OBR analysis suggests greater scope to stimulate the economy now
As the economy continues to slow, the labour market’s performence worsens and the risks of a further recession increase, the Chancellor’s key argument against further stimulus is that a departure from his auserity plan would lead the costs of Government borrowing to rise. His assessment is that more spending now would mean that the interest rates we have to pay on our increasing debt burden would rocket, costing us more to borrow, making it harder to refinance the national debt, forcing interest rates to rise for ordinary businesses and households and concequently exacerbating the living standards squeeze.
This assessment has always been questionable. The costs of Government borrowing could be affected as much by the Eurozone crisis and the poor availability of investment opportunities elsewhere in the UK’s private sector (as a result of poor growth expecatations in the future) as by a bond market endorsement of the Chancellor’s austerity plan. And at any rate poor UK growth is looking increasingly likely, as Duncan has set out, to unsettle the ratings agencies. But presume for a second that a significant government stimulus did lead to a small increase in the rates we pay for our debt, what do the OBR say would happen?
The answer is provided on page 179 of the OBR’s most recent economic and fiscal outlook. It contains a scenario analysis of the economic impacts the UK would be likely to experience should there be significant variation in the interest rates that the Government has to pay on future borrowing and some existing debt.
The OBR consider how the economy would be affected if ‘the central forecast of gilt rates were to suffer a shock’, examining the implications of increases of 50, 100 and 150 basis points (0.5, 1 and 1.5 per cent increases in the rates paid on Government debt), which would make Government borrowing more expensive. This analysis is significant – it essentially considers what would happen if the worst case scenario the Chancellor is continually reminding us of (an increase in the cost of Government debt) were to come to pass.
For this reason, the results are politically interesting – the OBR conclude that:
These illustrative shocks to gilt rates have a relatively small impact on the chances of meeting the mandate and supplementary target. This is because an increase in rates only applies to new debt issuance, and the UK has a relatively long average debt maturity for conventional gilts of 13½ years, and because new issuance is projected to fall as borrowing declines. Therefore over a short horizon, such as our five-year forecasting period, the impact of a shock to the average nominal rate on gilts is relatively small.
In other words, an increase in the cost of new Government borrowing would have a relatively small impact on the overall cost of servicing our national debt, because most of it is already held over a long-term period at agreed interest rates that can’t be changed. And – although this is unstated – if greater borrowing was to stimulate the economy and allow it to grow more quickly, the overall costs of servicing Government debt could fall as we’d be be able to borrow less and pay off what we owe more quickly.
But this reading of the situation would depend on there being scope for the speed at which our economy is growing to increase in response to a stimulus package – and as widespread coverage at the time suggested, in the OBR’s assessment the amount of spare capacity in the economy has reduced, meaning that they believe the downturn has caused more lasting economic damage than they previously assessed. But again, closer reading of their forecast provides a more nuanced view.
The OBR assessment considers whether there is evidence of a significant increase in the structural rate of unemployment or of employment moving from the most productive sectors of the economy to poorer performing areas, concluding on both counts that these changes are unlikely to have taken place. This leaves one key potential driver of poor economic performance (and higher than expected lost capacity): limited access to credit. The OBR conclude that:
“Analysis suggests that an impaired financial sector can lead to low productivity growth and that downturns associated with significant disruption to the financial sector are often characterised by large and persistent output losses”
This is hardly a rosy picture but it does suggest that if access to credit could be improved, potential economic output could also increase.
And it is also vital not to overstate the OBR’s assessment of lost economic capacity – even if there is less scope for the economy to grow than we previously thought (by no means an uncontested fact – as the OBR say there are ‘enormous uncertainties’ around any such assessment) that does not mean that there is no potential to boost growth now. Even the OBR’s arguably conservative view is that we still have an output gap of 2.5 per cent – there is plenty of potential for growth rates to increase over the years ahead (and there could be even more if access to credit could be improved).
So the OBR forecast shows there is definite scope for increased demand to boost growth; and that even if – in the worst case scenario – increased government stimulus was to lead to a small increase in the interest rates we pay on our national debt (a contentious point in itself) the impact on the overall costs of government borrowing would not be significant. Plan B is possible – the OBR say so.