Written evidence submitted by George Buckley,
Chief UK Economist, Deutsche Bank
THE ECONOMIC
FORECASTS
The OBR's latest forecasts for economic growth were
revised down slightly in the near-term, but looking further ahead
they remain more optimistic than most other forecasters (see chart
below). That's not to say that strong growth rebounds don't happen
- looking back over 200 years of data GDP tends to bounce by around
3% yoy on average in the two years following a recession.
How the OBR growth forecasts compare
As such, the OBR's near-term growth forecasts to
us look reasonable (the OBR describes the recovery as slow by
historical standards). However, we might question the OBR's strong
medium-term view. In particular, the robust recovery in investment
(due to replacement, the restarting of delayed projects and an
encouraging corporate financial position) may yet be threatened
by a still very uncertain global outlook (notably in the euro
area). On global growth, the OBR's forecasts are very similar
(slightly lower, in fact) to those of the IMF.
The OBR expressed uncertainty about the persistence
of the strong growth outturns in Q2 and Q3 2010. In this respect
it is worth noting that following the 1980s recession (which was
similar in duration and scale to the recent fall in output) the
recovery was very patchy indeed - we saw quarters of very strong
growth interspersed with quarters where there was no growth at
all. A similar volatile recovery might be in store this time round.
There are a number of key downside risks to
growth, in our opinion: i) the direct hit from fiscal consolidation,
ii) the possibility that credit availability takes time to recover,
iii) fallout from a broadening or deepening of the euro area banking/sovereign
crisis, iv) high public and private sector debt levels (research
by Reinhart & Rogoff suggests that higher public debt/GDP
ratios are associated with notably slower economic growth), and
v) and the need for further rebalancing in the financial and household
sectors (note the recent fall in the saving ratio and the possibility
of continued falls in house prices).
Key upside risks are: i) DB's "credit
impulse" research suggests we can see strong growth even
if de-leveraging continues (for this to happen de-leveraging just
needs to proceed more slowly), ii) the huge amount of stimulus
already injected into the UK economy (Bank Rate at historic lows,
quantitative easing worth 14% of GDP and a sharply weaker currency)
and iii) the better performance of employment than the fall in
GDP would have suggested.
The OBR considers two alternative growth scenarios.
"Delayed Rebalancing" assumes stronger consumption (among
other things) but to the extent that this could store up further
problems for the future, GDP growth could end up being weaker
looking ahead (the OBR assumes growth remains in line with the
base case). In the "Persistent Weak Demand" case the
OBR has cut baseline growth by 0.3pp to 0.5pp; still, from 2012
onwards growth is still stronger than consensus views.
Forecasts for the output gap appear reasonable, based
on a cautious view of potential growth. For example, between 2010
and 2012 the OBR forecasts an average gap of -3.2%. This is more
negative than the IMF (-2.3%) but less negative that that of the
OECD (-3.9%). Potential growth is assumed to be 2.35% (which is
roughly the long-run average rate of growth since the 1950s) falling
to 2.1% by 2014 on account of demographics.
The OBR sees total employment rising by over 1m by
2015, which implies job growth of 1% yoy from 2012 to 2015. That
is twice the long-run average rate of growth (0.5%) over the past
40 years. This might prove optimistic at a time of significant
public sector job losses (albeit fewer following the Spending
Review). Also, with firms having hoarded labour during the downturn
(causing sharp falls in productivity), the recovery phase might
equally see fewer jobs being created. That said, the OBR does
forecast a near-term rise in the unemployment rate.
An important risk relates to interest rates and inflation.
The OBR assumes that short-term interest rates follow the path
implied by the market, but if above-target inflation persists
then the Bank of England may not be able to keep rates as low
for as long as the market believes. Nonetheless, DB's view is
for only a gradual tightening in monetary policy from mid-2011.
THE PUBLIC
FINANCE FORECASTS
Based on the OBR's economic view, from a top-down
perspective the forecasts for the headline budget deficit (PSNB,
% of GDP) look appropriate (see chart below). If consensus expectations
for GDP growth were used then the deficit would of course be higher,
particularly in the final years of the forecast when the OBR's
GDP forecasts diverge the most from consensus.
The OBR made few changes to its overall deficit forecasts
in its latest forecast round. The deficit is still seen falling
to around 1% by the end of the forecast horizon, while the cyclically-adjusted
PSNB continues to fall from just under 9% currently to close to
zero by 2015-16.
So far this fiscal year (ie the seven months to October),
the PSNB has come in on average £1bn per month lower than
a year ago. If this pattern is repeated for the remaining five
months of 2010-11 then the deficit would be £133 billion
for the full year, £15 billion lower than the OBR's current
forecast of £148.5 billion. The central government cash deficit
too has shown signs of improvement. Alongside increased flows
into NS&I products this raises the risk that the Debt Management
Office (DMO) may end up over-funding the 2010-11 deficit. Given
the likelihood of i) a similarly large financing requirement in
2011-12, ii) a substantial amount of euro area funding expected
to come to the market in H1 2011, and iii) bond yields set to
rise as the economy continues to recover (note that the OBR estimates
1pp on gilt yields raises borrowing by £5 billion per year
by the end of the forecast horizon), an over-fund this year would
not necessarily be a bad thing.
What will the impact of the austerity programme be
on the economy? It is interesting to note that previous consolidations
in the (relatively) recent past have not been associated with
slow economic growth, as shown in the chart below. In the aftermath
of both the 1981 Budget and tightening during the course of much
of the 1990s economic growth averaged well above its long run
trend (in 1982-84 growth averaged close to 3%, and from 1994-99
it stood at close to 3.4%). That is not to say that fiscal consolidations
cause stronger growth via negative multipliers more than
offsetting the direct hit from tighter fiscal policy. Rather,
that in the aftermath of recession-induced fiscal blow-outs, other
policies tend to support economic growth during the period of
fiscal correction (this time, as last, monetary policy has been
significantly loosened while the exchange rate depreciated sharply).
This time round the focus of the consolidation has
been on spending cuts (with more limited tax increases) for a
number of reasons, including: i) research (by the IMF among others)
suggesting spending cuts are better for medium-term growth than
higher taxes, ii) government outlays as a portion of GDP are high,
having risen sharply from 36% in 2000 (in the lowest quartile
of OECD countries) to 53% now (in the highest quartile).
There remains an issue of how the spending cuts are
communicated to the public. I recently conducted a straw poll
of a group of economically informed individuals, almost all of
whom thought that total cash spending by the government
was to be cut over the next five years. In fact, based on the
government's plans, total managed expenditure in nominal terms
is forecast by the OBR to rise during every year of the
current parliament. Perhaps such expectations are negatively impacting
confidence.
Notwithstanding the OBR's generally optimistic forecasts
for growth and employment during the forecast horizon, we have
little reason to doubt the analysis of the OBR that the government
will achieve its new fiscal mandate - ie to achieve cyclically
adjusted current balance and falling net debt/GDP by 2015-16.
December 2010
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