Combined industrial output in the Group of Seven (G7) major countries and seven large emerging economies (the "E7" – Brazil, China, India, Korea, Mexico, Russia and Taiwan) rose by 8% between February and September but fell back marginally in October – see first chart. Within the G7 there were large declines in Germany and France, partly reflecting lower car production after the end of "cash for clunkers" schemes, while among the E7 output was down in India, Russia, Korea and Taiwan, in all cases following strong gains.

The October setback was not signalled by business surveys and probably represents a pause for breath in an ongoing solid recovery. As the chart shows, a composite of the OECD's leading indices for the G7 and E7 countries continued to rise strongly in October. G7 narrow money trends also suggest favourable near-term growth prospects – see previous post. Today's Chinese output numbers for November were upbeat.

The recent recession and current revival in world industrial output bear a close resemblance to the deep 1974-75 contraction and subsequent recovery – see second chart and another prior post for more discussion. This comparison suggests a continuing upswing through 2010 but with growth momentum slowing as the year progresses.

US non-financial corporations' financial surplus – the difference between their retained earnings and capital spending – rose to 1.3% of GDP in the third quarter, according to flow of funds accounts data released yesterday. Excluding the third and fourth quarters of 2005, which were distorted by a one-off repatriation of foreign profits to take advantage of temporary tax incentives, the surplus was the highest since the fourth quarter of 1960 – see first chart.

The further improvement last quarter reflected a combination of stronger profits and cuts in dividends and fixed investment, partly offset by slower destocking.

On top of this surplus, corporations raised cash from equity transactions for a second quarter, i.e. issuance exceeded share buy-backs and retirements due to cash take-overs – second chart. Bond issuance fell back from its record first-half pace but was again substantial.

Strong internal cash generation combined with capital market issuance allowed firms to increase their holdings of liquid assets and pay down short-term debt. The liquidity ratio – liquid assets divided by short-term liabilities – continued to surge, therefore, reaching its highest level since the fourth quarter of 1959 – third chart. This mirrors improvements in the Euroland and UK and supports hopes of a recovery in hiring and investment.

Some commentators have interpreted the contraction of bank lending to companies as supply-driven and likely to curtail business expansion. The flow of funds accounts suggest that bank debt repayment has been mostly voluntary, reflecting the financial surplus and fund-raising in share and bond markets. Bank loans and commercial paper outstanding fell more slowly last quarter and may stabilise and recover as destocking ends – second chart.

The yield spread of non-investment-grade corporate bonds over Treasuries is inversely related, with a lag, to the sum of the financial surplus and equity sales, expressed as a percentage of GDP. This remained historically high last quarter, suggesting scope for further spread compression – final chart.

The Pre-Budget Report announced surprisingly large medium-term fiscal tightening measures but these were necessary to prevent a further upward revision to borrowing projections. The Report takes a big political risk by raising taxes on the middle classes as well as high earners, and an economic risk by delaying a cut in borrowing until 2011-12.

Key points:

The main surprise was the 0.5 percentage point rise in National Insurance Contribution (NIC) rates from April 2011, which will hit middle earners and raise £3.0 billion by 2012-13. A further attack on pensions tax relief brings in £500 million and a freezing of the higher-rate income tax threshold £400 million in the same year. The one-off bankers’ bonus tax was overtly political rather than fiscally meaningful – it is doubtful that the projected £550 million in 2009-10 will be achieved.

The Chancellor also cut longer-term spending forecasts, with "total managed expenditure" now projected at £752 billion in 2013-14 versus £758 billion in the Budget. Savings include £3.4 billion from a one percentage point cap on pay settlements in 2011-12 and 2012-13 and £1 billion from pension reforms. The Report’s overview refers to growth in real current spending of 0.8% a year between 2011-12 and 2014-15 but this greatly underestimates the coming squeeze because it ignores plans to slash investment and a rising burden of debt interest. Detailed figures within the Report imply that total spending excluding interest will contract by a real 0.6% a year between 2010-11 and 2014-15.

Despite tax increases and reduced spending, the projection for public sector net borrowing in 2013-14 is only £1 billion lower than in the Budget, at £96 billion. With little change to underlying economic assumptions, the implication is that the Budget revenue forecasts either were too optimistic or embodied an assumption of further significant tightening.

The debt interest projections continue to be based on hopeful-looking interest rate assumptions. Net interest is forecast to rise from 1.9% of GDP in 2009-10 to 3.3% by 2014-15 but the latter figure implies an average interest rate on outstanding net debt of 4.3%, well below projected money GDP growth of 6.1% in the same year.

The Chancellor revised his projection of the fall in GDP in 2009 to 4.75% from 3.5% but maintained growth forecasts of 1.25% and 3.5% for 2010 and 2011 respectively. Despite this year’s shortfall, the money GDP projection for 2010-11 is higher than in the Budget because of faster-than-expected inflation.

By delaying deficit-cutting until 2011-12, the Chancellor is relying on the kindness of the gilt market as it takes over responsibility from the Bank of England for funding the current gargantuan shortfall. A big rise in gilt yields could yet derail his economic and fiscal strategy.

The US M2 money measure contracted over the summer, leading some commentators to expect the economic recovery to falter in late 2009, with attendant deflationary risks. Prior posts argued against this view on the grounds that the M2 decline was modest and followed strong growth, while the velocity of circulation was likely to be rising in response to miniscule interest rates and reviving risk appetite.

M2 now seems to be picking up again. It rose by 0.3% in both September and October and weekly numbers suggest a similar rise in November. Implied three-month annualised growth of about 4% is likely to be sufficient to support further solid economic expansion and could even be too strong if velocity rises by 4-5% over the next year, as an earlier post argued was possible.

Another approach to measuring monetary backing for economic growth is to add together broad money changes and mutual fund flows – the idea here is that fund flows are likely to be inversely related to the demand to hold money so provide an indirect measure of changes in velocity. As the chart shows, this indicator – the green line – has continued to expand robustly recently. (A post last week presented a similar chart for the UK.)

The concern for markets in early 2010 is not that monetary growth will be insufficient to support a sustained economic recovery but that stronger expansion and higher inflation will fully absorb the available supply, implying an absence of "excess" liquidity to push asset prices higher – in marked contrast to this year.