Select Committee on Treasury Written Evidence


Memorandum submitted by Mr Ben Broadbent, Goldman Sachs

UK PRE BUDGET REPORT 2005

MAIN POINTS

  The Treasury has had a good track record in forecasting, but the downgrade to current-year projections for GDP growth is much higher than the average forecast error. High oil prices are unlikely to be the main explanation.

  The Treasury says demand is close to 1.5% below potential this year (2005-06), in which case the public sector current budget, on a cyclically adjusted basis, is almost in balance. But most estimates of the output gap are significantly smaller. We think the cyclically-adjusted current balance is around -0.75% of GDP.

  This is not a very big number and, looking into the medium term, there is no great problem with public borrowing from an underlying economic point of view. But, after several years of very strong growth in public spending, there is little room for manoeuvre if the fiscal rules are to be met.

1.  ECONOMIC GROWTH

    —  As expected, the Chancellor has downgraded his economic growth forecasts for 2005 (Table 1). Forecast errors are inevitable and, over the years, the Treasury has had a good track record. But the latest downgrade is abnormally large (1.5%, compared with an average error of 0.5%). Nor can higher oil prices be the only, or even the main, explanation. Oil prices are around $15 per barrel higher than assumed at Budget time but, on standard estimates, an increase of this magnitude reduces UK GDP by 0.5% over a two-year period, or 0.25% a year. Notably, the Treasury's Budget forecasts of economic growth in other countries have held up much better. Excluding the UK, the Treasury predicted in the Budget that the other countries in the G7 would grow by just under 2.5% this year; the out-turn is likely to be around 2.7%. This suggests weak growth in the UK has more to do with UK-specific factors than with higher oil prices.

    —  The Treasury's projections for the next two years are closer to those of other forecasters than at the time of the Budget. For 2006, the Treasury forecasts GDP growth of 2%-2.5%, compared with central projections of 2.5% from the MPC, 2.4% from Goldman Sachs, and an average of 2.2% for all private-sector economists. Projected growth in 2007 is a little higher than our own forecasts (3.0% versus 2.7%), but marginally lower than the MPC's central projection in the latest Inflation Report (3.2%).

    —  The Treasury's estimates of the "output gap" may be more contentious. The Treasury has maintained its estimates of both the start-point of the current economic cycle (1997-98) and the rate of potential output growth since then. As a result, the dip in aggregate demand growth this year has resulted in a sharp widening, on official estimates, of the degree of spare capacity in the economy. The Treasury says that, in 2005-06, aggregate demand is 1.4% below potential output, compared with 0.5% last year and a projection in the Budget of just 0.1%. As a result, and given another year of slightly below-trend growth in 2006-07, the Treasury now says the current economic cycle will not end until 2008-09, three years later than projected in the Budget.

    —  The risk, however, is that the output gap has not widened by as much as the Treasury claims and, therefore, that the medium-term prospects for growth are not as favourable. In common with the MPC, we suspect (i) that recent demand growth may have been under-recorded in official ONS estimates, and (ii) that supply growth may have been affected by rising energy prices. So although we think the Treasury's redating of the start of the economic cycle is reasonable, we also believe potential output has not grown as strongly since. In particular, it is hard to see how potential output can be that much higher than actual output when unemployment is already below 5%. Our estimate of the current (2005-06) output gap is -0.5%, as is the OECD's. In the PBR, the Treasury concedes that "when the cyclical indicators used for the dating of on-trend points have previously been around current levels, the output gap has typically been somewhat narrower than currently estimated."

2.  THE PUBLIC FINANCES

    —  If official estimates of GDP growth are to be believed, and especially if the output gap has widened by as much as the Treasury claims, the public finances have held up remarkably well this year (Table 2). Historically, a fall of 0.9% in the output gap would increase government borrowing by around 0.4% of GDP, in the first year. In fact, the current deficit has fallen, by 0.8% of GDP. So, on the Treasury's estimates, the cyclically-adjusted deficit has declined by a total of 1.2% of GDP, to just 0.1%. Part of this reflects a strong rise in household income taxes, something that has probably contributed to the weakness of private consumption growth over the past year.

    —  We are less optimistic than the Treasury about the degree of slack in the economy, and no more optimistic about demand growth over the next couple of years. So we do not expect the current budget to improve as rapidly as in the PBR. The Treasury says the current budget will move into balance in 2007-08 (from a deficit of 0.9% of GDP in the current year); on our central projections, balance is reached only in 2008-09. This implies that, over the entire cycle (which now runs from 1997-98 to 2008-09) the fiscal rules are met with a margin to spare on the Treasury's forecasts, but narrowly missed on ours.

    —  But it is hard to describe the projected overshoot as being of great economic significance. On our forecasts, current borrowing will have averaged only £1 billion a year over that period. Within an economy worth £1,200 billion, and a global capital market worth much more, this is a very small number.

Table 1

ECONOMIC GROWTH


%yoy
2005
2006
2007

HMT (Budget 2005)
3-3.5
2.5-3
3-3.5
HMT (PBR 2005)
1.75
2-2.5
2.75-3.25
GS1
1.7
2.4
2.7
MPS 1, 2
1.7
2.5
3.2
Consensus
1.7
2.2

1 Central forecast.
2 November Inflation Report, assuming unchaged interest rates


Table 2

SUMMARY OF PUBLIC SECTOR FINANCE


2005-06
2006-07
2007-08
£ billion
GS
HMT1
HMT2
GS
HMT1
HMT2
GS
HMT1
HMT2

Economic Assumptions

Real GDP (%)
2.5
3
1.75
2.75
2.5
2.25
3
2.25
3
Output Gap (%)
-0.5
-0.1
-1.4
-0.4
0.0
-1.5
-0.3
0.0
-0.7
Surplus on Current Budget

£ billion
-12.3
-6.0
-10.6
-8.1
1.0
-4.0
-2.5
4.0
0.0
% of GDP
-1.0
-0.5
-0.9
-0.6
0.1
-0.3
-0.2
0.3
0.0
% of GDP (cyclically adj)
-0.7
-0.3
-0.1
-0.3
0.1
0.7
0.0
0.3
0.7
Net Borrowing

Public Sector Net Borrowing

£ billion
37.5
31.9
37
36.5
29.0
34
32.6
27.0
31
% of GDP
3.1
2.6
3
2.8
2.2
2.6
2.4
1.9
2.3
% of GDP (cyclically adj)
2.8
2.4
2.2
2.5
2.2
1.6
2.2
2.0
1.6

1 Budget 2005
2 PBR 2005
  
6 December 2005








 
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