The last week has seen the publication of further evidence about the state of the UK economy. First came some promising data on sales, the headline figure suggesting an increase of 1.8% in sales during March. To some extent this was aided by freak conditions - as people brought forward their consumption of fuel at the end of the month owing to fears of a strike by petrol tanker drivers. But retail sales excluding automotive fuel rose by 1.5% over the course of the month, suggesting that relatively little of the growth was due to the unusual circumstances.

Next came the GDP figures for the first quarter of this year. These indicate that the economy slipped back into recession, with negative growth being observed for the second successive quarter. The overall growth rate in the first quarter was -0.2%, but this figure tends to conceal experience that differs quite markedly across industries. The construction sector, in particular, performed badly, with a growth rate of -3.0% in the first quarter. Services (which comprise a high proportion of total output in the economy) grew, but by only 0.1%. So the news on GDP has been very disappointing (albeit not surprising to readers of this blog).

More encouraging news has come in the form of a boost to consumer confidence, with the Nationwide reporting a marked jump in its indicator.

Yet, while the first quarter of this year has been one in which there are a few (very patchy) signs of life in the economy, the wider environment remains one in which there are many uncertainties and downside risks. Spain has become a renewed source of concern - the spread between Spanish and German interest rates increased in early April and shows no sign of coming down any time soon - this spread currently stands at more than 4 percentage points. At the beginning of March it was 3, and at the end of March it was 3.5. Meanwhile, the unemployment rate in Spain has risen to more than 24%, presenting a severe challenge to government policy and raising questions about the sustainability of the country's debt - which is already approaching 80% of GDP. Parallels with Greece are starting to be drawn - but Spain's economy is much bigger than that of Greece, and its difficulties are likely therefore to have larger ramifications elsewhere.

The overall position therefore remains one that is best described as gloomy.

It is a while since I have updated the forecasts produced by my neural network model for the UK. Over the last few weeks, a number of indicators have suggested that there are increasing grounds for confidence.

The forecasts produced by my model do not back this up - indeed they suggest that we may need to wait till the first half of 2013 before we see growth re-establishing itself. After a slight upward blip (round about now), the model predicts that the rate of growth of output will dip back down. Once growth resumes, it rises quite sharply to around 2% per year.



The forecast is, of course, based only on limited information - about industrial output. It is not sophisticated enough to include information about policy shocks - changes in the behaviour of the European Central Bank, the successful Greek debt renegotiation, and so on. It therefore looks, to me, to be a pessimistic forecast. But it may serve, if nothing else, to remind us that times are still uncertain, and there remain some serious downside risks.

In the run up to the budget, there is much interest in the top 50% rate of income tax. Some commentators argue for retaining this band, while others would like to scrap it – the latter group claiming that such a high rate of tax carries the risk that high income entrepreneurs will choose to leave the country rather than pay the tax.

Some evidence on this issue comes from the work of Mathias Trabandt and Harald Uhlig, who calculate ‘Laffer curves’ for a variety of countries. Laffer curves plot tax revenues against the tax rate. Tax revenues are low when the tax rate is low for obvious reasons; they are also low when the tax rate is high because there is then a strong disincentive effect. The Laffer curve therefore takes on an inverse U shape, low at the extremes and peaking at some non-extreme rate of tax. For the UK the Laffer curve peaks at an income tax rate somewhere between 50 and 60 per cent. This suggests that the current top rate is about right.

Results that are apparently strong emerge from simple models of the economy such as those that appear in the textbooks used by our students. In reality, the world is rarely as simple as these models might suggest. More complex models often generate more complex results - in other words, things are rarely so simple as they appear.

The current generation of macroeconomic models is based on building blocks of utility maximising individuals and profit maximising firms, all with the ability to make sensible forecasts of the future evolution of the economy and with the ability to adjust their behaviour in line with the current and expected future economic environment - which includes, amongst other things, government policy. There is a lot going on in these models - just as there is a lot going on in the real world. In many cases, the results obtained from these models are the same as those that emerge from the textbook models. In some cases - unusual cases, perhaps - they are not. Since we live in unusual times, it is not altogether ludicrous to consider some of these unusual cases.

A recent paper does just that. It asks the question: in a world where sovreign debt is approaching the limits of sustainability, does fiscal policy work in the same way as textbook models say it should? The answer is: it may do, it may not. Under certain (extreme) circumstances it may even be the case that austerity can stimulate the economy. Under more plausible scenarios, however, the results of the paper emphasise the 'benefit of delaying fiscal adjustment until after the economy has recovered from the worst of the initial recession'

Giancarlo Corsetti, Keith Kuester, Andre Meier and Gernot J. Mueller (2012). Sovreign risk, fiscal policy, and macroeconomic stability International Monetary Fund Working Paper

The operations of the European Central Bank since December have helped stabilise what had, until then, looked an increasingly precarious state in the financial sector. Spreads (measuring the difference between the interest rate that a country needs to pay on debt and that which Germany needs to pay) had, until December, risen in a number of European countries and were reaching disturbing levels. The spreads are still high for Greece, of course, and are still high in Portugal (though it recently dipped below 10 after hitting a high of over 15). In Spain, the spread has fallen from over 4.5 to around 3.5; in Italy from about 5.5 to 3.8; and in France from around 2 to around 1.1. Moreover, in the UK, the LIBOR - often seen as an indicator of how confident banks are in lending to one another - has started to fall, thus suggesting that some confidence is being restored in the system - though it still remains more than half a percentage point above the central bank's rate of interest.

Meanwhile, consumer confidence has started to rise.

It remains far too early to suggest that a corner has been turned. Future developments in Europe remain unclear. While monetary policy, with renewed quantitative easing, is likely to stimulate the UK's economy, fiscal policy is still restricting growth. And the labour market situation remains bleak; unemployment typically rises for some time after output starts to recover. But, while still very fragile, the overall economic outlook now looks more promising than has been the case for some time.

The UK's output fell by 0.2% in the last quarter of 2011. This is no surprise - some observers have been predicting a fourth quarter fall in output for over 18 months now. That being the case, the policy response has been disappointing. But perhaps that is, in part at least, because official forecasters - such as the Office for Budget Responsibility - got their forecasts wrong. The predictions made by these bodies do indeed impact on policy, and the question needs to be asked: why did these forecasters fail to predict a downturn that was both predictable and predicted?

The International Monetary Fund now predicts the Euro area to go into recession this year. It is predicting growth of 0.6% for the UK - this may or may not mean recession in the early part of the year. The Fund anticipates that 'adverse spillovers from the euro area' will stall growth in a wider range of countries, and that the 'downside risks have risen sharply'. Crucially, the Fund states that countries 'with very low interest rates or other factors that create adequate fiscal space, including some in the euro area, should reconsider the pace of near-term fiscal consolidation'. The meaning of 'fiscal space' is discussed in a blog post by Jonathan Portes. The implications for UK policy are clear.

It's taken the IMF a while to get it - but they have not been alone in the policy-making community. Hopefully their words will not fall on deaf ears.