Duncan’s Economic Blog

The £12bn blackhole: What Next?

Posted in Uncategorized by duncanseconomicblog on September 19, 2011

Today’s FT story on the structural deficit is potentially very big news.

As the paper reports:

The Financial Times has replicated the model of government borrowing used by the independent Office for Budget Responsibility, which suggests the structural deficit in 2011-12 is now £12bn higher than thought, a rise of 25 per cent.

By repeating and extending the fundamental elements of the OBR methodology, it is clear that even if there is no slippage in borrowing from previous forecasts, the level of spare capacity in the economy is lower than expected, so the OBR will not be able to forecast as much catch-up growth as it did in March.

(Presumably they used this OBR briefing paper to replicate the exercise).

£12bn might not sound like much in the context of the deficit – but what really matters is that this is a forecast of the structural  deficit. That’s what makes this story far more important than previous revisions to the deficit forecast. An increase in the structural deficit (the assumed deficit at a time of ‘normal’ growth) cannot by definition be eliminated by economic growth – it requires tax rises or spending cuts.

Before proceeding it’s worth noting two important caveats:

First – we shouldn’t really blame a higher structural deficit forecast on George Osborne. The OBR forecast is driven by a belief that the economy is actually capable of less growth than previously thought rather than by the current slowdown. That isn’t the governments fault.  How they respond to this potential new forecast is what matters and we can judge them on that.

Second – Estimating the structural deficit is notoriously difficult. Although that said, Osborne has made this notoriously hard to calculate variable a target of fiscal policy so complaining that structural deficits are hard to estimate would make little sense from the government now.

Caveats aside let’s remember that raising £12bn more than targeted means putting VAT, for example, up to 22.5%.

So, if the OBR model does indeed imply that the structural deficit should be revised up by £12bn in November, what happens from here?

The best case for the government is that the OBR either changes it’s methodology (not impossible – they changed in June last year how they calculate public sector job losses) or decides that the structural deficit isn’t £12bn higher – which they can do without changing their methodology:

It is also important to bear in mind that these techniques are used to inform the judgement that the OBR makes about the size of the output gap in its central forecast, but that we do not apply them without question. We might make (and would clearly explain) a judgement that diverges from what they tell us if we felt that the weight of other evidence suggested that would be appropriate.

So it may be that the OBR decides that although its methodology implies a £12bn higher structural deficit, they ‘judge’ it to be lower. I can’t see Robert Chote, who has long warned that the UK’s growth potential has been badly damaged by the financial crash going for that – although the figure they come up with may be lower than £12bn (they might decide for example that enterprises zones and corporation tax cuts have raised potential growth – this seems unlikely).

The second thing that could happen is that Osborne could announce that he will no longer meet his fiscal rule of eliminating the structural deficit this Parliament. In effect this would be pushing £12bn of austerity back into the next Parliament. For Osborne to be forced to abandon a fiscal rule 18 months after making it would be highly embarrassing. Assuming the markets don’t panic at that (and I see no reasons why they would), this would be the best outcome for the UK economy if there is an additional shortfall.  Osborne should accept the political hit and not try to shift it into an economic hit on the economy.

The most worrying outcome would be if the OBR announced that the structural deficit was £12bn higher and Osborne was determined to stick to his fiscal rules. In which case an additional annual £12bn of tax rises and spending cuts would be required this Parliament. Just what the economy doesn’t need in its current weakened state.

The November Statement is starting to look very interesting.


8 Responses

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  1. Gareth said, on September 19, 2011 at 10:03 am

    The choice for a Conservative Chancellor, on being told that he has inherited an economy of which the supply capacity has been devastated, after 13 years of Labour rule?

    Only one thing: rub his hands with glee, and enact truly radical supply-side reform.

    • duncanseconomicblog said, on September 19, 2011 at 10:16 am

      The problem for him though Gareth is that so far the OBR seems distinctly unimpressed with his supply side reforms and their likely impact.

      • Gareth said, on September 19, 2011 at 11:14 am

        Indeed, and I’d certainly agree with the OBR, because significant supply-side reform has been AWOL thus far. We really *should not* have relatively high inflation and high unemployment. It is a bad place to be.

        Regardless, I’d say this stuff is noise. No spare output capacity with 2.5m unemployed, and 9 million “economically inactive”? Give me a break. It was dumb of Osborne to pick the structural deficit as his fiscal target, I totally agree with you on with that.

        I don’t see how Labour can make hay out of this either. If supply capacity really was so weak:

        a) it is a damning indictment of the state of the economy after many years of Labour “investment”

        b) it is very difficult to argue that you would want to tip the spending scales back towards the government, given the ONS estimates of public sector productivity improvements over the last decade.

  2. Dave Holden said, on September 19, 2011 at 10:41 am

    Anything based on what the OBR predicts needs to be taken with a large pinch of salt – they’re track record hasn’t been great.

    Of course Osborne has to take notice of them since he’s nailed his colours to that particular mast. So I guess there’s a chance we may get a repeat of Gordon Brown’s trick where you arbitrarily move the goal posts while insisting nothing has changed.

    The point of course is it’s easy for government to increase demand via an increase in debt it’s a lot less easy to make that sustainable.

    The real solution to this mess of course is for banks and bond holders to be made to write down their bad loans, until that happens we’re going to be – at best – treading water.

  3. Stephen said, on September 19, 2011 at 11:35 am

    You say that we cannot blame the present Govt. for this weakening of growth capability — but Krugman makes precisely the opposite point that short-run austerity in the US is damaging long run growth potential right now.

    Is it really so different in the UK?

    Economic Bleeding Cure http://nyti.ms/qY7zjN

    And with detail on manufacturing capacity:
    Hysteresis Begins http://nyti.ms/pVvWdA

  4. dan said, on September 19, 2011 at 2:21 pm

    did the UK “lie” like Greece?

  5. gastro george said, on September 19, 2011 at 3:52 pm

    “… it is a damning indictment of the state of the economy after many years of Labour investment”

    More a damning indictment of thirty years of economic nostrums from both main parties.

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