The Structural Deficit is a bad target for policymakers
The big economic news this morning is the FT reporting (behind the paywall) that the OBR is likely to say that the Chancellor will miss his fiscal targets:
Increased public borrowing this financial year alongside little widening in the estimated amount of spare capacity will prevent the OBR forecasting a period of rapid catch-up growth to cut the deficit without further spending cuts or tax increases.
The scale of the structural problem is close to £15bn a year, indicating that austerity will have to last until 2017-18, three years longer than Mr Osborne suggested in his emergency Budget in 2010.
The FT has come up with these numbers by replicating how the OBR assesses the amount of spare capacity in the economy, repeating an exercise they conducted last Summer – which proved to be quite accurate. (And the OBR should be congratulated on being so open about its methods that such exercises can be conducted).
This story is generally being reported in terms of what it means for fiscal policy at the Autumn Statement. As PoliticsHome put it:
The Government will be told this autumn that it will need to extend the deficit reduction programme until 2018 due to higher than expected borrowing.
For me though, what this story really throws light upon is quite how odd our fiscal framework actually is. The Chancellor is targeting eliminating the structural deficit, but the size of the structural deficit depends upon one’s estimate of the output gap.
Last week, Capital Economics gained a lot of attention by arguing that the output gap is actually a lot larger than many people estimate. And this matters because we now have a fiscal framework whereby spending and taxation decisions are made, 5 years out, based on a estimate of the output gap.
Looking at the most recent estimates, as published by the Treasury, we can see that there is quite a lot of variation amongst forecasters.
…estimating structural deficits is notoriously difficult. This is because they depend upon three things, all of which are uncertain: the size of the output gap; the responsiveness of public spending to economic growth; and the response of tax revenues thereto. Small and reasonable differences in estimates of these factors can produce large differences in your estimate of the structural deficit.
It should be stressed that the OBR’s negative reassessment of the fiscal position reflects a downgrade to its estimates of current and future potential output rather than worse-than-expected recent borrowing outturns. This downgrade may or may not be warranted but it is troubling that the fiscal framework pivots on a concept subject to huge empirical uncertainty.
We are basing fiscal policy, much of the political debate on the economy and the Government’s supposed ‘credibility with the markets’ on something ‘subject to huge empirical uncertainty’.
Let’s try a thought experiment – imagine that the OBR, in time for the Autumn Statement, decides to change its forecasting methodology for the output gap and becomes convinced that Capital Economics are correct and the gap is much larger. It will then say the structural deficit is much lower than it currently estimates and the additional fiscal tightening penciled for 2015-2017 will not be required. Once again the Government will be on ‘on course’ to eliminate the structural deficit ‘this parliament’. No doubt that would be celebrated by the Government’s supporters as a vindication of their fiscal policy. A vindication simply because of a change in an estimate.
Or, on the other hand, imagine that the OBR gets more pessimistic. It revises its view of the output gap in the other direction. It now says the structural deficit is even bigger then it thought and more cuts will be required (this is what happened last year and may happen again this year).
Of course, which ever way the OBR swings it may change its mind in the future. As the IPPR’s Tony Dolphin has observed it is perfectly possible that in, say, 2016 the OBR will decide it was wrong all along, that the structural deficit has already been eliminated and that austerity went beyond what was necessary.
Does anyone seriously think this is a sensible basis for a fiscal mandate?