Memorandum submitted by Professor Peter
Spencer, University of York
The economy has performed very well over the
last two years and the Chancellor is rightly proud of his record
in forecasting its performance. Regrettably, the Treasury's record
in forecasting the fiscal deficit is nothing like as good. Despite
the strength of the economy, asset and oil prices we saw another
mark-up in the forecast of the current account deficit for this
year, the sixth in succession.
As a result of these fiscal forecasting errors,
the Chancellor had very little room for manoeuvre on fiscal policy
and had little option but to bring in a tight Budget this year,
despite the approach of the general election. Even so, the margin
for comfort in the present economic cycle is very narrow, making
it likely that the golden rule will yet be breached. More of a
worry, the economy will start the next cycle with very little
leeway on fiscal policy if things go wrong. A prudent Chancellor
would buy himself more room for manoeuvre by tightening policy.
The precautionary principle would dictate that this should be
sooner rather than later.
THE TREASURY
ECONOMIC FORECAST
The Treasury are assuming that the good times
will continue and that the economy will post another 3 to 3½%
growth this year. My (ITEM Club) forecast is close to the consensus
at 2.6%. Table 1 shows these differences.
The main area where the Treasury is more optimistic
than ITEM is on investment. This does not reflect a different
view on prospects for business investment, which the Treasury
expects to rise by 4¼-4¾% this year, very close to our
forecast of 4.6%. Rather, the main disagreement is about general
government investment, where the Treasury expects a rise of 2¾%
this year against ITEM's forecast of 13.7%. (The Treasury figure
is revised down from 30% in the PBR.) This is of course an area
where the Treasury forecast has been notoriously unreliable. For
example, in last year's Budget it forecast an increase of 17%
in government investment in 2004, but the outturn was less than
4%.
In addition, the Treasury is more optimistic
than we are on the outlook for exports, expecting export growth
to accelerate to 6% despite the strong pound and trend decline
in the UK's share of world trade. This translates into a more
upbeat forecast for manufacturing output, which the Treasury expects
to rise by 1½-2% this year compared with ITEM's forecast
of 0.8%. However, the Treasury is at the same time more pessimistic
about the outlook for the current account, mainly because they
are less optimistic about the prospects for the UK's net investment
income.
These differences are not large and the Treasury's
3 to 3½% range is still achievable. However, the risks to
this forecast are plain to see. Consumers are looking very unsure
of themselves and although the housing market appears to be stabilising,
it is still on the critical list. Exports have revived in recent
months, but we are losing market share and prospects are threatened
the weakness of by the dollar and our important European markets.
Recent business surveys suggest that the economy will grow in
line with trend but no faster.
THE FISCAL
ARITHMETIC
As usual, my main concern about the Budget arithmetic
lies not with the economic forecast but with the way in which
this translates into tax revenues and government borrowing. The
Treasury are assuming that the corporate recovery & fiscal
drag will boost the tax take and that this year's overspend will
be clawed back, bringing the deficit down by £10 billion
in the outgoing fiscal year to £6 billion next year.
It is hard to be confident about this prediction
in view of the Treasury's recent record in forecasting the current
deficit. The chart shows how these forecasts have deteriorated,
starting with the bottom line, which shows the prediction made
in the 2002 Budget and ending with the top line which is their
2005 Budget forecast. For example if we look at the projections
for the outgoing year, 2004-05, we start at the bottom with the
forecast of a surplus in Budget 2002 and read up to the latest
forecast of a £16.1 billion deficit. This represents a deterioration
of £25 billions in just three years, when the economy has
been recovering and the Treasury's GDP forecasts have been nicely
met. Admittedly the scale of the revisions has diminished over
the last year, but they continue in the same direction.
Despite these systematic errors, the Treasury
continues to roll its optimistic current account figures forward,
always ending the forecast period with a surplus moving into double
figures. Our forecasts have been much more cautious and continue
that way. We are forecasting a current account deficit of £12
billions. With the help provided by the recent reclassification
of road maintenance expenditure, this is just enough for the Chancellor
to meet the golden rule in this cycle. However, in view of the
risks, which we believe are skewed to the downside, the changes
of making this are less than 50%. However, it is too late to do
anything about that now.
CONCLUSION
The Treasury's forecasts are optimistic but
on the margins of the achievable. The margin of error for meeting
the golden rule in the present cycle is too small in view of the
underlying uncertainties.
Looking forward to the next cycle, which is
likely to start in 2006-07, the situation also looks problematic.
The current account is likely to start in deficit, leaving very
little room for manoeuvre on fiscal policy. Of course if the economy
is as shock-proof as the Chancellor seems to believe than that
would not matter. We could muddle through, relying of fiscal drag
to build up a surplus over the course of the cycle.
There is evidence to suggest that the UK economy,
once the most volatile in the G7, is now among the least volatile.
However it would be complacent to rely on this until we better
understand the reasons for this transformation and its durability.
Moreover, the UK is not immune to events elsewhere. The chart
should remind us that the public finances can deteriorate alarmingly
if the world economy turns down, even if the UK avoids a recession.
18 March 2005
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