FT Alphaville highlights a near 50-year low in 10-year gilts and puts the blame for this fall squarely at the feet of bearish comments from new MPC member Martin Weale in the Times:

'It would be “foolish” to rule out the possibility of a double-dip downturn, even if it was not the Bank’s central prediction, said Dr Martin Weale, the newest member of the Monetary Policy Committee (MPC). He also feared that the Bank’s central outlook — which is for growth of about 2.8 per cent in 2011 and 3.2 per cent in 2012 — could be too optimistic…

Dr Weale said that the Bank’s latest economic forecasts, published on August 11, had a 10 per cent outside chance of four-quarter long economic contractions in 2011 and 2013. “The forecast is putting a significant chance on the economy contracting over a four-quarter period,” said Dr Weale.'
 

The link between Weale's bearish-ness and the drop in gilt yields raises questions about what effect yields will have on business investment (remember - the Chancellor and the OBR are staking their reputations on fiscal restraint lowering 10-yr yields and so helping to encourage business investment).

So what's pushing 10-yr yields close to record lows?

Well three factors: global risk, domestic weakness and fiscal consolidation.

Let's breifly take those in turn.

1. Global risk. With the global recovery stumbling and sovereign default still a moderate risk, investors are seeking safety in the arms of US, UK and German government bonds. As demand for these longer-term bonds goes up, so does their price, pushing down the yield. So far, so good. The problem is the affect on business investment. If financial markets are shunning risk, then its because there's something worrying about the state of the global economy. Concerns about the global recovery makes businesses uncertain - and that's why most are sitting on piles of cash and holding off on investment.

2. Domestic (UK) risk. Well, a weak economy typically favours bonds as investors move out of relatively riskier equities in favour of relatively safer goverment bonds. This is the sentiment behind the Weale-driven dip in yields. But yet again, domestic weakness will make businesses cautious about investing.

3. Fiscal consolidation. I'll put this upfront so there is no second guessing our views: this isn't a 'deficit denier' arguement. There is a deficit, it needed to be tackled and EEF supports most of the government fiscal consolidation plans. And tackling the structural deficit will provide downward pressure on gilt yields (or at the very least limit any upward pressure). The question we're raising about the affect on investment. The government is making a 'crowding out arguement' that says shrinking the deficit will lower rates and boost private sector investment. Not only is this arguement weak - all interest rates were low prior to the recession, which was part of the problem behind the financial crisis, so there's only a weak case for the government to make. Add on top the uncertainty caused by their unnecessarily deep capital spending cuts, and you've got businesses being cautious about investment because they've got concerns about their public sector-related orders.

So in reality, two of the three drivers pushing gilt yields down will naturally imply only limited growth in business investment. And the government's gamble on fiscal consolidation boosting investment actually cuts both way, providing an uncertain benefit.

The minutes from the most recent Monetary Policy Committe (MPC) meeting makes for interesting reading - and not just for egg-head economists like me, but for consumers and businesses as well.

Why should non-economist types care?

Well, whenever monetary policy is involved, it comes down to two things: prices and interest rates.

Where prices are headed matter for household budgets that are going to be stretched in the coming months and years and taxes go up and public spending (and jobs) are cut. Interest rates matter to home owners - for many, mortgage interest payments will have fallen over the last 18 months, providing a nice cushion as incomes stagnated or fell. Others will be wary of buying homes because they expect interest rates to go up - which may keep house prices and home building on hold for some time to come.

For businesses it's about credit conditions.

Troubles in Europe have rocked financial markets and made it costlier for banks to access the capital they need to underpin lending here in the UK. Market volatility and uncertain has pushed the pound around - volatility that makes manufacturers catious about pushing into new export markets. And prices matter too, as rising imported input and raw materials costs could undermine competitiveness, even as markets rebound.

So why the interest in the MPC?

Well, the MPC is split on where they think the economy is. Some, like the Governor Mervyn King, think that economy has enough room to expand (called spare capacity by us boffins) to stamp out any inflationary pressures.

A second, cautious camp is concerned about rising inflation expectations - because prices have been rising, people come to expect them to continue to rise, which in turn pushes prices up, either through higher wage demands or through stronger demand or by passing costs on to customers.

A third (and small group of one) want to start raising rates now beacuse of the risks that inflation would continue to persist far above the 2% target.

For businesses and households, the prospect of either future (and sooner) rate rises or further inflationary pressure comes down to a key call on the economy: is there spare capacity in the economy (in businesses and in the labour market) to let the economy expand and grow without creating problems for inflation.

Like much in economics, there's unfortnately no single definition or measure of spare capacity. For economists, it comes down to your view of the world and what you hear from businesses.

What we're hearing is a worrying word - shortages.

Shortages - in skills and in raw materials - implies little or no spare capacity. And that puts us in the middle cautious camp. Inflation's has proved a persistent problem despite a series of temporary price pressures. But while fiscal consolidation remains on tough track, the MPC should still be worried about the health of the recovery.

That means keeping rates and QE on hold for now, but raises the prospects of interest rates going up sooner rather than later.

Today, the government launched the Office of Tax Simplification to help reduce the growing complexity of the UK's tax regime.

The OTS will do what it says on the tin - simplify the tax system - by looking at two key areas.

First, it'll conduct a wholesale review of small business taxation - including tackling the tricky IR35 that allows people to set up their own companies inorder to minimise NI contributions and income tax, while paying themselves in dividends. But hopefully it will also look at how to tax smaller businesses on a cash flow basis - something that would strip out enourmous amounts of complexity.

Second, the OTS will take a good hard look at the 400 plus reliefs and allowanes that permeate the tax system. The OTS will be looking to scrap obscure, anachronistic or narrow reliefs in an effort to make a modest beginning in paring back the masses of tax law.

The OTS is a good innovation - given the need to improve the competitiveness and predictability of our tax system, the OTS is likely to have a really important role in simplifying the vast stock of complex tax code.

By focusing first on small businesses, the OTS has an opportunity to strip away the administrative and compliance burdens they currently face.

The key test will be the OTS’s ability to work effectively with business to make substantial and visible progress in reducing complexity and enhancing competitiveness.

But more importantly, the OTS should ensure that simplification isn't an ends, but a means to improving the competitiveness and predictibility of the tax system.

Cynics might question the value of yet another independent 'Office' based out of the Treasury. Business will be hoping that the OTS gets to work as soon as possible.

EEF's take on the Emergency Budget was simple: job well done on deficit reduction, but there needed to be more about longer-term growth and rebalancing.

Echoing EEF's comment piece in the Telegraph before the Budget, a piece in the FT by Mohamed El-Erian, the Chief Executive of PIMCO, one of the leading global investment management firms, writes about the false debate between growth versus austerity:

"The majority of industrial countries need to adopt both fiscal adjustment and higher growth as twin policy objectives....Squaring the circle of growth and fiscl stability needs policies that focus on long-term productivity gains...[with a] new emphasis on infrastructure and technology investment."

Given the need to complement austerity with growth, EEF's key concerns about the Budget hinged on a few key announcements: the government maintaining savage cuts to capital spending (around 1.5% of GDP) and cutting the level of capital allowances to 18% and lowering the Annual Investment Allowance to £25,000.

Deep cuts to capital spending limit long-term productivity and economic growth - it places a cap on future growth. The cut to capital allowances makes the investment needed to rebalane the economy more expensive.  

On Wednesday, the Institute of Fiscal Studies detailed analysis of the Emergency Budget echoed our view on capital allowances:

"Cutting capital allowances is not a good way to raise money [because] capital allowances are an efficient way to promote investment. The reform is not a simplification."

And a leader on the Budget in today's Economist notes that:

"...Mr Osborne should not have accepted inherited plans to trim capital spending by as much as 1.5% of GDP; a growing economy needs modern roads, railways and the like."

With the experts worried that the Budget didn't quite deliver the investment needed for growth and rebalancing, Martin Wolf writes about the implications for the government and the economy:

"The biggest economic point in the Budget is the need to rebalance the economy away from debt and government consumption. Moreover, the Office of Budget Responsibility believes this is likely to happen....A surge in fixed investment and net exports is forecast....the average contribution to growth of gross fixed capital formation and net exports was 0.5 percentage points and minus 0.3 percentage points, respetively between 2000 and 2008; these figures are expected to jump to 1.2 and 0.7 percentage points between 2011 and 2015."

Given the deep cuts to capital spending and the higher cost of investments, rebalancing is less likely. Wolf continues:

"The depressed level of investment, the low interest rates and the big fall in the real exchange rate make these shifts conceivable. But they are far from assured....[The Chancellor] assumes what is still to be proved: a rebalancing of the UK economy....Mr Osborne may believe this Budget was unavoidable. So, too are the risks the government now runs."

UPDATE: Krugman queries El-Erian's piece, asking what the policy recommendations are and invoking Keynes about all being dead in the long run.

El-Erian's point was not so much about specific policies (though his view does have specific policy implications, very much in line with our views on capital spending and investment allowances.) What El-Erian is trying to say is that growth and deficit reduction can and should be complementary aims, and that the current simplistic debate pits them as contrasting visions.

Combining El-Erian's subtle point with Wolf's critique is extremely relevant to the UK: once the public sector has been pared back and reformed, we cannot simply assume that the private sector will fill the void. We need to lay the foundation for future growth - through investment in infrastructure and new technologies - now.

There were no easy choices on deficit reduction and the Budget was never going to tick all our boxes - that's why we were supportive of the decisions the Chancellor made on deficit reduction, such as the VAT rise.

And rebalancing our economy will be an easier job with the deficit firmly under control. But now that we've had a Budget that made investment in growth more difficult, it's up to the other parts of government to support rebalancing. Whether that's a Green Investment Bank, support for bank lending or a carbon tax we can still move towards a better balanced economy through some strategic policy choices.

But it is important to remember that rebalacing isn't simply matter of preventing the public sector from crowding out the private sector - the public sector filled a void over the past decade because there was minimal private sector growth.

Sure the private sector will eventually drive growth and jobs outside of London and the South East, but only in the long run. But in the long run...well, lets just say its what comes before that matters.  

While the Chancellor faced and made plenty of tough decisions in his Budget, we worry that he didn't do enough to support growth. 

The coalition had certainly prepared the ground for the raft of tough measures this Budget would bring forward in order to get the public finances back into the black.  But the Chancellor not only needed a deficit reduction plan that was achievable, he needed to present one which supported longer term economic growth and investment.  

You can read EEF's Budget recap, but the numbers speak for themselves on the first objective.  Last week the Office for Budget Responsibility forecast an even larger structural deficit in the public finances that previously expected.  But significant cuts to welfare budgets, a new bank levy, cuts to investment allowances and an increase in VAT were among the measures announced today to help plug the gap. 

On the spending side, the government are sticking the savage cuts to capital budgets announced by the previous government.  And while individual department spending totals won’t be revealed until the Autumn, Ministers will be spending the Summer identifying cuts of around 25% of their budgets. 

Not all the revenue raised will be used to pay down the deficit as there were some giveaways for lower income households and pensioners and the Chancellor stuck with his pre-election pledge to cut the headline rate of corporation tax, choosing to do it over time rather than in one hit. Together the measures will bring public sector net borrowing down to 2% of GDP by the end of the parliament.  It was an aggressive deficit reduction plan, but one that looks to be deliverable.   

We are less convinced that the measures will also deliver the longer-term, better balanced growth the economy needs.  The Chancellor stated that business investment and exports need to make a greater contribution to growth, but the cuts to investment allowances are at odds with this.  The headline rate of corporation tax provides only one signal that the UK is open for business.  For smaller companies investing in modern machinery after April 2012, there will be cashflow consequences from the change that will hurt their ability to reinvest in their own competitiveness.   

Writing in today's Telegraph, EEF's Chief Executive Terry Scouler has called on the Chancellor to use his first Budget to make tough choices on deficit reduction, but also kick-start private sector investment in jobs, technology and growth.

Rather than rush for a draconian and unacheivable 80:20 split between spending cuts and tax rises, EEF believe that deficit reduction and growth can and should be complementary aims.

That's why we've been pushing for a 60:40 split, with a VAT rise minimising the need for savage cuts to captial spending and to capital allowances.

Capital spending is government funding of new roads, schools, hospitals and energy infrastructure - invest in any of these and you boost productivity and growth. Savage cuts to capital spending may be a politically easier target, but would inevitably fall most heavily on a small number of departments with responsibility for infrastructure and national security. This would have an immediate impact on businesses, including manufacturers, that count on Government as a major customer.

Capital allowances are how the tax system recognises the cost of investing in new machines and equipment. Cutting the level of capital allowances would make investing in the UK almost prohibitively expensive and force manufacturers to compete on labour cost, a battle they simply cannot win.

So we've opted for a 60:40 split with taxes on consumer spending (a VAT rise to 20%) to fill the hole in the public finances.

Unfortunately, the Chancellor appears wedded to higher spending cuts, as Stephanie Flanders blogged last week:

"Remember, too, that Mr Osborne and his advisers have always been much taken with the overwhelming historical evidence suggesting that raising taxes to cut large deficits can damage economic growth - whereas spending cuts do not. In fact, this same evidence suggests that cuts can even help, by supporting market and business confidence.

You may not endorse these arguments. There are those who say the research doesn't apply in this era of banking crisis and deeply fragile global demand. The point is that Mr Osborne does. And so does his team."

Like Osborne's advisors, we've done our homework too. But don't listen to us, just read a recent paper by Harvard economics professor Alberto Alesina on the right balance for fiscal adjustment:

"...evidence drawn from several episodes of fiscal adjustments in the late eighties and nineties (following the recessions and the large increase in public spending of the seventies and early eighties)...[shows ] spending cuts are much more effective than tax increases in stabilizing the debt and avoiding economic downturns....In the case of successful fiscal adjustments about 70 per cent of it came from spending cuts and in the case of expansionary almost 60 per cent."

The chart below shows the results of Alesina's research. On balance, a 60:40 split is likely to deliver deficit reduction and growth.

Germany, according to Dani Rodrik, an economics professor at Harvard.

His rationale is that if much of Europe needs to get their respective fiscal houses in order, then Germany's half of the bargain is to reduce its own imbalances by increasing domestic expenditure:

"But trying to redress budget deficits in the midst of a collapse in domestic demand makes problems worse, not better.

So Europe needs a short-term growth strategy to supplement its financial-support package and its plans for fiscal consolidation. The greatest obstacle to implementing such a strategy is the EU’s largest economy and its putative leader: Germany.

If Germany wants the rest of Europe to swallow the bitter pill of fiscal retrenchment, it...must pledge to boost domestic expenditures, reduce its external surplus, and accept an increase in the ECB’s inflation target. The sooner Germany fulfills its side of the bargain, the better it will be for everyone."

Hmmmmm...a growth strategy to supplement fiscal consolidation? Might be a few lessons in that for the new Coalition government.

So the long slog of fiscal consolidation begins today.

And the new government has got off to a good start by delivering the £6.24bn in savings through cuts in the cost of government itself.

Because it's a big spending the deparment, the Department for Business was never going to be immune from the tough decisions.

Where EEF have concerns, however, is the uncertainty around investments in energy security: where commercial contracts are involved, the government need to fairly quickly provide some certainty for the companies concerned.

As our Chief Executive, Terry Scouler, said today,

“The task of repairing the public finances is a significant one and we don't have to look too far to see what happens when governments don't act quickly to address deficits.

“Given the tough decisions it faces the government is right to make an early start and proceed with a focus on reducing the cost of government and ensuring value for money.  The Efficiency and Reform Group should formalise the process of bringing transparency to what should be an ongoing process of improving public sector productivity.

“However, the decision to freeze funding for frontline investments from the previous government’s Strategic Investment Fund could have significant consequences on investments already underway. Where commercial interests are involved these must be resolved as quickly as possible.”

In March, EEF called for VAT to rise to 20% as part of tax reforms designed to rebalance the economy.

Today, the BBC released a poll showed that 24 of the 28 independent economists that help guide HM Treasury forecasts believed VAT is likely to rise as part of the package to cut the deficit. The IFS - which exposed the massive holes in the parties' pre-election budget plans - also expects VAT to go up.

And a closer look at the coalition agreement between the Conservatives and the Liberal Democrats suggests the new government has left the door open to a VAT rise.

But why a VAT rise?

To help rebalance our economy, we need to look at where the balance of the tax burden lies. Currently, the VAT rate in the UK is below the EU average, and typically, VAT rises are less damaging than other taxes - a slightly higher tax rate on spending will help shift our economy away from debt-fuelled consumption, while higher taxes on investment or profits simply punishes productive companies trying to grow and invest in the UK.

This shift in tax receipts will have reinforced the economic trend towards debt-fuelled consumption: households need to supplement higher taxes with borrowing to finance relatively lightly taxed consumption.

EEF's recommendation of a 20% VAT rate from 1 January 2012 would accomplish two goals.

Firstly, it would provide a boost to spending before the VAT rise, helping to reinforce the recovery through 2011.

It would also raise almost £12 bn a year.

That revenue could - and should - be used to rethink and realign priorities for public sector spending cuts. In particular, the government could offset some of the economically damaging cuts to capital budgets built into the last government's plans and ignored during the election.

The coalition government can either find ways to repair the public finances by cutting into economic muscle, or do it in ways that boost growth at the same time.

We think a VAT rise is not only needed to raise revenue, but is also economically rational to help rebalance the economy.

During last night's leaders' debate on the economy, Brown and Cameron clashed on manufacturing investment and capital allowances.

Capital allowances are incredibly vital to manufacturers' competitiveness. They are how the tax system reflects the cost of investing in new machines. So while the staff costs count as an expense that immediately reduces the amount of tax a company pays, investment costs are only counted as an expense over 30 years.

On average, manufacturers replace their machines every 7-8 years, which means the tax system artificially adds to the cost of investing in machinery in the UK.

The Conservative Party is likely to reduce the level of capital allowances from 20% to 12.5% - which means the tax system will take 53 years to reflect the cost of modern machines.

On it's own this proposal would be extremely damaging to manufacturers' competitiveness. Consequently, EEF have been raising this issue with the Conservative Party for the past year, and have been working constructively to help them firstly understand the investment needs of modern manufacturers and secondly on how to modernise the tax system to match those needs.

And they have listened, acknowledging that many modern machines are only really productive for a few years before technology moves on. They have also committed to working with EEF to find ways of improving the tax system - by adopting our recommendations on the Short Life Asset regime - to reflect the real costs and shorter lives of modern machines.

EEF's proposals essentially say that modern machines have become like computers (in fact, most machines are powered by sophisticated computer systems): advances in technology makes them obsolete long before the machine stops working. So we've recommended that the tax system treats machines like it does computers, allowing manufacturers to write of the full cost of their invesments within eight years.

And because rebalancing our economy must remain a priority, EEF will continue to work with which ever party/parties that form the next government to ensure that the UK has a tax system that enables manufacturing and a balanced economy to flourish.

For background, here's each of the three parties views on investment and capital allowances: