Select Committee on Treasury Minutes of Evidence

Examination of Witnesses (Questions 120 - 139)



  120. The MPC will no doubt read what the independent analysts make of it as well, and it looks like they might be faced with contrary conclusions because two of the independent analysts are telling us that there is a fiscal loosening of between 0.4 per cent and 0.7 per cent GDP?
  (Mr O'Donnell) But you have to be careful what they are saying because, for the MPC's purposes, they have already factored in what was in the PBR. If those analysts are saying that relative to the PBR they think there has been a loosening then I would disagree, and what is relevant to the MPC is the news in this Budget which is the change since the PBR. I would be surprised if analysts saw that the change since the PBR is a loosening because it is a tightening; maybe they have different forecasts for the economy but, again, I would be surprised.

  121. You said earlier you were expecting private consumption to slow. Is part of the reason for that because you are planning a slight fiscal tightening?
  (Mr O'Donnell) A little bit, yes. I expect that when there is talk in the newspapers about increases in taxes, people may look at their consumption plans going forward. Also they will take their overall debt levels into account and think carefully about whether they want to carry on building up their debt in the way they have been in the last couple of years. Overall they will moderate their debt and they will be looking at what has been happening to incomes going forward. This time last year we were in a stage where there were very big bonuses paid out, and that had quite a dramatic impact on average earnings. This year, if you look at the average earnings figures, they are much lower and a large proportion of that is bonuses, and that lower income path is one reason why we expect consumption to be lower.

  122. Was the MPC briefed about the Budget before its April meeting?
  (Mr O'Donnell) No, certainly not before its April meeting, because there was such a long time between that meeting and the Budget. Our intention is that, when they have an interest rate decision coming up, we will brief them beforehand to let them know but also as a courtesy we brief them before the Budget, so this time round on the Monday before the Budget I gave them a briefing on the overall macro forecast and the macro implications of the Budget certainly, but we do not go into specific individual measures; we give them the overall fiscal sign. The reason we did not do it before the April meeting is that it was a long way away and the Budget was not finalised then.

Mr Fallon

  123. Clearing up this loosening/tightening point, we have had evidence from the Institute of Fiscal Studies saying that the Budget has a negligible impact on the fiscal stance in 2003-04 and 2004-05 but that the net effect of the Budget is to loosen the fiscal stance by £9 billion in 2005-06 relative to what it would have been had the Chancellor not introduced any of the measures in the Red Book, and that this arises from an £8 billion increase in taxes and a £17 billion increase in spending. Is that right or wrong?
  (Mr O'Donnell) The figures are all laid out there. The change in the fiscal stance is there. You are talking now about 2005-06. If you look again at table 2.8, this is what reconciles the two. It makes it clear there is a fiscal tightening in 2002-03 and in 2003-04, a tiny one in 2004-05—0.1—and then 2005-06, which is the figure you chose to highlight, it moves to a plus 0.3. So that is the answer. That is a very long way forward. These are based on forecasts a long way ahead—

  124. Mr O'Donnell, the year has been highlighted by the Institute of Fiscal Studies and presumably they have done that because you and the Chancellor have talked about negligible impact and tightening and so on, but this figure of £9 billion is a substantial loosening in 2005-06, yes or no?
  (Mr O'Donnell) The reason we emphasise the earlier ones is because they are much more certain and relevant to monetary policy which looks two years ahead. They are not setting monetary policy on the basis of that number and as the years unfold we will be changing that number quite substantially, but certainly it is there. It is a 0.3 per cent plus increase, most certainly, in the cyclically adjusted public sector net borrowing requirement.

  125. So that is a £9 billion loosening in that year?
  (Mr O'Donnell) I have not got the figure in my head as to what 0.3 per cent is, but it is certainly 0.3 per cent of GDP in cyclically adjusted terms.

Mr Laws

  126. Can you tell us what has happened to the Government's public sector borrowing position since comparing the Pre-Budget Report and the Budget figures?
  (Mr O'Donnell) Certainly. Looking at annexe C, that is probably the best place on public finances, for example, C1 on page 206 gives you net borrowing numbers and compares them with the Budget and the Pre-Budget Report, and gives them in billions and in per cents of GDP.

  127. Would you agree, particularly for the further out years, comparing the Budget with the Pre-Budget Report, there is an increase in borrowing?
  (Mr O'Donnell) There is an increase in borrowing because we have upped the public sector net investment numbers. That is certainly true. You have basically current surpluses much the same so you are meeting the golden rule every year and over the cycle, and what you have is an increase in our estimates public sector net investment. We now expect PSNI to be around 2.1 per cent of GDP so that is why you have slightly higher borrowing. But it is a long way out and, again, I stress that this is subject to forecasts that are going 4-5 years out. We talked at the start about our forecasting performance being one year out, and you need to bear in mind when you are doing these things a long way out that they are dependent on forecasts that have high standard errors.

  128. Do you agree that those borrowing figures would be substantially higher had you not increased the trend rate of growth that you use in the public finance calculations?
  (Mr O'Donnell) We were very explicit about precisely what impact the change in trend growth had on the numbers.

  129. It is quite large, is it not? In 2005-2006 and 2006-07, if you compare the Pre-Budget Report with the position now and you extract out the growth factor, then you are talking about underlying borrowing which is about £8 billion higher in 2005-06, and something like £10 billion higher in 2006-07?
  (Mr O'Donnell) The trend growth effect is about £1 billion a year, cumulative. You can look at that either way. Indeed, a number of people, including the Commission, said to us that using 2.25 per cent going forward, which is what we were doing, was building in excessive caution and was making our numbers rather difficult to interpret. We are trying for our economic forecast to use central views about what is happening to trend growth and then we build in the same degree of caution as we had before, a quarter point, and use the lower figure of 2.5 to forecast forward.

  130. You mention the Commission and you are anticipating my next question, which you can probably guess: do your projections of central government net borrowing comply with the Stability and Growth Pact?
  (Mr O'Donnell) They comply with what we regard as a prudent interpretation of the Stability and Growth Pact, yes.

  131. You mean a less prudent interpretation?
  (Mr O'Donnell) No. A prudent one.

  132. How can looser borrowing figures be more prudent than the Growth and Stability Pact?
  (Mr O'Donnell) Basically, even when you go to the end of this period and even on cautious assumptions, the figure that the Commission is worried about, and you may have remembered the discussions with Germany about an early warning, was deficits hitting 3 per cent of GDP. We are well away from that—even on these assumptions.

  133. But you agree that when the statement was made about the UK's convergence position by Ecofin on 12 February of this year, they did express their concerns about the lack of convergence on the part of the UK with the Growth and Stability Pact. They said in part that they were quite relaxed about that because of the 2.25 growth assumption you would then use, but you are now not using that any more and they said in their note, however, in view of a sustained deficit of 1 per cent of GDP which was then being protected it is now more like 1.5 per cent, based on a very cautious growth assumption. It notes the requirements of the Growth and Stability Pact that you should either be in balance or surplus, and it urges you to be cautious about any deterioration and preferably to come back towards what is supposed to be the Growth and Stability Pact objective of either balance or surplus. So the next time you get a note from these guys they are not going to be very happy, are they, because since they gave you this light slap on the wrist you have upwards revised your growth forecast and your borrowing figures. So you are going to get a bit of a ticking-off, are you not?
  (Mr O'Donnell) I would be surprised. The whole point of the Stability and Growth Pact is to ensure that countries have sustainable fiscal policies. When you think about what determines what is a sustainable fiscal policy, and when they wrote the Maastricht Treaty, they were worried about countries with excessive debt levels, and if you run big deficits you end up with big debt problems because the debt is the stock equivalent of the flow which is your deficit. When you look at the UK, throughout these figures we have a net debt level of around 31 per cent of GDP by the end of the period—among the lowest in the EU. If you look at our generational accounts, you find that because of our demographics and our policies, our fiscal sustainability over the medium to long term is much better than the vast number of EU countries, so when they look at the sustainability issue I am sure they conclude that the UK is one of the most fiscally sustainable positions in the whole of the EU.

  134. You are making a very good argument for reforming the Growth and Stability Pact to take into account some of the issues that you have just mentioned, but at the moment the Growth and Stability Pact is not defined in the way you might like it to be. The Government so far has argued it is taking a prudent approach and therefore has been less prudent, but do you think that is going to remain the Government's position—in other words, you are going more or less to turn a blind eye to the literal interpretation of the Growth and Stability Pact—or do you think that you will be able to achieve reform in Europe which will mean you will get agreement of other members to a more sensibly structured Growth and Stability Pact?
  (Mr O'Donnell) I stress that what is literally written into the treaty is about avoiding 3 per cent deficits, and there is a question about precisely how one implements that. Certainly our view is that, when implementing that, we should, of course, stay away from 3 per cent deficits—that is in the treaty—but implementation in terms of deficits should take account of things like where your net debt levels are. Also, I think there is a strong case, and the treaty refers to investment explicitly, for a country like the UK that has a very low level of public sector investment compared to other EU countries.

  135. Are you in discussions with other EU members over that type of redefinition?
  (Mr O'Donnell) Yes. We have made these arguments to other EU countries and the Commission and we will carry on.

  136. Are you making progress?
  (Mr O'Donnell) I think so. If you remember a year ago we were at the point then where some of the discussion in this Committee was about the difference between actual deficits and cyclically adjusted deficits, and we stressed the need to think about things in cyclically adjusted terms. Now, virtually all the analysis is in cyclically adjusted terms, and that is a big step forward. It mattered going backwards in that it mattered that during a downturn you were allowed the automatic stabilisers, but it matters going forward. One of the big mistakes in Europe, when they had a period of relatively high growth, because they looked at absolute numbers rather than cyclically adjusted numbers, they did not have tight enough fiscal policies during that period so it is quite important.

  137. So there is going to be no criticism of the Budget by Ecofin when they do the next report?
  (Mr O'Donnell) That is for them to decide but certainly I think the more we can get the discussion about the economic principles and why you need a Stability and Growth Pact basically about fiscal sustainability the more we will get into discussions about debt, investment, and basically ensuring that you have a sustainable path in terms of reasonable public services as well. A number of other countries are quite sympathetic to that view.

Mr Plaskitt

  138. Could you clarify why you make the decision now to increase the trend rate of growth assumption by a quarter point?
  (Mr O'Donnell) Sure. We look at the trend growth assumption regularly. Now, we are in a situation where the Government Actuaries Department had supplied some new population numbers, which they did just after the PBR, and we are at a spending review time so we are thinking over the medium term, three years out, what we can afford for the economy to do. That depends in part on what the trend growth numbers are. Given that we had new population numbers and that we wanted to put a solid base for that spending review period, we wanted to look at the degree of caution we were building in by the assumptions we had made and the population numbers and some analysis, that led us to look at the demographics, the changing age cohorts—we looked at the activity rates in each age cohort—and there were some views being put forward about how hours worked might change, it seemed to us that we should bring all this together, and also review whether there were grounds for claiming an increase, being able to say on solid grounds that productivity had gone up. We put all of that together and that is why we reviewed trend growth now.

  139. But you have told us now you are assuming no growth in productivity?
  (Mr O'Donnell) That is right. We looked at it with a hope that we would be able to say that actually productivity had picked up and all the rest of it. We think there are some reasons to suppose it might have done but it is not there in the figures yet, so we erred on the side of caution, as is appropriate, and we did not change it.

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