Select Committee on Treasury Minutes of Evidence


Examination of Witnesses (Questions 40 - 59)

WEDNESDAY 7 DECEMBER 2005 (Morning)

MR BEN BROADBENT, MR ROBERT CHOTE, PROFESSOR DAVID MILES AND MR MARTIN WEALE

  Q40  Ms Keeble: What your argument is is that the pressures can be contained simply by slowing down the growth in public spending and that that would not be a bad thing in terms of the requirement for public services and there would not be other implications for the economy or that there would be catastrophic implications for the well-being of society? In a nutshell, is that your argument? Then I was going to ask if other people on the panel agree with that.

  Mr Weale: No, I could not see catastrophic implications flowing from having public spending growth in real terms of something under 2% for a number of years instead of the 2.5% growth rate. I do think at some stage more room will have to be made for higher spending on pensions and there is a question whether that is going to be done by increases in taxes or by squeezing at the other end. I suppose I am more inclined to do it by increases in taxes than by substantial cuts in other areas.

  Q41  Ms Keeble: You think that that growth you have projected is sustainable over the medium term?

  Mr Weale: I think looking at the Government's forecasts up to 2010-11 they are projecting a current account surplus. My bet would be zero or something less than zero but not very much less than zero, so I do not think the surplus is there. I do think that with the slow spending growth that is now pencilled in and the tax increases that we have had, we are much closer to something that is sustainable than we were in the Budget earlier this year.

  Ms Keeble: Does anybody disagree and want to put a different viewpoint, in particular whether any slow down in the projected increase in public spending—forget about our political views, some of us are in strong agreement—but do you think for example it would have a negative effect in terms of tackling the problems in education which I think are well-known?

  Q42  Chairman: Quick answers please. David, quick!

  Professor Miles: I think squeezing these big areas of spending—education and health—so that growth is less than GDP for a sustained period would pose a real challenge to significant increases in results. Yes, it could.

  Mr Chote: To put a rough order of magnitude on it, if total spending is now projected to grow by 1.8% a year over the next Spending Review period, if you have a Wanless-style growth in the NHS, you keep the overseas aid budget rising to the level it needs to do to get to the 2013 target, and you spend a constant share of GDP on education, that leaves everything else to grow by about 0.8% a year in real terms over that period, which is clearly significantly lower than the growth rate of the economy. On the point about sustainability, I have argued before you previously that we thought the Treasury's tax projections were probably overly optimistic and that therefore some combination of freshly announced tax increases or public spending restraint would be needed to bring about the improvement in the public finances they were looking for. Mr Brown has given us slightly more cautious projections on revenue, a tax increase, and a tighter squeeze on public spending, so all those things together clearly move in the direction that we have argued for. Now whether, given all that, you still get the improvement he is looking for depends on (i) whether there is enough spare capacity for the economy to grow as quickly as the Chancellor hopes over next three to four years, (ii) whether the spending plans are inked in as well as pencilled in and then delivered, and then (iii) whether the growth in tax revenues per pound of GDP is still plausible. The Chancellor is still obviously pencilling in quite strong corporation tax growth, still relying on fiscal drag to pull more people into the income tax net, but certainly from the measures he has announced yesterday he has done a lot of the things that we have been arguing that he needed to do.

  Mr Broadbent: I agree with all that. Probably, like the others, I would be slightly less optimistic on the central projections. I do believe whether or not the Government borrows an extra five or ten billion relative to its forecast or even relative to its rule is neither here nor there in terms of the overall economy. These are relatively small numbers. As to whether the lower spending profile would be difficult, I am sure it would be. These are not cuts strictly but productivity growth tends to be lower in services in general and in public services in particular and so they would be harder. It does help if you announce them and, as Robert says, pencil them in quite a long time in advance, which probably means that the next Comprehensive Spending Review will be quite a challenging one, but once those are set it helps if departments know quite a long time beforehand what their resources are going to be.

  Q43  Mr Love: In answer to the very first question that the Chairman put, Martin Weale commented in relation to the average living standards as between different countries, naturally enough primarily due to productivity, but then tied that in more particularly to low skills. I wanted to ask the other members of the panel whether they agreed about the low skills being the major issue or whether there are other issues in relation to productivity.

  Professor Miles: I strongly agree that we have a problem with low skills, with a substantial proportion of the adult population having real problems with numeracy and literacy. Those skills are arguably far more important now in terms of people's productivity than they were 20 or 30 years ago. They are likely to become even more important. It is one of the factors that I think will hold back growth of living standards in this country, so I strongly agree with Martin there is a real problem with education.

  Mr Chote: I would agree with that. There are obviously other things that matter—the competitive environment of the country, et cetera—but clearly the skills point is a very important one. I guess another area of disappointment in terms of delivering sustained improvements is that much of the argument that was made for saying we need arrangements that will deliver macroeconomic stability was that it would provide an environment conducive to greater private investment. I think one of the disappointments has been that the Government has managed to deliver—through a combination of luck or judgment—the stability, but the investment has not improved to the same degree and there may be other factors.

  Q44  Mr Love: I was going to come on to that—and I will ask Ben—we have had very sluggish business investment yet profits are up, the gearing is moving in the right direction, the cost of finance is coming down, so why is business not investing and what contribution does that make to the productivity problem?

  Mr Broadbent: Quite a significant one over the long term. It takes quite a long time to change the capital stock of the country but you can only do it by investing more. The truth is I do not really know, it is a puzzle globally. Throughout the last three or four years firms at least in the OECD countries have invested much less than you would have expected them to have done and it may well be that the hangover from the boom of the late 1990s/early 2000s is to make them persistently cautious about increasing their capital spend despite very low interest rates and despite the fact that profits are, if anything, above average. So firms are instead accumulating financial assets and accumulating bank deposits at record rates instead of investing in physical capital. It is something of a mystery. It is not something that is sustainable forever but it has been going on for a couple of years. On the productivity point I would only add one thing, I fully agree that the main problem would be education. It is probably also true that our infrastructure, transport in particular, is worse than that of our competitor countries and that probably at the margin also has an impact on productivity.

  Q45  Mr Love: I am going to come on to public sector investment but let me just ask Martin that question about business investment. Why are they failing to invest? Do you disagree with anything that has been said?

  Mr Weale: No, like Ben, I am afraid I do not know. Profits are high, the economy is stable, demand has not fluctuated very much, and I do not have an explanation.

  Q46  Mr Love: Can I move on to public sector investment and without wishing to get into the whole issue about public sector productivity we have got investment currently at 2.3% yet we have talked in response to earlier questions about the squeeze that is likely to come upon that. How critical is that level of public sector investment to increasing productivity in the economy, Martin?

  Mr Weale: I think it depends on the areas where the public sector investment is taking place. There are some forms of public sector investment which are obviously extremely valuable, having clean hospitals and so on, but most of the people who use hospitals are not thinking of going out to work, or a disproportionate number of them, and that does not have a great impact on the overall level of productivity. On the other hand, if you look at investment in roads, there that can have quite an impact but at the same time we have to remember that the pressure groups that are blaming the quality of the roads for their poor performance are wanting to get better roads without having to pay for them and in the public sector investment debate you always have this problem that what one hears from the private sector is a wish-list of things that it wants and knows it is not going to have to pay for directly.

  Q47  Mr Love: Robert, can I ask you when Labour first came in in 1997 we followed the path of the previous government and that took public sector investment down to 0.5% of GDP. Can we afford to go back to that? Can we squeeze public sector investment and still hope to improve productivity?

  Mr Chote: The Government is clearly not intending to do that. If it inks in what it has pencilled in for the next Spending Review figures then it is ring-fencing the amount of public sector investment at roughly 2.25% of GDP. One of the justifications for putting the Golden Rule in in the first place, as either David or Martin said, was to stop investment being the first thing that gets squeezed. But that can be one of the problems you get, as David implied, when you leave a 40% ceiling.

  Q48  Mr Love: That is likely to happen. The ONS is gradually coming towards us on PFI and various other changes in accounting practice will take us to 40%. Will that become a real constraint?

  Mr Chote: It could do and then the Government has to reach a judgment about which is more important, sustaining the level of investment that it is looking for or sticking with that 40% ceiling. Remember that there is nothing written in stone about 40%, there is nothing in the economic textbooks that says 40% is right and that 20% or 60% is not. If you look at the spectrum of different countries there are some countries, Scandinavia or Australasia, where the debt burden is much much lower but there are others where it is higher and that is a judgment to be reached. At the end of the day it is a question of whether you are more interested in meeting the letter of the rule or more interested in delivering the broader objectives, and that is a political judgment as much as an economic one.

  Q49  Damian Green: Can we return to the Golden Rule which we have touched on briefly. Robert, the IMF has been moderately scathing about the fact that we have now had the dates of the cycle changed not only at the beginning but also in the future as well, conveniently giving another year of putative surplus. Do you think the rule has much credibility left?

  Mr Chote: I have to say I do not think the fact that since the Budget we have seen a move from the idea that it is really important to assess performance over this seven-year period to now arguing that it is really important to assess performance over this 12-year period has done anything to help the credibility of the framework. We have argued for some time that while it might be perfectly reasonable to say in the way that you are structuring fiscal policy you want to be in a position where the government can borrow more when the economy is weak, and therefore you have to take some account of where you think you are in the cycle, that does not necessarily imply that the way you should do this is by trying to identify some fixed period, call it an economic cycle and say that is the period. You do not have to do it in that way. I think the problem is that having had such a big shift in the width of the goal that you are trying to kick the ball into undermines the idea that this is going to provide people with a clear anchor in terms of knowing what the Government is likely to do. That is not the same as saying necessarily that they have done this in a cynical way in order to make things easier. The problem in practice is that by moving the beginning of the cycle back it makes the rule easier to meet over this cycle. By moving the end of it forward it makes the rule easier to meet over the next one. Inevitably it will raise suspicions that this has been done to make the rules easier to meet. An independent body, if you want to stick with this framework, which I am not suggesting you do, may have come up with exactly the same judgments about the width of the cycle. At least that would mean that it was not likely to be interpreted as a politically motivated change.

  Q50  Damian Green: Are you saying that you think the whole framework is flawed?

  Mr Chote: The Golden Rule at best was only ever a reasonable rule of thumb because it is premised on the idea that it is worthwhile borrowing for investment because investment benefits future generations of taxpayers whereas current spending does not. That is an imperfect judgment anyway. Current spending on teacher training may well benefit people more than a velodrome in the Lea Valley. That distinction is not there. I think you should only treat it as a rule of thumb. The idea that over a period of seven or 12 years if you beat it by one billion that is terrific and you miss it by one billion that is a disaster just is not sustainable on any analytical grounds. The problem is that more rhetorical capital has been invested in this than its analytical foundations will bear.

  Q51  Chairman: Martin, you said to us in evidence on the Pre-Budget Report in 2002 that it was quite likely that the start date for the current economic cycle would be revised back to 1997 because "It would not take much of a change to the numbers or to the estimate of the trend line to say that the economy had been above trend for the whole period from 1997", but more recently you said in a quote, "The Treasury has done a good job of discrediting the use of the economic cycle as a guide to economic policy making." How do you reconcile those remarks for a simple person like me?

  Mr Weale: I think those two remarks are entirely consistent. I might almost ask why you are asking that question.

  Q52  Chairman: You said it. You have come to give us evidence.

  Mr Weale: The cycle between 1997 and 1999 was very poorly defined. The National Audit Office, for example, said, above paragraph 49, "The cyclical indicator evidence is consistent with both 1997 and 1999 being on trend points, although there is considerable uncertainty in making such judgments." That is what I was forecasting three years ago. My view is that because we have now all seen that that is the case, the National Audit Office is saying that, it demonstrates that the Golden Rule as handled by the Government is inappropriate as a means for assessing fiscal policy and my view is that it has been discredited and should be replaced by some assessment which is superficially perhaps less precise but is forward looking and does not hinge on small changes in trend lines from the ONS and all sorts of things happening nearly 10 years ago.

  Chairman: Okay. That is your story!

  Q53  Angela Eagle: Mr Weale, I am not sure you would hack it as a politician. The Governor of the Bank of England, when talking about the cycle, actually said, "I am not even sure it makes sense to think about a cycle as if it is a well-defined phenomenon." In other words, it is a construct that we use to analyse; it is not something that exists out there that everyone can agree about like a measurable thing. Do you not think it is time that we think again about the concept of the cycle and not be so enslaved to an economic construct and change the way that we actually anchor the Golden Rule?

  Mr Weale: Yes I do. Perhaps I could illustrate that by asking you to turn to Chart A3 on page 189. This is the Treasury's estimate of the output gap and therefore implicitly what defines the cycle. You can see the sort of small amount of bouncing around there between 1997 and 1999 that essentially is why I said what I did three years ago and why I think it is all very much up in the air. You can also see that around the start of 2004 there is something that looks very close to being a cyclical peak or it would be a cyclical peak if the zero line was tilted only very slightly. In the Treasury write up they say that it is a bit of a mystery that the economy nearly went to that peak but did not then burst through into finishing the cycle. My view is it is not a mystery at all. Like the Governor of the Bank of England, I think economies have periods of fast growth and they have slow growth, but what they do not have is a regular and clearly defined cycle and therefore we should look for alternative ways of assessing whether fiscal policy is being run on a sound and sustainable basis.

  Q54  Chairman: The Governor was very clear when he said, "We do not like this sort of fixed dating and have a different way of thinking about the productive potential of the economy and how it evolves. So inevitably we have different views about the cycle and I am not even sure it makes sense to think about a cycle as if it is a well-defined phenomenon." In general terms do you all agree or disagree with that?

  Mr Broadbent: Clearly it exists in the sense that there are periods when spending in the economy is above what one would consider to be the capacity.

  Q55  Chairman: What about the fixed dating aspect?

  Mr Broadbent: It is very problematic if only because, as we have seen recently, it just takes a revision in the data to change your view of that and it is a very odd situation for that then to change your view of the appropriateness of fiscal policy today. If only for that reason the fixed dating is difficult. The notion of the cycle exists but, as Martin said, it may not be dealt with in the right way in these fiscal rules.

  Mr Chote: In a sense the Government is a bit of a victim of its own success here. If it believes it has abolished boom and bust then the idea that you have a big, chunky, well-identified period below potential followed by a big, chunky, well-identified period above potential will not be the case. What you will get is a wobbly noise around the trend, which is clearly what is happening in 1997 to 1999. It is not the same as saying you should not take account of the short to medium term growth prospects in assessing how much you expect the fiscal position to improve, but the idea of judging it over a fixed period, as the Governor implies, just seems to be not at all sensible.

  Professor Miles: I would like to make two points. Firstly, having a set of rules and drawing distinctions between current spending and capital spending is better than where we were before. Before we had the code there was nothing. I think it would be helpful to focus on the forward looking questions, which are how soon we will get back to current balance and when we think there is very little spare capacity in the economy and therefore you are back at a neutral point and if we have plans in place for spending and taxes which roughly give you a balance on the current budget. To focus on those more forward looking questions seems to me more fruitful than looking back.

  Q56  Chairman: The Governor goes on to say that it should be forward looking, which is exactly the point you are making now.

  Professor Miles: Having said that, when you read the documentation and the PBR stuff, there is a huge amount of focus on the forward looking stuff. It is not just that there is also a lot of focus on the backward looking issues of 1997 or 1999. To my mind it would be more helpful if there was yet more evidence on the forward looking things.

  Q57  Mr Mudie: Before Gordon introduced the Golden Rule there was nothing. The Golden Rule has been a source of great comment and earnings potential for some of you.

  Mr Chote: I wish!

  Q58  Mr Mudie: It has been a source of great fixation by the financial press. Are you arguing that we should evolve it further, we should keep it and finesse it or do we go back to what there was before, ie nothing?

  Professor Miles: I would not want to go back to there being nothing. Focusing on the distinction that is drawn between current budgets and drawing a distinction between investment spending and current spending in principle is a good one but difficult to do in practice. To my mind tweaking it in a sense and making it much more forward looking would be a good direction to go in. Going back to having no set of rules or guidance on where the fiscal position was going I think would be a retrograde step.

  Q59  Chairman: I would like to ask you a final question about the Treasury's fiscal forecasting record in recent years. I notice from your submission that Ray Barrell thinks you are the bee's knees and that you have done better than the Treasury on this particular issue. Is there any reason for the systematic error in Treasury forecasts of current receipts and current budgets?

  Mr Weale: My guess is that they have been inherently prone to optimism because they have not wanted to produce a forecast which shows that the Golden Rule was going to have to be rescued by a change in the length of the cycle and in that sense it is very similar to what was happening in the first half of the 1990s when the budget forecast showed the budget returning to balance in the not too distant future, because the fiscal rule then was that the budget should be balanced. I think the Treasury is highly bound by the fact that it cannot produce forecasts which show the rule not working, not being met or close to not being met. My guess is that has been the main influence.

  Chairman: Can I thank you for your time this morning. We will move on now to the microeconomic issues.





 
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