Several years ago there emerged into public discourse one of those phrases that becomes ubiquitous solely on the basis of its banality – ‘joined up thinking’ – and which could be deployed to allow people with more of an agenda than a plan to escape the scrutiny of the serious observer.
This article’s purpose is not to explore the decision making process behind the alternative budget presentation, except to ponder that those Lib Dems who wanted the coalition to have the impact of us being taken seriously as a potential party of government can hardly be satisfied at how we have been ridiculed in the wake of that particular initiative.
And what is particularly frustrating is that set pieces of the nature performed by Mr. Alexander are unnecessary; Osborne’s budget was a particularly vacuous effort, which left plenty of serious points for an aspiring party of government to highlight and tackle.
Most grievous of those, certainly in terms of the narrative corner it paints future Chancellors within, is the claim by Osborne that Britain can be recording a budget surplus by 2019.
Instead of limbering up for the presentation the next day, Alexander and his staff should have been examining the basic arithmetic implied by Osborne’s statement, and ridiculing it, instead of bringing the scorn upon himself and his party.
The figures quoted by Osborne show that to achieve the surplus he wants, nominal GDP growth (that is growth that includes inflation) will have to hit 5 per cent per annum quite soon.
The average of UK real (not adjusted for inflation) GDP growth between 2010 and 2014 was 1.8 per cent. The Chancellor disclosed in his budget that growth in the UK in 2014 was 2.6 per cent, and it wouldn’t, in these globally uncertain times, take much for that GDP number to slip closer to the average number it has been under the coalition.
The second problem is, even if the 2.6 per cent number of 2014 were to become typical in the coming years, for the 5 per cent nominal target Osborne requires to hit his surplus projections, there must be inflation of around 2 per cent, the Bank of England’s long-term target, and considerably above the current number.
In a world where disinflationary and deflationary drivers on the demand side of the inflation equation are evident, from the stagnation of the Eurozone to the sclerotic progress of China’s reform agenda, and technology driving supply side disinflationary prices through the fall in the oil price, inflation of 2 per cent, whatever the growth rate, could be pie in the sky.
And the fiscal implications of Osborne’s projections being proved fantastical are enormous. If the next four years of growth in the UK is at the 1.8 per cent level that was the average from 2010-2014, and inflation were to be at 1 per cent, so below the Bank of England’s target but above the current level, the hole in the accounts would be of the order of £120 billion, as this graph demonstrates.
If that happens, people really will be calling for a serious party of government to take the reins, hopefully we can offer that, rather than more of the same sort of gimmicks witnessed last week.
* David Thorpe was the Liberal Democrat Prospective Parliamentary Candidate for East Ham in the 2015 General Election
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16 Comments
Higher taxes ya doofus
Perhaps not to the extent you might imagine George.
The clue is in David’s line “even if the 2.6 per cent number of 2014 were to become typical in the coming years, for the 5 per cent nominal target Osborne requires to hit his surplus projections, ”
Readers here might understand the sense of irony I would feel if, post the election, a Tory chancellor instructs the Bank of England to achieve a new target of “5% NGDP growth” Perhaps Osborne doesn’t need to require the Treasury to send the formal letter – Carney may take this budget as a nod and a hint in that direction.
As David suggests, Osborne’s figures, such as they are, only add up if the Bank of England delivers 5% NGDP growth. Oh, and that means that our figures only add up, such as they are, if the Bank of England delivers 5% NGDP growth.
Pity it is all years too late.
George-Higher taxes on what? Osborne does not plan them……and higher taxes do not contribute to higher nominal GDP growth in the short term-the precise opposite in fact
Geogre-the taxes a tory chancellor might raise would be those that would reduce the velocity of money in the system and so serve to, at leats, reduce inflation, and almost certainly reduce growth-please don;t use personal insults if you haven;t really put any thoughts into your comments
David – I agree with you that the projection of a budget surplus by 2018-19 is ambitious. But the reason for that is not pie-in-the-sky projections of nominal or real GDP growth, but the fact that none of the main parties have yet revealed how they intend to make the required fiscal adjustment. They’ve all been highlighting the areas they plan to ‘ringfence’ or increase spending, while offering little detail on the savings they would make.
You say Osborne’s plans rely on nominal GDP growth of 5% per annum, and you refer to these as “Osborne’s projections”. But in fact the economic forecasts are provided by the OBR, not the Treasury. In making their forecasts the OBR take account of announced fiscal policy.
In any case the OBR are not predicting 5% per annum nominal GDP growth. The forecast for nominal GDP growth is closer to 4% across the forecast horizon (4% in 2013-14, then 4.5%, 3.8%, 3.5%, 4%, 4.4% and hitting 5% only in 2019-20). This represents real GDP growth in the 2.3%-2.4% range and inflation of the order of 1.5%-2.5%. Note that the measure of inflation in the nominal GDP forecast is the GDP deflator, not CPI inflation. Even this financial year the GDP deflator is forecast to come out at 1.7%, so these projections do not seem implausible.
Of course, it is possible that nominal GDP growth will fall short of the roughly 4% per annum envisaged by the OBR. The effect on demand would depend crucially on whether the shortfall was due to higher inflation or lower real growth. The lesson of 2011-12 (when there was a spike in inflation due to sharply rising commodity prices) and 2014-15 (when the reverse happened) is that the composition of nominal GDP is at least as important as its total level; a fall in imported inflation by itself reduces nominal GDP, but the improvement in household disposable income can feed through into higher domestic demand and consumer spending. Since consumer spending is by far the largest of the expenditure components of GDP, this has a crucial effect on the level of real GDP, real GDP growth and living standards.
Of course, if the deficit is as per the forecast in cash terms, but nominal GDP is lower, the deficit as a proportion of GDP will be higher. But I’m not sure on what basis you are expecting Danny Alexander, or the Lib Dems, to challenge the OBR forecast for nominal GDP growth (which in any case is not out of line with independent forecasts)? And if your contention is that nominal GDP will fall short of the OBR’s forecasts, what is the policy response you are recommending?
Alex,
Great post thank you-I am aware that the forecasts are from the OBR-but Osbornrne’ forecasts that the countryw ill be in surplus by 2019-that is his forecast and that is what I think is silly.
Osborne has included his figure for fiscal consoldation-he annunced it in the budget-so we do know that.
As for alternatives, we should simply be expecting rewlatively low growth for a very long-time, pursuing policies that increase the multiplier on the demand side, and managing inflation on the other.
Thanks
David
Alex, but if the target were a level target of 5%, (ie bygones will not be bygones), those making investment decisions would have some certainty that a) GDP would not fall below 5% for more than a single period (say a year), which I reckon will be their main concern today; and b) would not go above 5% for more that a single period which would make them think very carefully of adding to inflationary pressures through investment spending at a time when the target was being or was about to be breached.
If business people do not trust politicians and if they assume that actual policy after the election will be almost anything but what is being said now, then, I imagine they are very circumspect at the moment.
Hi David – Sure, the Budget set out the overall fiscal ‘envelope’. In itself I do not find the path of fiscal consolidation – the move from a deficit of 5% of GDP to a bare surplus over a four-year period, and then stabilising the surplus at 0.2%-0.3% of GDP – to be implausible, although it would have been possible to smooth out the trajectory over the final 2 years (2018-19 and 2019-20).
There have been periods in previous fiscal consolidations where the public finances have improved at a faster rate than this, although it has generally required brisk GDP growth (eg over 1968-70 there was an improvement of 5.7% of GDP, in 1975-77 an improvement of 2.6 percentage points, in the single financial year of 1981-82 an improvement of 2.4ppt despite near-flat output, between 1993 and 2000 an improvement of 8.9ppt including a drop of 2.7ppt in the 1997-98 financial year alone). So there are precedents for such turnarounds, though all these examples have involved exercising considerable political will and resolve.
As I said, I think the credibility gap comes not with the headline numbers but with how these can be reconciled with the other spending and tax commitments Osborne has made. If you ring-fence the largest areas of public service spending and more than half of social security spending (on pensions and pensioner benefits), and also plan to cut taxes (the big-ticket commitment here is raising the personal allowance to £12,500) by more than the amount you intend to raise in extra revenue, it is hard to see how these targets can be met without a higher growth path or a sustained rebound in tax receipts, neither of which Osborne would be wise to count on.
That said, historically the public finances have quite often shifted in both directions faster than expected: deficits have ballooned more quickly and to higher peaks, but they have also come down faster than planned. For example, Gordon Brown did not forecast a surplus of 1.5% of GDP in 1999-2000 when he tightened fiscal policy a couple of years earlier, he expected approximate budget balance. In the late 1960s a similar sharp turnaround took Roy Jenkins by surprise.
If a similar thing happens then Osborne could hit his headline targets without having to implement the full measure of austerity, relying more on cyclical factors for example. In fact, already in these plans the OBR’s forecasts of much lower debt interest costs have enabled Osborne to scale back the implied cuts to public service spending – the magnitude of this one change since the Autumn Statement dwarfs the arguments politicians are having about a billion here or a billion there on the NHS or defence or whatever.
Like many cliches, “joined-up thinking” has a meaning and a purpose if used properly. It means not thinking in strict categories without considering the side effects – for example, that an economic development measure might bring in some jobs but deter tourism or damage health – and to be open to unconventional ideas that might be more familiar in some other context. As with similar phrases, the trick is to ask what precisely is being joined up, for what.
Alex,
Yes I agree that all parties are committing to spending and to cuts-and no elabroating on hat.
Bill – I definitely think ‘political risk’ (of various forms, including the credibility or otherwise of the parties’ fiscal plans, the prospect of an unstable minority government, uncertainty over our relationship with the EU, and the ongoing Greek crisis) can affect investment decisions. These could yet derail the recovery, or at least choke off the momentum it has been gaining in the past year to 18 months.
However, as things stand, if you look at the figures in the Red Book it’s striking that business investment is now growing pretty stoutly: 5.3% in 2013, 6.8% in 2014, and forecasts of between 5% and 7.5% through to 2018. So the recovery appears to be broadening out, with household consumption growing broadly in line with overall GDP, business investment rising sharply as a share of GDP, and a moderation of house price growth.
The current account is terrible at the moment but the main driver of this appears to be UK residents receiving lower income on their overseas investments: there has been a sharp deterioration in the ‘primary income’ balance whereas the overall trade deficit (goods and services) has been more stable. The OBR sees net trade picking up and making a positive contribution to GDP growth but of course this will depend crucially on the state of world trade and the eurozone in particular.
As well as private investment rising sharply, on current plans the government will be providing a modest stimulus to investment throughout the period, with general government fixed investment growing every year. Henceforth fiscal consolidation is set to be delivered through lower government consumption and transfer payments, not investment cuts.
Another interesting point is that the OBR has not significantly revised its real GDP forecast for the final year of the forecast despite the fiscal loosening for that year announced in the Budget (of about 0.8% of GDP relative to the Autumn Statement). It now expects inflation to be a bit higher in that year, but real GDP growth to be unaffected. Likewise the looser Lib Dem plans for the ‘out years’ are not expected to change real GDP materially. The Treasury document which outlined these (entitled ‘An alternative fiscal path beyond 2016-17’) explains: “The impact on real GDP of fiscal policy changes in later years is likely to be fully offset by monetary policy… This assumption is consistent with the OBR’s treatment of changes made to the 2019-20 Total Managed Expenditure assumption in Budget 2015.”
So the OBR’s position is that higher public spending, or lower taxes, beyond 2017 are assumed to affect the composition of GDP rather than its total level. Therefore the question of what is the appropriate pace and scale of deficit reduction is essentially a judgement call on the trade-off between a higher borrowing/higher debt path and higher spending/lower taxes, and the economic and political advantages and disadvantages of these alternative paths. The OBR are treating the aggregate macro effect on real GDP as basically zero.
I meant to add, the reason why the OBR are assuming there would be an offsetting tightening of monetary policy in response to any fiscal loosening beyond 2017-18 is that they think that by then the ‘output gap’ will have fully closed, the economy will be at its trend level, and actual output will be growing in line with potential output. So they would not be looking for any overall demand stimulus at that point since it would tend to feed through into higher inflation rather than higher real GDP or lower unemployment. Hence an increase in public spending, without offsetting increases in taxation, would be met with higher interest rates.
Alex, was just about to write this ” … the reason why the OBR are assuming there would be an offsetting tightening of monetary policy in response to any fiscal loosening beyond 2017-18 is that they think that by then the ‘output gap’ will have fully closed, the economy will be at its trend level, and actual output will be growing in line with potential output.” Then read your words in quotes above!
But then that would be an admission that they were intentionally or otherwise targeting NGDP growth of 5% 😉
Which also encourages me to think that, if deflationary forces persist or become entrenched, we may yet see a) forward guidance Mark II in the shape of an overt NGDP level target, and b) further extraordinary monetary stimulus.
Bill – To me it looks like the OBR have a working assumption that something like 4%-4.25% annual NGDP growth (on average) is likely to be appropriate and sustainable over the next few years, split roughly 60:40 between real growth and GDP deflator inflation (with the Bank expected to ‘look through’ short-term fluctuations around its 2% CPI target).
This is consistent with the OBR’s assessment of the permanent hit to productive potential from the financial crisis (some of which they assume was caused by the effect of the crisis on the productive capital stock, and some of it revealed by the crisis, ie an element of pre-crisis growth was a mirage).
Of course, it is possible to hypothesise either that the output gap is larger (as Capital Economics believe, for example), and therefore there is more cyclical ground to make up, or that the output gap has already closed (as some others reckon). The OBR is somewhere in the middle on this, putting the outgup gap at 0.8% of potential GDP this year and closing steadily. It assumes the Bank will ‘look through’ the current below-target inflation (as it did when CPI was well above target a few years ago) so that even above-trend real growth will not take nominal GDP growth into the 5% range.
The view that the output gap is now small is supported by the evidence on the tightness of the labour market, capacity utilisation etc. But as the OBR said when explaining their methodology for estimating the historical UK output gap: “Any output gap estimate remains highly uncertain, even when it relates to the past: the level of potential output is never observed, and while a longer run of data undoubtedly helps the identification of cyclical and trend fluctuations in output,2 estimatesofthehistoricaloutputgapremainsensitivetothe assumptions, data and methodology used to construct the series.”
I suspect the Bank of England will continue to play it by ear, as in reality they have done throughout the post-crisis period, both before and since Mark Carney’s rhetorical gesture of ‘forward guidance’. You could argue that the Bank signalling it would keep rates nailed to the floor until unemployment came down served its purpose by boosting confidence at a fragile stage of the recovery: ie it set in motion a virtuous cycle. On the other hand, indicating a trigger point for a potential change in monetary policy and then ignoring it can hardly be expected to instil confidence in the credibility of the policy framework!
Quite clearly, the variable the Bank chose – unemployment – has confounded their expectations by falling so rapidly and continuously. On the face of it this was yet another instance of ‘Goodhart’s Law’: pick any single target variable and it promptly starts misbehaving! If the Bank had followed the implications of their forward guidance approach, they would have raised rates significantly by now. Instead they have sensibly heeded other tell-tale indicators – particularly falling inflation and low wage inflation – and bided their time.
This flexibility and pragmatism cuts both ways. If, as you say Bill, “deflationary forces persist or become entrenched”, then no doubt the Bank will consider further stimulus. But it would be a mistake to interpret the current fall to zero CPI in the UK as a threat to the recovery. On the contrary, it is the fall in inflation that seems to have done most to improve consumer confidence and stimulate spending – unsurprisingly, since it has largely been driven by sharp falls in the price of imported commodities which are staples of the household budget (just as the spike in inflation, and consequent drag on demand, in 2010-12 was driven by sharp rises in commodity prices).
This is clearly different in nature from the domestic deflation through falling real wages and producer prices that has gripped much of the eurozone. So I don’t think the Bank will hit the panic button just yet. Obviously if deflation starts to become endemic in the UK and spreads to domestic wages and prices, that would be a cause for concern. (In terms of headline CPI, if anything I’d expect a moderate pick-up over the next year simply as a function of arithmetic, as the big fall in the oil price drops out of the year-on-year calculation.)
The bigger issue is going to be how to handle the exist from QE and the ‘normalising’ of interest rates when they eventually happen, given how dependent the stock market, financial institutions and still-indebted households have become on artificially cheap credit.
This is a live issue in the US where the interest rate cycle looks likely to turn this year. Ambrose Evans-Pritchard reports today on the debate there and the pressure from the St Louis Fed, the San Francisco Fed and others to begin ‘rolling the pitch’ for monetary tightening given that the US recovery is gathering pace. A further concern is the impact of further strengthening of the dollar on emerging market corporates who are holding huge amounts of dollar-denominated debt. One of the problems of ’emergency’ monetary stimulus (necessary though it may be) is that it becomes the norm and extricating yourself from it is inevitably going to be hazardous.
http://www.telegraph.co.uk/finance/economics/11492447/Feds-Bullard-sees-roaring-boom-for-US-economy-but-nasty-shock-for-markets.html
My penultimate para should read: “…how to handle the exit from QE…”