1,059 ($1,065), going nowhere slowly.

John
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One day we will realise that low rates are part of the problem and not the solution. Planet ZIRP was always supposed to be a stopover not a permanent settlement. Low rates, and QE effectively mis price capital leading to a misallocation of resources. Misallocation of resources leads to asset price inflation in housing, commercial real estate bonds and gilts.

Asset price inflation leads to yields and dividends collapsing, putting pressure on annuity yields, savers, pensioners, pension funds and insurance companies. Pension funds are forced to over invest in bond volumes to secure yield mass despite the risk of price collapse in the medium term.

The lack of realistic yields and bond collapse can lead to capital flight. Overseas investors will reduce holdings of domestic gilts to offset the low yields and risk of bond price collapse in the medium term. Currently overseas holdings of UK gilts are down to 25% compared to a 30% plus average.

Over the medium term, we expect bond yields (after Fisher) to reflect a hedge against inflation plus a real risk return. Hence we consider the normalised yield on ten year gilts to be between 4% to 4.5% if the plausible inflation target is 2%. There is a real risk of capital collapse as bond yields rise and capital prices fall as yields return to normalised values.

The mis pricing of capital leads to unrealistic gilt yields (currently around 2%) which then leads to the mis pricing of risk in the search for yield. In 2012 Zambia was able to issue a dollar denominated government bond twenty times oversubscribed yielding 5.4%. Current Zambian 2 year yields are 22%.

Low interest rates and the low cost of capital have led to an over investment in commodities and energy supplies. In turn over investment, despite strong demand conditions leads to over supply and pressure on prices. Low prices introduce a disinflationary spiral on planet ZIRP which reduces the pressure to increase rates, compounding the misallocation of resources and delaying the departure date.

The Fed, is considering a rate rise in December, the MPC must surely follow in March or April next year. Draghi should avoid further talk of easing monetary policy and follow the counsel of the council of Wise Men.

Warning from the Wise men of Europe …
In Europe, Berlin's Council of Economic Experts - known as the country's five "wise men" - said the ECB must consider tapering its bond-buying measures early to avoid dangerous imbalances from building up in the bloc. The European Central Bank must end its unprecedented stimulus measures to prevent a new financial crisis from erupting in the eurozone.

"Monetary policy is leading to a build-up of risks to financial stability which could pave the way for a new financial crisis,”.

"Persistently low interest rates erode the earnings of banks and life insurance companies, and raise the appetite for taking risks. It is important to avoid delaying an exit from the low interest rate environment for too long.” Instead, they called for the ECB to announce "a timely end to monetary policy accommodation which could effectively prevent the further build-up of risks in the financial system.”

Asset Price Inflation …
In June 2013 Andy Haldane warned : “Let’s be clear, we have intentionally blown the biggest government bond bubble in history” speaking before the Treasury Select Committee. Andy Haldane was then the director of financial responsibility at the Bank of England.

Not to worry, the markets will get the message in the end. High bond prices and absurdly low yields are a by product of life on Planet ZIRP. With short rates at or near the zero interest rate bound, undermining long term rates was considered to be the next great step. Who could possibly think that creating a financial climate with negative long term real rates, would encourage lending, in an uncertain business world.

There is no “Lonely Planet” Guide to life on Planet ZIRP as we pointed out in December 2008. Commenting on a paper by Bernanke - we said then - “OK it’s official, the effects of QE remain quantitively quite uncertain. Welcome to Planet ZIRP. We don’t have a hand book or fully understand the terrain. We cannot be sure QE is going to work at all. The process of quantitative easing, the plan to helicopter money may work but as a fire fighting option, it may be like dropping water into a desert, such are the fissures in the financial system”

We also said, “This is your captain speaking, Welcome on board flight QE 2009. I hope you have a nice flight, I am relatively new at this, haven’t actually flown before, we shall be flying by the seat of our pants but have every confidence, we will get somewhere, but not sure where, in the end.”

QE was an experiment which is still five years late unproven. We warned then, Planet ZIRP, would be a desiccated sterile planet where a liquidity crisis is exacerbated and prolonged. Now, eight years on, the US markets are beginning to welcome the end of the Bernanke experiment and the departure from Planet ZIRP. Soon too UK and Euro markets will follow suit. We need to ensure an orderly exit, avoiding the mad rush should an asset collapse and sterling crisis precipitate a more rapid response.

JKA