Autumn forecast 2010 - Treasury Contents


Written evidence submitted by Policy Exchange

Further to your invitation to Policy Exchange, dated 30 November 2010, to offer evidence to the Treasury Select Committee inquiry into the OBR's Autumn Forecast, here is our submission.

Last April, we published The Cost of Inaction, whose subtitle was "Why cutting spending will boost recovery, even in the short term". The Office of Budget Responsibility's (OBR) recent fiscal outlook seems to bear us out. Contrary to many predictions of economic doom after the Spending Review, growth for this year has been revised upwards from 1.2% to 1.8%, though this is partly offset by slower growth early next year due to the rise in VAT. As a consequence of greater welfare savings, public sector employment will be reduced by 160,000 less than previously forecast. Since private sector employment will grow strongly - more than cancelling out these reductions - employment levels are expected to increase from next year - and 900,000 by 2015. Unemployment is forecast to begin falling in 2012 - and keep falling (though we are less sanguine about this). The Coalition is forecast to be comfortably on track to eliminate the current structural deficit by 2015 (and will probably have enough room for some "giveaways" in budgets before then) - and to have public sector debt falling as a percentage of GDP by that time.

Unlike the OBR, we continue to believe a (probably brief) period of slowdown or contraction is likely (as has happened after all UK recessions). Sovereign debt crises and/or gilts crisis in the Eurozone could be a catalyst and sluggish growth worldwide, in particular the US, would only serve to reinforce a slowdown in growth in the medium term. We also remain sceptical about a continuation of the relatively benign inflationary environment due to the difficulties of unwinding quantitative easing. Additional regulatory burdens floated for financial services could seriously damage the competitiveness of the City. Of course, as the OBR has admitted, all these forecasts have "considerable uncertainty" about them.

As stated in our previous submission to the Committee, we believe the key problem facing the UK economy is that households are heavily over-indebted, having gambled on rapid wage rises to service very high debts, particularly mortgage debt. If households do not achieve rapid wage growth, they are likely to begin defaulting on their mortgages, imposing large losses on the banking sector and leading to the failure of a number of banks. Because the UK government has (arguably ill-advisedly) chosen to stand behind the bonds and deposits of a large portion of the UK banking sector, failures of UK banks would lead to the UK sovereign's guarantees of the banking sector being called upon, threatening the sovereign's creditworthiness. This is the key threat to the UK's creditworthiness — failure in the banking sector — not, per se, the UK government deficit or the stock of UK government bonds. Of course, because the UK sovereign has been under threat in this way, it was very important for the sovereign not to add to its already-over-extended position by failing to reduce its annual borrowings, so it is good that the deficit is being reduced. But the key danger remains the banking sector. To enable households to service their debts, the UK's medium-term growth prospects needed to be restored. The Coalition's deficit reduction plan has restored this to an extent as can be seen in the OBR's forecasts for average earnings and growth. However we believe, though unlikely, there is a slight possibility that the UK could fall into Irish-style deflation, with widespread defaulting on mortgages as households gave up the attempt to service them, and the banking sector collapsing despite sovereign guarantees, dragging the British sovereign into the abyss shared by the Icelandic and Irish. Despite this, we believe the more likely scenario is high inflationary pressure with the RPI measure peaking at around 10%.

Thus, overall, we are in agreement with the OBR's stance the economic outlook in the medium term is sluggish, however we believe there could well be a further slowdown in the economy catalysed by the Eurozone crisis and sluggish growth in the US. There also remains the risk of a further (perhaps decisive) phase of banking crisis erupting at any time. Although there is a risk of a Irish-style deflationary crisis, the more likely outcome is high inflation in the medium term.

December 2010



 
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