From the TUC

Growth, the output gap & the public finances: Three choices for the Chancellor

02 Aug 2013, by Guest in Economics

Following a strong construction sector PMI this morning and a solid manufacturing PMI yesterday, the outlook for Q3 2013 growth is strengthening.

It is now perfectly plausible that growth in 2013 as a whole may be north of 2%. This compares to the most recent OBR forecast of just 0.6%

 I have written quite a lot recently on how this is the ‘wrong kind of recovery’ and pointed to the reasons to remain cautious. I am also concerned that any pickup in growth will not feed through to rising living standards (a subject of a blog post next week, time permitting).

But leaving aside the nature of the recovery and the impact of living standards, it is worth taking a moment to consider how any recovery will help the public finances. Indeed, I think recent economic data may well have a profound effect on the government’s fiscal targets (and the associated politics) that has been under analysed.

The government’s main fiscal target is to eliminate the structural deficit (or more accurately it is targeting a surplus on the cyclically-adjusted current budget). I have written at length over the past couple of years (for example here) on why I think this is a bad target for policy-makers, but putting my objections to one side – what will the impact of better growth be on the government’s targets?

One answer is ‘very little’. A cyclical pickup in growth will reduce the public sector deficit but should not have an impact on a structural measure of borrowing. If this is the case then borrowing will fall faster than expected in 2013 (which the government will make some political capital out of) but will have no perceived impact on the actual fiscal targets.

Somehow though, I doubt this will be the case.

I think faced with quicker than expected growth in 2013 the OBR will not just revise up its estimate for 2013 but also for 2014 and subsequent years. I also think it will revise up its estimate of the size of the output gap – which is really the crucial variable at play.

As Dan Corry noted last year:

A possible scenario is that, by 2015, we are starting to have a little growth but how quickly the deficit and debt will come down when and if UK and EU growth kicks in is very hard to say. Economists are hopeless at forecasting this sort of thing but historically tend to severely underestimate how quickly deficits rise in a recession and how fast they fall in an upturn.

There is of course precedent for this – last December the OBR, as explained at the time by Ian Mulheirn, changed its output gap estimates:

…even with the extra year of austerity the Chancellor announced, he would have likely missed his fiscal mandate had the OBR not junked its models and adopted a more, how shall we say, sympathetic one.

Now as it happens, that’s probably a sensible judgement. But the point here is that everything about the scale of necessary future cuts and tax rises hangs on this judgement about an obscure economic concept. And that’s a judgement that just changed radically and without warning. If the last OBR models were so wrong, who’s to say that the new production function one isn’t also wrong?

Let’s look at the effect of that on the public finances. If we take a forecaster whose estimate of the output gap is higher, such as NIESR’s implied output gap of -4.3% (NIESR give a range of -4% to -4.5%), the OBR’s analysis suggests that this would put the current budget into a structural surplus of around £40bn in the target year 2017-18. In other words, on this analysis the Chancellor is making cuts way in excess of what’s needed to balance the books.

And NIESR is hardly an outlier here. Oxford Economics estimates the output gap at -5.2% while Capital Economics recently argued that it could be -6%. Think of all the unnecessary austerity if these people are right. By junking its models, the OBR has invited a very lively debate.

I rather suspect the next set of forecasts in the Autumn will see a similar pattern. Faced with evidence that the economy is growing faster than it expected the OBR may just conclude that this is purely a cyclically tick up in growth but there is a strong chance that they will see this as evidence that the economy was less damaged by the crash than they thought. This could easily lead to them upping the size of their output gap forecast to be more in line with NIESR or the IMF and that would have a big impact on the structural deficit forecast.

The key table here is 5.4 of the latest Economic and Fiscal Outlook, which shows sensitivities to changing output gap forecasts.

On their current estimates the structural deficit will be in surplus of 0.8% of GDP by 2017/18 (i.e. the government is currently tightening fiscal policy by 0.8% of GDP more than is required to meet their fiscal rules).

If they upped their output gap estimate by 1% of GDP then that 0.8% surplus becomes a 1.5% surplus, if they up it by 2% it becomes a 2.3% surplus.

For reference the OBR currently estimate the Output gap at the end of 2012 to have been 2.7%, NIESR have it at 4.0%, the IMF at 4.2%, Oxford Economics at 5.6% and Capital Economics at 6.0%.

The OBR upping their own estimate to 4.2% (an increase of 1.5%) is hardly implausible. This would mean that the structural surplus in 2017/18 would be around 1.9% of GDP.

In other words if the OBR react to better than expected growth as I expect them to, then they will likely revise down the size of the structural deficit by around 1.5% of GDP and say that the government is over-tightening (benchmarked to what is required to meet it own rules) by around 2.0% of GDP.

This raises several big questions about the latest Spending Round which set out a big fiscal tightening for 2015/16 – possibly now much bigger than what is ‘required’ to meet the fiscal mandate. (Again it is worth emphasising here the OBR may choose to not revise its output gap forecasts – but I doubt this will be the case).

As I see it the Chancellor would then be faced with a choice of three courses of action in his budgets of 2014 and 2015.

The first would be to change nothing – to simply announce that the OBR now estimated he was well on track to beat his first fiscal rule and to say that the ‘prudent’ course of action was to run a larger than required structural surplus.

The second would be to announce that as things are now better than expected the scale of the spending cuts pencilled in for the years up to 2017/18 could be scaled back. His message would be along the lines of ‘we took the difficult decisions and now things are better than we feared, so departmental spending plans announced in the latest Spending Round can be moved upwards’.

Or there is a third course, which might appeal to a very political Chancellor – leave the spending cuts as they are and use some of the near 2% structural surplus to announce tax cuts for post-2015. Maybe another large increase in the personal allowance coupled with a penny off the basic rate. If the output gap is revised up and the spending plans left as they are, there will be the fiscal space to pledge this whilst still meeting the rules.

The size of the output gap (as estimated by the OBR) may seem an esoteric measure – but it could have profound political consequences.

2 Responses to Growth, the output gap & the public finances: Three choices for the Chancellor

  1. Has the Office for Budget Responsibility achieved genuine independence from government? | Whitehall Watch
    Aug 21st 2013, 5:05 pm

    […] upturn in growth – which is still weak in historical terms for this stage of a recovery – is likely to see the OBR make a similar decision this at this year’s Autumn Statement. The consequences of this could be even more politically […]

  2. Has the Office for Budget Responsibility achieved genuine independence from government? | Richard Berry
    Sep 23rd 2013, 9:00 pm

    […] upturn in growth – which is still weak in historical terms for this stage of a recovery – is likely to see the OBR make a similar decision this at this year’s Autumn Statement. The consequences of this could be even more politically […]