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
|
|
