Select Committee on Treasury Minutes of Evidence

Examination of Witnesses (Questions 140 - 159)



  Q140  Kerry McCarthy: Being outside the eurozone would not be a major factor in terms of our UK share of the European market?

  Mr Cunliffe: No, I do not think so. The last work we did on this was in the five tests that we have updated a bit. It is clear that within the eurozone there has been an increase in trade between the eurozone countries but that has not led to a drop in trade levels with non-eurozone countries. There is some evidence that eurozone economies have started to enjoy an increase in trade between themselves, which is what optimal currency theory will tell you should happen. It has not been at the expense of the UK or other non-euro countries as far as we can see and it is still quite a small effect. We have to wait for a number of years to see how big it is. I would not put the euro down as an issue, I think the small changes in the global economy are much more marked.

  Kerry McCarthy: Can I turn to the US current account deficit and throw a few quotes back at you. When you gave evidence to the Committee in December 2004 you referred to the fact that the trade deficit was over 5% and you said: "all of the received wisdom has been that when you get over 5% it has to be corrected". In March of last year you said that you thought the US current account deficit heading past 5% of GDP was a concern. With the deficit now heading past 6% and the dollar strengthening, what do you say today?

  Chairman: How apoplectic are you?

  Kerry McCarthy: Have you become more concerned?

  Q141  Chairman: Take your time.

  Mr Cunliffe: It is still a risk. We note it as a risk and I think most economic commentators would say, and I mentioned before even Alan Greenspan says, this will have to correct at some point. The US current account deficit cannot grow to 100% of US GDP. The stock of foreign owned assets in the US is growing and I think it is now something like a third of GDP but I will have to check that. It cannot carry on, it does have to correct at some point but the risk is it corrects abruptly rather than smoothly. Why has it gone on much longer than the IMF and others forecast? Again, looking at past relationships, there is a structural change in the world economy. I think global savings are much freer now to move around and to go to where returns are higher, so the rest of the world is prepared to finance the US current account deficit. It is easier to finance it than it was. I think we understand it a little better. There was a very interesting examination in the last IMF World Economic Outlook which suggested that some of the problems are on the investment side but because there is a shortage of investment opportunities in Asia and in Europe, and this comes back to some extent to companies not investing as much as they would, there are more global savings around and those global savings go to the US. So it is being driven not by the US consumer borrowing to consume and the US Government borrowing, but it is being driven by a surplus of savings. It is very odd that China is exporting capital to the US where theory hitherto would say that capital should move to emerging market economies, not the other way round. That is not to say that investment in China is not very high, it is just not as high as savings. I think what has happened over the last two years probably makes me a little less apoplectic or a little less concerned because it does seem to me there are a number of forces at work here and the global economy seems to be dealing with the strain, but it will have to adjust and the key is that it adjusts by savings adjusting the US, by investment opportunities in Europe and in other places increasing and by a more balanced economic growth and not by some more abrupt currency adjustment. If I may make just one other quick point. It has been complicated over the last two years by the oil market. I know that every answer seems to come back to oil but I think for the Gulf States their oil revenues have gone up by something like 200% over the past five years. Saudi Arabia is now running a current account surplus of 20% of GDP. The current account surpluses of the oil producing countries are larger than those of Asia, so we had an issue with emerging Asia building up current account surpluses, exporting into the US and then lending the money back to the US, if you like, which was driving this, and now it is complicated by very large surpluses building up in the oil producers, particularly in the Gulf, and that is what it has kicked it up above 6%. I am still concerned but I do not know when it will correct and how.

  Q142  Kerry McCarthy: How well-placed is the UK to benefit from the increased demand from oil producing countries?

  Mr Cunliffe: It depends what they invest their money in. I was in Saudi Arabia a couple of weeks ago and they were talking about investing in education, in health and social services. Those are areas where we can play a part, particularly in education. Some of the new investment, I hope, will go into oil and creating new oil production capacity where the UK, with its North Sea oil industry, should be quite well placed to cope. Some of the monies being spent are on capital goods, on investment goods, and there Germany has had an advantage on things like luxury cars and the like in which other countries have more of an advantage than we do. I think we are relatively well placed. The big question is how much of it are they going to spend. The first thing the Saudis have done is to pay off debt and they have tried not to spend the oil windfall completely and not to recycle it back quickly. I would have thought if it is high tech exports, if it is knowledge based exports and services, if it is oil exploration, we should do quite well.

  Q143  Chairman: So you do not subscribe to the benign view of some economists that in terms of savings problems it is not much of a problem because there are already willing savers in China and Asia to buy the dollar and solve the tax problem?

  Mr Cunliffe: I do not know. The fact that this has continued longer than people thought it would, on the one hand, would make you more worried but, on the other hand, the world does seem to be able to adjust to it. My main judgment, I guess, is that it does have to adjust at some point. I think we have got longer for it to adjust than perhaps we thought but, nonetheless, it could adjust messily or cleanly.

  Q144  Mr Fallon: Can we turn now to your forecasting record. I think you have admitted this week that you were wildly wrong on the growth forecast, but turning to public finances your record is now pretty consistently shocking, is it not? The Chief Economic Adviser told us at PBR 2000: "our assumptions are cautious so that should always mean the outturns are better than our projections". In each of the five years since he said that, the difference between outturn and forecast for both current receipts and surplus on current Budgets has been wrong negatively. You told us at the time of Budget 2000: "All of the public finance projections are cautious", so how is it that over five years you have said all of your projections are cautious yet they have always turned out to be over-optimistic? Would you elucidate?

  Mr Cunliffe: If I start with your opening point that it should be easier to forecast the public finances in the economy; it is actually more difficult. You only have to look at the standard errors of forecasters generally between economic forecasting and forecasting public finances to see that. The reason is quite simple: in order to forecast the public finances you need to plug in your economic forecast, which is open to error, and then you have to do fiscal forecasting and a number of other forecasts on top of that, so the public finance forecast, if you like, is the coming together of a number of forecasts and that is why generally you find that whoever is doing it their error rates are higher. The point I made at the Budget hearing in March was if you looked at our fiscal forecasting record since the new framework was introduced, which has two phases of the cycle, an upswing and a downswing, you would find in terms of its absolute error, which is how far was it off one year ahead from the outcome, not whether it was off by being over-forecasting or under-forecasting, its absolute error was better than before the new framework was introduced. If you look at the degree of caution which says if you sum the times we over-forecast borrowing and the times we under-forecast borrowing, it is more cautious as well, considerably so. If you look at us against the US Congressional budget office—

  Q145  Mr Fallon: Let us stick to your forecasting. You have been wrong five years in a row. You could excuse being wrong once but you have been consistently over-optimistic in each of the last five years, both on current receipts and on surplus on the Budget. Why?

  Mr Cunliffe: I think what I am saying is fiscal forecasting needs to be looked at against the record of fiscal forecasters. The numbers I just pointed to suggest that no fiscal forecaster is right all the time, most fiscal forecasters do not come out with an outturn that is like the Budget. If you look at our record, the only way to judge us is to benchmark us against others and if you benchmark us against others we are better than most countries in the European Union, we are better than the IMF, we are better than the OECD and we are better than the position that applied before the new framework was introduced. The other point I would make, and the OECD brought this out when they looked at cyclically adjusted forecasts, is that there is a tendency for forecast errors to be correlated with the economic cycle, so when you have a positive output gap there is a tendency for forecast errors to be one way and when you have a negative output gap there is a tendency for forecast errors to be the other way. That is why it is quite important that you look at this over a whole cycle. I do not think I would accept that our forecasting record is worse than our peers.

  Q146  Mr Fallon: It has been wrong for the last five years, perhaps that is another reason why you are extending the cycle, so you can finally get it right. Let us go on to why you are moving the cycle. We had the first fiddle going back two years adding two years on at the beginning and now we have got a new fiddle adding three years on at the end. That will make meeting the golden rule easier through the new cycle, will it not?

  Mr Cunliffe: I will have to think about whether it has any impact on the new cycle. Because we are now forecasting the cycle ends two years out and after that the economy is on trend, I do not think there is a strong issue about the new cycle because now we are showing—

  Q147  Mr Fallon: Does it help the Chancellor or hinder the Chancellor in meeting the rule over the next cycle?

  Mr Cunliffe: I think we were showing we could meet the rule over the next cycle in the Budget when we were still estimating the end date of the cycle in 2005-06.

  Q148  Mr Fallon: Does it help him? Does it make it easier?

  Mr Cunliffe: I do not think it makes much difference actually. We are showing roughly ¾% of GDP surplus by three years into the new cycle and I do not that is very different from what we were showing—

  Q149  Mr Fallon: You may be interested to know that the advisers this morning advised us that it would help him.

  Mr Cunliffe: Over the next cycle I do not think there is a very big material effect.

  Q150  Mr Fallon: Do you not think it is time that we had the assumptions surrounding the cycle properly and independently audited, or at least set? We took evidence this morning that showed us how the cycle is a fairly arbitrary concept, but it is your concept that the rule is based on. Is there not a case, because there are arguments on fiddling it at either end, for getting this thing set independently by somebody else, either the National Audit Office or the Bank of England, somebody authoritative, to stop you doing these fiddles?

  Mr Cunliffe: The dating of the cycle has been done for 1997 and for 1999, when we thought that was on trend point, and 2001 in a transparent way. We set out what we have done and why and we have had it audited by the National Audit Office. Your point about is there a case for having main assumptions on the cycle audited, yes, and we do. The National Audit Office have audited the change in the date of the cycle, they will audit the date of the next cycle, they audit our trend rate assumption which is the key assumption that conditions fiscal policy and they audit the main assumptions that go into fiscal forecasting. Yes, these assumptions should be audited. The end date of the cycle is transparent and has been audited. The Comptroller and Auditor General has come to the conclusion that there are reasonable grounds for the change we made. We put out an awful lot of information on this and, as far as I can see, it is transparent and audited. Should someone else do it is a rather different question. I think the point I would make there is this is very analogous to the Bank of England. When we gave the Bank of England responsibility for operational independence on monetary policy, we gave them the whole process. We gave them the forecasting process and we gave them the interesting rate setting process. We did not say, "We will have the NAO or PricewaterhouseCoopers do the economic forecast and you, the Bank of England, will do the monetary policy". That is because the two things are very closely intertwined and you need to understand how you put the forecast together to understand what policy action you take. You do not want to be in a position where the Bank of England, using that example, comes back and says, "We did not get monetary policy wrong, we took the right interest rate decisions, it was the economic forecast and the forecast of the cycle that somebody else did that was wrong". If you apply that to fiscal policy, I think it is very important that all the stages of the process, which are interdependent, stay with the same authority and that one authority remains accountable. The answer is not that you contract out different parts of the process, the answer is you make transparent what you do, which I think we do, and you audit it, which we have done.

  Q151  Mr Fallon: Just for clarity, you did ask the NAO to audit the change to the end of the cycle as well as the change to the start, did you?

  Mr Cunliffe: We asked them to audit the end of the last cycle, which is the start point.

  Q152  Mr Fallon: The end of the last cycle?

  Mr Cunliffe: We have said that when we get to the end of this cycle we will ask them to audit our judgment, and they will.

  Q153  Mr Todd: I want to cover a related topic to the one that has just been touched on, which is the underspend on investment expenditure where that happens every year, and I think even longer than the mis-forecasts in other respects. Can you throw any light on the consistent performance there that public investment expenditure is always predicted as being rather greater than it actually turns out to be?

  Ms Brivati: I want to say something about that, if I may. It is the case that we see underspend on public sector investment year after year. However, it is discernible also that the extent of the underspend has been smaller over the last years, particularly since there was a large increase in public investment around 2000-01 and a very large underspend following that, and we have seen an increasing convergence between planned investment and actual investment. The underspend is still there but it is getting smaller and we believe that means departments are getting better at actually spending and realising their investment plans.

  Q154  Mr Todd: What steps have you taken to make them more accurate? You were saying that it is becoming more accurate, you were implying almost by a natural process, but are there any approaches you are taking to monitor more accurately what they are doing through a year and also to identify best practice?

  Ms Brivati: It is not entirely a question of getting forecasts right, it may be the right and best value for money decision on the part of any given department to delay expenditure from one year to another. Of course, our system of end-year flexibility applies to capital spending as well as current spending and permits any capital budget that is unspent to be carried over into future years. The reason behind the underspend for any given department in any give year may be complex. What we are doing, and what is set out in the PBR document, in the Comprehensive Spending Review, which we will report on in summer 2007, is we are undertaking a review of capital spending, a zero-based review, with the objective of maximising the impact of capital spending and we would expect in the course of that to review the behaviour of departments' capital spending, planning and our monitoring of it.

  Q155  Mr Todd: To be honest, it is not that unusual a problem. Most large organisations, and this is the largest I have dealt with, have got this problem as well, people will consistently project that they will be able to do more within a particular year in capital expenditure terms than they turn out to do. I would have expected by now a greater degree of accuracy to be imposed either by just making assumptions that there will be a failure to deliver or by looking at the methodologies for control that seem to work better.

  Ms Brivati: It is not an unusual problem and the reasons for that are well documented. Capital spending is very lumpy and, as you say, we are dealing with very large amounts of it and it is even lumpier than small amounts. A lot of it is to do with uncertainties over a precise time of capital spend on different projects.

  Q156  Mr Todd: On 2004-05 compared with 2005-06, you are expecting an acceleration in the second half of this year that was not reflected in the previous year. Is there a reason for that?

  Mr Ramsden: What we have found looking at in year trends in spending from one year to the next is that the profile of spending through the year can change. In the data up to October that was published in mid-November before PBR, so that was the data set we had to go on, public spending was running below what had been set out in the plans for 2005-06 in the first seven months of the year growth rate. That reflects the fact that the actual amounts of spending are not as high as in the plans but also the fact that last year the profile in that earlier part of the year was higher, so the growth rate is depressed. We are expecting our full year percentage growth rate for DEL spending to be as in the plans, but then on top of that there are changes going on in AME. What that all comes back to is saying there might be some pick-up in spending by the end of the year but that would be entirely consistent with plans and entirely consistent with our new set of end-year forecasts. It is just in the data.

  Mr Cunliffe: I think last year was unusual because spending grew more quickly at the beginning of the year than the normal profile. I remember at the time that was one of the issues: was spending growing too fast and would it reach its end-year total. It did reach its total. This year the profile seems to be more back loading and, of course, as Dave has said, last year had a higher base so it shows up more.

  Q157  Mr Todd: Ms Brivati mentioned end-year flexibility and the ability to transfer expenditure between years. Are you comfortable with the disciplines within departments on how that is used because in theory, at least, that could widen? It is very welcome in terms of preventing people wasting money on end-year projects to simply get it out of the way but it will also be impossible to catch people out if those all move forward at the same time with a large surge of expenditure which might not be predicted. How do you manage that process?

  Ms Brivati: We do monitor departments' ability to use end-year flexibility. We do that for two sorts of reasons. One is because departments are under an obligation to present realistic estimates to Parliament and obviously end-year flexibility is part of that. The other is that we would clearly wish to be alert to a situation where a department had a large EYF stock—end-year flexibility stock—and at the same time perhaps wish to suggest that we did a reserve claim for some other form of expenditure. Clearly we need to take into account the overall financial position that any department is in. There is an ongoing dialogue between trade you spend in teams and departments on the financial situation and the EYF stock, the departments' desire to draw it down as part of that dialogue.

  Q158  Mr Todd: Do you audit what has led to that EYF stock? In other words, why has this been carried forward and what is it?

  Ms Brivati: I cannot give you the detail department by department but it is usually evident to any spending team how EYF is building up where it is building up.

  Q159  Mr Todd: It can come from a variety of sources. There may be some genuine savings, for example, which people may wish to transfer forward and use for other purposes; there may be projects which have been slow to get off the ground, all sorts of reasons.

  Ms Brivati: It arises for a variety of reasons, as you say.

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