Examination of Witnesses (Questions 1
TUESDAY 4 DECEMBER 2001
1. Good morning, Mr O'Donnell. May I welcome
you and your colleagues to this session on the pre-Budget report.
Could I ask you to introduce yourselves.
(Mr O'Donnell) Certainly. I am Gus O'Donnell,
the managing director of the Treasury in charge of macroeconomic
policy and international finance. On the far left is Nicholas
Holgate, who is the director of Welfare reform; next to me, on
my left, is Adam Sharples, who is the director of public spending;
on my right is Alex Gibbs, head of tax policy; and next to Alex
is John Kingman, who is the head of productivity.
2. Thank you very much. I will just lead off
with a general question. Can you tell me what degree of uncertainty
you were working under for the pre-Budget Report, given the current
economic situation, and to what extent the Treasury has sought
to address these uncertainties in the policies and in the forecasts
in the pre-Budget report.
(Mr O'Donnell) Certainly. I know it is a cliché
of forecasters to say we are entering a period that is more uncertain
than usual. Quite often that is not the case but actually for
this forecast it certainly was. What happened, particularly post
the tragic events of September 11, if you look at the spread (
the range of forecasts for 2002) was that suddenly the standard
deviation of those forecasts increased by about 40 per cent, so
there was a big increase in the range of uncertainty about what
would happen next year. That does make forecasting much more difficult.
So the big change post-September 11 was a slight reduction in
the forecast level but a very big increase in uncertainty. In
terms of how our policies respond to that, clearly I would say
that probably our forecasts for next year should be regarded as
having a wider error band around them than normal. It also means
that it is more important than ever that we adopt a cautious approach
to managing particularly the public finances. Our procedures allow
us to do that because we build in caution in a whole range of
ways; for example, by using the bottom end of our opportunity
range of growth forecasts and also by the NAO audited assumptions
which build in a degree of caution. The degree of caution built
in was much higher at PBR time simply because of changes to things
like equity prices.
3. The Treasury forecasts have always been seen
to be conservative, in that you have attained those quite comfortably,
and there has been comment on that. Given the projected growth
forecast next year of 2¼ per cent, do you feel very confident
that that can be reached?
(Mr O'Donnell) I think there are two parts of the
forecast that you need to distinguish. First of all, there is
the forecast of the economy, where our forecasts attempt to be
central, in the sense that we operate a range but the centre of
that range is our best-guess as to what is going to happen to
the forecast. It is certainly true there that we are slightly
more optimistic than the consensus, but it is really a very small
margin between us and the consensus, particularly if you think
about that wider error band that I was mentioning because of the
greater uncertainty. It has turned out, if you look back at pre-Budget
reports, the 1997, 1998 and 1999 ones, that certainly in all those
three cases our central economic forecast was slightly above the
independent consensus forecast, and that turned out to be the
correct place to be. The forecast for this year, the pre-Budget
report for the year 2000, we were slightly more pessimistic than
the independent consensus, and, again, that turned out to be the
right place to be. I think at this point you need to put up one
of those little stars, like they have in those adverts for financial
companies, that says "Past performance may not be a guide
to future outturns" because it is a very uncertain period
and this is a particularly difficult time for forecasting. That
is the economic forecast. On the fiscal forecast, as you rightly
say, things have turned out better than we thought. That is not
unexpected because we do not go for central fiscal forecasts;
we actually attempt to be cautious and we expect the outturns
to be slightly better than we forecast. As I say, that degree
of caution is built into the way we do our forecasts and we hope
that that will happen through time, that things will be slightly
4. You expect growth to "move temporarily
above its trend rate from the middle of 2002" and a further
rebound in 2003. What will happen to growth in the first half
(Mr O'Donnell) We do not publish quarterly numbers
but certainly we would expect there to be a slowdown there.
5. In growth or . . . ?
(Mr O'Donnell) In growth, that is rightin the
light of a slowdown in the world economy most certainly.
6. Would you actually think it quite likely
that there will be a slight decline in the first half?
(Mr O'Donnell) I would think that unlikely. Certainly
that is the view of the consensus, the IMF, the OECD and the National
7. The IMF, OECD and especially Goldman Sachs
are predicting an overall growth rate next year of about one per
cent less than the central Treasury forecast, so they are looking
at 1.4 to 1.8. You are saying today that they are predicting positive
growth in the first half. Just trying to make the figures come
together, does that mean that you think that the Treasury is predicting
a stronger rebound in the second half than they are?
(Mr O'Donnell) I would stress that the differences
between these numbersyou know we are talking about 2 ,
the IMF is 2.1, independent consensus 1.9are really small
compared to, you know, the difficulty of forecasting in a world
environment where we are seeing the first synchronized downturn
that we have seen for the big three areas since 1974. So I would
not put too much store in these relatively small differences in
8. Just to clarify, there is a difference between
the brief that I perceived and what you have just said, that the
independent consensus is around 1.9. I have figures of 1.7 for
the European Commission, 1.8 for the IMF, 1.7 for OECD, 1.4 for
(Mr O'Donnell) The Treasury publishes an independent
consensus which puts all of them together, like Goldman's, JP
Morgan's and all the rest of them. That November publication showed
an average of 1.9 per cent.
9. Given the shallowness of the slowdown that
you predict, the relative shallowness, what factors would you
expect to cause the above trend growth in 2003?
(Mr O'Donnell) If you think about what the nature
of this slowdown is, basically it is a slowdown caused by exogenous
factors. It is a world slowdown. The US, Japan and the Euro area
are all slowing down at the same time. That has hit our export
markets quite hard and so that causes a slowdown. Also, on top
of that you have the effects of September 11th and their impact
on business confidence. What we would expect to happen is particularly
for investment decisions to be delayedit is not that they
will be cancelled, but they will be postponed for a while. Because
of this increase in uncertainty, because of the higher risk premium
people will wait to see what will happen. For a while we would
expect slower growth, and then, towards the second half of this
year, as some of these uncertainties are resolved, we would expect
a pick-up. Also policy is kicking in. The Monetary Policy Committee
started cutting interest rates in February. They have cut interest
rates now by 200 basis points; seven times. That sort of monetary
policy response should lead through to a response in the economy
over the 18 months to two years post those changes. So monetary
policy should start to kick in and the fiscal policy will be supporting
that through that period, so that is why we would expect a recovery
through the second half of next year.
10. It is not true that interest rates in real
terms are actually still quite high because of the low rate of
(Mr O'Donnell) You have got 4 per cent nominal interest
rates and inflation is not that far away from target. If, as the
markets expect, inflation is over the medium term 2½ per
cent, we are talking about 1½ per cent real rates, so that
is, I think, quite low.
11. Could you say a little bit about the US
situation. First of all, how big is the impact of what might happen
in the United States on the UK economy? Is it the biggest single
(Mr O'Donnell) No. When we do world export markets
we weight them altogether. The Euro area is about 50 per cent
of our tradeables so the Euro area accounts for more, I would
say, than the US. How big an effect will it have? We are bound
to be hit by a US slowdown, particularly, as I said, through the
effect on our export markets. We were expecting the US to slow
down and our budget forecasts were built around a slowdown in
the US, but obviously the effects of September 11th were not something
that we forecast so it has turned out to be rather bigger than
we thought. But we are assuming that there will be a sort of v-shaped
recovery, with main areas of the world recovering in the second
half of next year. So the US, yes, does have a big impact but
we are assuming again that the impact of policy feeds through.
Whereas the MPC started cutting rates in February, the Fed started
cutting rates in December 2000. They have had 10 interest rate
cuts and they have cut interest rates by 440 basis points and
they are now down to 2 per cent. If monetary policy works, we
would expect that to cause quite a big turnround, and, on top
of that, they are having discretionary fiscal loosening.
12. Does it not give you some cause for concern
and make you just a little bit sleepless at night the thought
that you have put out a forecast of 2½ per cent at a time
when the world's three biggest economies have all decided to go
south: one of them is already and has been for a decade in serious
recession and America is going to join it and we have got a bad
reports in the FT today about Germany. There has never been a
time, has there, where Britain has avoided getting itself into
difficulties when these three have been in recession?
(Mr O'Donnell) As I said at the start, this is the
time when, asked to do a forecast, you might want to answer "Pass"
because there is a much higher degree of uncertainty now. But
certainly we are thinking that economic policy works. The monetary
policy responses we have seen in the Euro area, through the European
Central Bank, and by the Fed, and the fiscal actions that have
been taken will turn things round. Japan is a special case I think.
What I have said about policies turning things round does not
apply in JapanI mean, they are almost attempting to explain
to us why all these curiosities in economics text books are in
fact true. They have got a Keynesian liquidity trap, so they cannot
lower interest rates, and on the fiscal side they are proving
that Riccardian equivalence actually holds, that when they try
and stimulate through fiscal policy consumers offset it, and so
we end up with a situation where neither policy is particularly
effective. So we would not assume that there will be a big turn
round in Japan. Overall, though, I would expect those other areas
to come back and we have had very aggressive, very early policy
responses. That is what we expect to happen. I would not take
forecasts to the nearest point very seriously, but it is true
that the OECD, the IMF and the rest all think that the UK will
be the fastest growing G7 economy next year, and I think that
result is rather more robust.
13. There have been reports in the newspapers
over the weekend that a lot of the fiscal relaxation in the United
States is going to get tangled up in wrangling up on the Hill.
If that does not materialise, how will that affect your forecast?
What weight do you attach to the fiscal as opposed to the monetary
action that has been taken in the United States?
(Mr O'Donnell) I put a lot more weight on the monetary
than the fiscal side for two reasons. First of all the monetary
loosening has happened, it is definite, it is there. They have
already cut interest rates to 2 per cent and I think you can already
see areas in which that has affected the economy. On the fiscal
policy front, I am personally not a believer in fiscal activism,
that you can actually manipulate fiscal policy and fine tune it
to manage unexpected events. Whilst I think fiscal policy will
be overall supportive, we have not factored in that bigger packages
will come through, and also, even if they come through, you do
have to accept that there may be some offset in the economy.
14. You are saying that your forecast is predicated
on the view that the fiscal package in the United States does
(Mr O'Donnell) No, I did not say that. What I said
was that I think fiscal policy actions will not have as much impact
as some people are thinking. We are expecting there will be some
sort of fiscal stimulus that will come through, but I think the
more important element for US recovery is monetary policy.
15. What are you doing to address current account
(Mr O'Donnell) We are trying to increase the productivity
of the UK economy, I think is the long-run answer to that, which
I think is the best, and by having a macro framework that is stable.
I think part of the problem has been caused by particular exchange
rate relationships and there is a limit to what we can do there.
If you look back on it over the last three years, what has happened
is that sterling has fallen against the dollar but the euro remains
very weak, and that is the real problem in terms of our current
account deficit. If the euro were to move back to what might be
a more sustainable long-term level, then that would help certainly.
16. Tax receipts as a share of GDP are now projected
to be 0.7 and 0.9 percentage points lower in this and the next
financial year respectively compared with the Budget forecasts.
Does this indicate the sensitivity of the tax base to changes
in the economy? How much of the decline in forecast receipts is
due to cyclical, and how much to structural, factors?
(Mr O'Donnell) The tax/GDP ratio is affected actually
on the numerator and the denominator. If we take the GDP numbers
first of all, the Office For National Statistics, when they published
their Blue Book in the autumn, revised the GDP numbers really
very substantially, back to 1992. They changed the path of UK
economic history somewhat and those GDP numbers revised GDP upwards.
The tax numbers on the other hand, our tax receipts estimates,
have been revised down, so you end up with a lower tax/GDP ratio
there. In terms of the second part of your question, which was
about how much of the revision is due to different aspects of
17. The cycle or structural factors.
(Mr O'Donnell)if you look at table 2.4 in the
pre-Budget report, page 23, there is a decomposition there of
the factors behind the changes to our receipts comparing the Budget
forecasts with the pre-Budget report forecast. We have split it
down into the impact because of a different GDP estimate, and
then the impact due to audited assumptions (the NAO audited assumptions)
and financial companies. There the GDP effects are, in 2001-02,
we expect, due to the GDP changes, about one billion; in 2002-03
about two billion; and the other factors are mainly to do with
these more cautious NAO audited assumptions. Because of the rules
we have on how we forecast, for example, equity prices, that creates
a reduction in our revenue forecasts. For example, when we did
the budget, the NAO assumption for equity prices going forward
is that we have to assume that wherever they are they will carry
on forward in line with money GDP, and they were up there
at Budget time. The bubble bursting in equities has meant they
have come down quite a way and we have to assume now that they
have moved to that lower level. That means that we automatically
have lower forecasts of stamp duty receipts, capital gains tax
receipts, inheritance tax receipts. It feeds through in some ways
to corporation tax receipts as well. So this extra caution that
is built in has the impact of lowering our receipts numbers, and
we have decomposed it in table 2.4.
18. Can we turn to public expenditure and perhaps
give Mr Sharples an outing. Can we just deal with the preparation
point. At what point were the health department told of the Chancellor's
conclusions to be announced on the Tuesday?
(Mr Sharples) I do not know exactly at what point.
As you will appreciate, discussions on preparation of a package
of this kind take place over a number of weeks leading up to the
announcement. This is an iterative process that goes on over several
19. It is possible the Health Secretary did
not know on the Monday what was going to be announced on the Tuesday.
(Mr Sharples) I cannot comment on precisely what point
the Health Secretary was aware of these changes. As I say, this
is an iterative process which goes on over several weeks leading
up to the announcement.