Hamish McRae: Cameron is wise to warn: it'll be tough going in a world burdened with debt

Economic View

David Cameron's sunny optimism deserted him somewhat in Davos when he warned about the scale of the task ahead. He was wise to do so for two reasons.

Most obviously there has been a wave of concern here in the UK about the state of the economy. Less obviously, but in the long run more significant, is rising concern worldwide about the shape of the recovery and the huge debt burden carried by all developed economies.

Anyone reading the papers last week will be aware of the debate about the true state of the UK economy. Did it really shrink 0.5 per cent in the final quarter as the first estimates of GDP from the Office for National Statistics (ONS) suggested? Or is the view of some independent forecasters and, though it can't say so in public, the Bank of England, that the decline, if it took place at all, was much smaller? There was no hint in the reports from the Bank's agents around the country of the economy actually shrinking, and just ahead of these figures another member of the Bank's monetary committee voted for a rise in rates.

My own guess is that as further data comes in, these figures will be revised upwards and that the economy was probably pretty flat overall, with growth in October and November offset by a weather-related decline in December. But there's not much point crawling over the figures until we know more.

What is beyond dispute, however, is that this year will be difficult. Consumers have been hit by the rise in VAT and though the experience of Germany that a rise in VAT had only a temporary effect, it comes at a bad time. Living standards were already being squeezed by pay freezes or very low increases and higher-than-expected inflation – or perhaps I should say higher than the Bank expected, though not higher than some thought probable.

You can see the squeeze in the main graph. Mervyn King noted last week that real wages were falling and that is was the sharpest reduction since the 1920s. Maintaining consumption this year will depend on whether people are prepared to run down their savings. Some economists, for example those at Lloyds Bank, think they will and that consumption will rise. But a lot obviously depends on inflation and here things are to some extent outside the hands of British policymakers.

We have had a 20 per cent-plus devaluation of the pound, and rising import prices have inevitably meant higher prices for everyone. Global demand for energy and commodities, mainly from China, has pushed up these prices, which in turn has pushed up food prices. As you can see from the right-hand graph, so-called core inflation has not been too bad; it is food and energy that is the problem. But for most people food and energy are very much a core part of their household budgets. Everybody has to eat and most people have to heat their homes and fuel their cars.

This puts huge pressure on the Government. It cannot reverse the broad thrust of spending cuts or the tax increases. We are still borrowing 10 per cent of GDP. But within the big totals there ought to be some flexibility, with fuel prices the obvious candidate. The Government cannot do anything about the oil price or the sterling/dollar rate. But it can avoid the charge of profiteering from higher fuel prices by handing back some of the additional tax it is receiving. Expect that to happen – it is something that the Lib Dem side of the coalition really needs, for many of its constituencies are rural ones.

A year or so ahead there may be further scope for easing up. The Government has won the trust of the financial markets. That has bought it some space to change the detail of the plan. This is important because there is already a shift of mood in the markets, a shift towards requiring greater fiscal discipline, and this is likely to grow.

And so to the second concern. A few things have happened recently that hint at what might occur. One was the downgrading of Japanese debt by Standard & Poor's. Of itself that is not important. More than 90 per cent of Japanese government debt is held by Japanese residents, mostly financial institutions. They are not going to take fright at what some American rating agency thinks. But it poses the question: can Japan ever repay its debts? That then leads to questions about the one country that has not yet faced up to its fiscal disaster, the US.

Up to now US sovereign debt has been a "safe haven" for worried holders of cash. It has also been where China is prepared to hold its liquid assets. China has passed Japan as America's largest lender, to become in President Obama's phrase, its bank manager. What China does will be crucial. In the past few weeks, notwithstanding all the fears about the weaker eurozone members, the euro has strengthened because China seems to be supporting it. Meanwhile the plight of the weak eurozone states remains as worrying as ever, with Portugal almost certain to need a bailout and Spain on the brink, though I see that Goldman Sachs now thinks that Spain can pull through without one.

The main point to understand is that the debt crisis is not over. Quite the reverse: it has broadened. Countries whose governance seemed secure are suddenly shaky: look at Tunisia. And there is contagion: look at Egypt. Markets have made huge errors in under-pricing sovereign risk and a seemingly little thing, such as the downgrading of Japanese debt, makes people wonder what happens next. There was a warning on Friday from another rating agency about the AAA rating of the US. Even some of the new darlings of the investment community are suspect. The Brazilian finance minister described a critical IMF report on the country as "totally wrong" and "stupid". Not a good line to take.

So if the UK has managed, by taking control of its fiscal policy, to win itself some credibility, that is all to the good. It will need it. Unfortunately it is the rest of us who feel the effect as the tax increases and the spending cuts strike.

Volkwagen's 313mpg hybrid marks a step change in energy use

There was a nice irony in the fact that Volkswagen should choose to launch its new super-efficient car, the one that does 313 miles to the gallon, in oil-rich Qatar. But it makes sense to choose a glitzy Middle East venue, for it is a statement that VW is talking to the world. It is interesting, too, to see what can be done with conventional technology, for it uses the now-familiar hybrid battery/diesel combination coupled with lightweight materials and excellent aerodynamics. It is scheduled for production in two years' time.

Other things are happening too: just in the past few days, GM said it would double next year's production of its all-electric Volt car, and the Nissan Leaf is arriving at US dealers right now. But it's not all about cars. I saw a story last week that solar power is now cheaper than nuclear power; for the costs of the former have been steadily falling while the costs of the latter climb. And all over the world, small incremental advances are made in energy efficiency. We have to, if rising energy prices are not to snuff out growth.

The really interesting question is whether higher prices are leading to a step change in energy use: a combination of investment in energy-saving technology and changes in habits made possible by that technology. If you go back to cars, the UK fleet becomes more efficient every year. Less noted have been changes in commuter patterns, as people do a higher proportion of their work at home. Before the recession, about 10 per cent of the workforce was tele-working, and it was rising every year. I have been unable to find data but suspect the trend may even have speeded up.

The central point surely is that the market is working: higher prices force conservation. Government policy can reinforce that shift but policy is much more effective when it goes with the grain of the market. And we will see the changes on our streets every month that goes by.