# Lost: £200bn of GDP

Today 2016 Q4 GDP figures showed growth of 0.6 %, and the economy continuing to survive the Brexit vote.

But we should not lose the wood for the trees. The economy is still bearing serious scars of the financial crisis and the austerity which followed.

Today’s figures also give us an annual figure for GDP growth in 2016 of 2%.

Taking a longer-term perspective, this is a poor outcome, continuing a run of poor outcomes since the financial crisis. Average growth since 2010 (the first year of recovery after the crisis) has been just 2% a year.

When the OBR first forecast outcomes under the coalition they expected growth to be well above this, at 2.4 % a year – and this was still pretty conservative.

The chart below shows annual growth figures from 1831, with averages across continuous expansions – defined here as runs of years broken by two consecutive negative annual growth figures. On this longer-term perspective, the 2% average since the financial crisis is the lowest episode on record (just) for a continuous expansion, and by far the lowest since the war. In the pre-crisis decades (1981-2007) growth averaged 2.8% a year. The closest previous episode of growth as low as that seen in the current episode was over the 1880s-1910s when growth averaged 2.1% pa. (Though pre-war figures should be approached with caution.)

**Real GDP growth and averages across expansions and contractions, 1831-2016**

This is not splitting hairs. Reduced growth is cumulative in effect and means the economy (and incomes) are greatly smaller than expected when the coalition took office.

We can estimate the impact of this by projecting GDP figures forwards in *cash* terms from 2009. The economy has increased in size from £1,520bn in 2009 to an estimated figure of £1,930bn in 2016 (see end for method). But according to the OBR’s original projection of growth of the economy in cash terms it should have grown to £2,150bn.

The shortfall is therefore £220bn – equivalent to nearly two NHS budgets.

#### GDP in cash terms: OBR expectation v outturn, £bn

And of course a much weaker economy means a much lower tax take. With government revenues accounting for around 36% of the economy, 36% of 220bn is £79bn. This corresponds very closely to the shortfall in public borrowing against original expectations of £84.8bn that the OBR have recently reported for 2015-16.

We are still operating under the delusion that cutting spending is somehow good for the economy. It isn’t. It damages the economy and the labour market, and so also damages taxes which means it doesn’t even repair the public finances. It doesn’t seem the greatest leap of logic to the idea that the opposite might be true. That government spending strengthens the economy, increases revenues and so supports the public finances.

(Notes on method: The ‘expectation’ is based on the OBR forecast nominal GDP growth rates in June 2010, but projected forward from the current 2009 cash figure, to put them on a consistent basis against current outturns, and hence updating for changes in ONS methodology for estimating GDP in the intervening period. The original OBR forecast extended only to 2015; I have projected a cash forecast for 2016 at the same growth rate they projected for 2015. The cash outturn for 2016 uses the newly published ONS volume figure and the OBR forecast for the GDP deflator.)

Martin KilgariffJan 28th 2017, 2:35 pm

I’m trying to understand the growth rates implied in your article.

Actual increase 2009 GDP 1,520 => 2016 GDP 1,930 in cash terms

Projected increase 2009 GDP 1,520 => 2016 GDP 2,150 in cash terms

The increase from 1,520 to 1,930 over 7 years requires a compounded growth of 3.6%

The increase from 1,520 to 2,150 over 7 years requires a compounded growth of 5.1%

The difference in average growth between the two figures is 1.5% (i.e. average growth of 3.5% rather and 2%) which seems rather high unless this is due to the rate on inflation between the actual and projected being different (cash figures not accounting for inflation), which would of course makes the 220bn figure nonsensical.

If the difference between the two growth rates isn’t due to inflation, then what level of investment in the economy would be required to achieve and extra sustained 1.5% growth, and how much of the extra GDP would be required to service that new debt (unless we did it via QE of course – say an extra 140 – 200 billion of QE between 2009-2016)

geoffJan 31st 2017, 4:57 pm

Hi Martin.

The figures are in cash terms, as you infer.

So you have a fair challenge. But I think it is not so straightforward.

If we look at real terms figures only, we abstract entirely from price developments as if they are wholly neutral.

When really the lower than expected price inflation is likely to be a consequence of policy and the associated constrained aggregate demand growth.

Key is that the public finance outcomes are cash outcomes and depend on the outcomes for nominal GDP. Here my cash projection of the shortfall in tax revenues is basically consistent with the OBR’s own assessment of outcomes against their forecast.

And here the huge shortfall against original plans is far from neutral. With public finance measures and associated targets expressed in cash terms, a shortfall against nominal plans strictly means a further, corresponding reduction in cash amounts of public spending. (Though this depends on the targets adopted as well as the logic of the public finance arithmetic.)

It is also unlikely that the costs for the public sector have been reduced to the same extent as the shortfall in the GDP deflator, not least because the reductions in the wage-bill must have turned out broadly as expected. So the more relevant figure to the impact of the shortfall in GDP on public services is more likely to be closer to the nominal one.

The point I really seek to make is that the cumulative effect of this prolonged shortfall in economic growth is far from trivial. But I accept that quantifying this shortfall is far from straightforward.

I don’t offhand have the answers to your arithmetic. But on the basis of Keynes-type thinking, if spending had not been cut then the economy would have been stronger, tax revenues higher and public borrowing lower. So long as conventional borrowing could have been conducted at the same low rates of interest that have prevailed over the past years, then, with lower borrowing and so lower debt, interest payments would be lower. If an expansionary package put upward pressure on interest rates then as you suggest QE would be one way around this – though there are others e.g. borrowing directly from banks.

I hope this makes sense.

Geoff

Martin KilgariffFeb 1st 2017, 6:25 pm

Thanks for your reply Geoff. You key point is of course valid, we now have a smaller economy than we otherwise would which is directly due to the spending cuts of the last 6/7 years.

Where you write:

“if spending had not been cut then the economy would have been stronger, tax revenues higher and public borrowing lower.”

I presume you mean the ratio of public borrowing to GDP would have been lower, since the Labour plan in 2010 was to half the deficit by 2015 – which is what the coalition government actually did (though it wasn’t their plan). Under Labour we would have expected to have a similar level of absolute debt, but a bigger economy and hence as you point out, higher tax revenues.

By cutting spending and investment, far from saving the economy the Tories damaged it. In 2015 we ended up with debt level was no better than that expected under the Labours plan, but we’re left with a smaller economy from which to generate revenues – i.e. as a Nation we’re poorer.

Martin KilgariffFeb 3rd 2017, 1:10 pm

Having reviewed the OBR Forecast evaluation report to which you so kindly provided a link ( http://budgetresponsibility.org.uk/docs/dlm_uploads/Forecast-evaluation-report-October-2016-1.pdf ), I have to question the detail, if not the thrust of your argument.

I see now that the main reason for the difference in growth in cash terms (which I initially asked about) between the forecast and outrun is due to the difference between the:

Forecast GDP deflator at market prices (15.4 – Table 2.1) and the

Actual GDP deflator at market prices (8.8 – Table 2.1)

So the bulk of the difference between the forecast GDP growth and the Actual GDP growth was down to the forecast error in forecasting the correct level of inflation as it effected GDP.

From the same table we see that the difference in GDP growth between the forecast and the outrun was 17.2 and 12.9 respectively (until 2015) which gives a difference of 65 billion, or around 75 billion if you project it to 2016 using the 2015 GDP growth forecast (2.7) and actual GDP growth 2.2% (adjusted from 2.0% in recent updated figures).

This 75bn shortfall is of course between the 2010 budget forecast and the actual outrun (adjusted for inflation). We now know that once the coalition government started to implement the proposed cuts to spending, GDP fell and looked to be moving into double dip recession land. The coalition government actually eased up on austerity in 2012/2013 which is what allowed the actual GDP growth which we experienced between 2013 and 2016 – which I now see described as a mini boom! Goodness knows what would have happened if the coalition government had fully implemented it’s proposed cuts from the 2010 budget – maybe Greece gives us some clue!

I think one forecasting lesson to be learnt from this failure in the forecasting process is that once you announce spending cuts, including cuts to government investment, the private sector doesn’t grow in confidence and start borrowing and investing more, and it was only after the government signalled it was easing up on the cuts that confidence slowly returned and investment began to pick up.

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