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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