Select Committee on Treasury Memoranda




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 are assuming that the good times will continue and that the economy will post another 3 to 3 ½% 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 22¾% 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 3 ½ % 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.


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 3 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.


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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