George Osborne’s autumn statement on November 29th will necessitate an extremely challenging and important judgement call. The Bank of England, along with virtually all other serious economic forecasters, has downgraded Britain’s 2011 and 2012 growth forecasts. Alongside the autumn statement, the Office for Budget Responsibility (OBR) will publish its latest assessment of the government’s fiscal plans, and in particular its view as to whether, on current spending and tax plans, the Chancellor will meet his “fiscal mandate” for eliminating the structural deficit in the government’s budget.
In the 2010 Emergency Budget, the Chancellor set himself the target of eliminating what is called the “structural current deficit” (i.e. the part of the deficit associated with non-capital spending that will still be there when the economy has recovered ground temporarily lost as a consequence of the recession) by 2015/6. His Emergency Budget, and the subsequent detailed spending cuts and tax rises announced in October 2010, actually allowed him to meet that target early, in 2014/5.
Moving decisively on deficit reduction, before bond markets had panicked, has bought the British government’s fiscal stance considerable credibility with international investors. One consequence is that the British government is currently able to borrow at only fractionally above the price paid by the German government, well below the price paid by the French, and many percentage points below the prices paid by the Spanish and Italians.
Credibility is not, however, the only reason British government bond yields are low. The other reason is that the ten-year outlook for UK growth is dire. In its previous statements, the OBR has estimated the sustainable long-term growth rate for the UK as being about 2.35 per cent per year at present, falling to 2.1 per cent by the end of the Parliament. British government bond yields suggest that markets believe the UK’s sustainable growth rate is only around 1 per cent or perhaps even lower.
This difference is crucial to Osborne, because the value for the sustainable growth rate feeds into the OBR’s estimate of how much of the deficit is structural, and how much is temporary — the lower the sustainable growth rate, the slower the economy can grow over the medium term, and so the less rapidly tax receipts will grow naturally, and so the more of the current deficit is structural, rather than temporary. If the OBR were to say the sustainable growth rate of the economy is only 1 per cent, not 2.1-2.35 per cent, then it would have to tell us that Osborne’s plan would leave him with more than £20bn of structural deficit left by the end of the Parliament, roughly equivalent to his needing to raise income tax by 4p, or cut the education budget by a quarter.
The OBR will not downgrade growth by that much. But it might take the numbers down to perhaps 1.7 per cent. That could still leave Osborne of order £10bn short. And of course that is not making allowance for the risk of Eurozone meltdown creating another significant recession / depression in the UK.
The upshot is that, on current numbers, Osborne has no realistic chance of eliminating the structural current deficit by 2015/6 — his original commitment. So what should he do instead?
There are those that say that, if one reads the fine print of the 2010 Emergency Budget closely enough, the government wasn’t actually committed to eliminating the structural current deficit by 2015/6. Rather, the Emergency Budget stated:
“The fiscal mandate applies to the end of the five-year forecast period, set at this Budget as 2015-16. In the future, when the forecast period moves forward a year, the deficit target will continue to apply in the final year, so anchoring the Government’s medium-term fiscal stance.”
So, these folk say, since we are no in autumn 2011 the target end date has rolled forwards one year, and now only needs to be met by 2016/7 not 2015/6. That being so, Osborne’s might still meet his target “by the skin of his teeth”.
I regard this as one of the stupidest proposals I’ve ever encountered. If the government chooses to go down this route, everyone will say that Osborne’s Treasury shares all the worst smoke-and-mirrors deception traits of Gordon Brown. They will say, quite rightly, that the deficit elimination mandate is a sham.
Here is a “deficit elimination” plan totally compatible with this ridiculous proposal. We began with around £100bn in structural deficit. So what we’ll do is to announce £100bn in permanent tax rises, to commence next year, and a “mandate” that there should be no structural deficit forecast for five years ahead on a rolling five-year ahead basis. Then as next year begins, we’ll announce £100bn in one-off one-year tax cuts, to apply just this year. But of course the five-year-ahead target is still intact – now a year later. The year after, we’ll announce a different set of £100bn in one-off one-year tax cuts. And every year we’ll announce a different set of £100bn in one-off tax cuts. So the structural deficit will always be £100bn, but the mandate will always be satisfied, because on this nonsensical interpretation of a rolling five-year programme for eliminating the structural deficit, it is never required that the structural deficit ever actually be eliminated!!
Garbage. Do people think bond markets are totally stupid? If Osborne chooses this route, then the government’s fiscal credibility will be chucked away, in a moment of madness. A rolling five-year mandate requires that the target be met every year from the original fifth year out. The target has to be met in 2015/6, and in 2016/7, and in 2018/9 and so on.
What, then, can he do? He could announce £10bn of additional tax rises and spending cuts. I don’t recommend this, either, yet. First, he’ll struggle to get Lib Dem backbencher consent for more tax rises or spending cuts. They think that the plan is the specific cuts already agreed to, not some abstract commitment to eliminate some conceptual deficit measure. Second, I wouldn’t support it myself at this stage, because in my view uncertainty concerning how the Eurozone crisis will be resolved is so great that UK policy needs to react to events, rather than seeking to pre-empt them. More specifically, the scale of further cuts required if there is a meltdown in the Eurozone will be vastly greater than that required if there is not. Given that the Eurozone crisis is likely to be resolved one way or another within the next six months, what is the point in announcing cuts for five years ahead until we know what those next six months will bring?
Alternatively, he could just say that he’s going to miss. It’s not inconceivable he could get away with the honesty of that, in the international environment. And quite a lot could happen between now and five years’ time. Even if bond markets dislike it, he might still win the ugly contest and Britain’s safe haven status could survive. But I personally wouldn’t recommend this (though it’s a zillion times better than the nonsense five-year-rolling-mandate-still-met proposal).
My recommendation is to neither concede that the target will be missed, nor announce a plan for meeting it, nor claim that the target actually only applies from 2016/7. Rather, what we need is some excuse for masterful inaction until matters are clearer in the Eurozone. My plan for masterful inaction has two key elements: creating the possibility of extra growth; and making a vague commitment to do what is necessary on spending cuts and tax rises, without spelling out what that would be.
There are four ways we could adjust the plan to get rid of more structural deficit:
- inflation could be higher
- growth could be higher
- spending cuts could be greater
- tax rises could be greater
There probably will be more inflation, but let’s set that aside, having noted it. Some of the work can be done by the government’s publishing, alongside the autumn statement, a plan for raising the sustainable growth rate of the economy. There are some clear elements in this. The government could argue, more robustly than it has so far done, that cutting spending will raise the sustainable growth rate. (One gets about 1-1.5% additional annual growth for each 10% of GDP reduction in public spending / tax.) The government could raise public sector productivity, by introducing more market methods to public services. (If public sector productivity had grown at the same rate as private sector productivity from 1997-2007, (true) annual GDP growth would have been about 0.5% higher.) The government could argue that some of its finance sector reforms will raise the sustainable long-term growth rate of the economy. (If they won’t do that, it’s hard to see what merit they could have.) The government could argue that some of its education reforms will raise long-term labour productivity growth.
All in all, I believe a package delivering perhaps 0.3% to the sustainable growth rate by 2015/6 should be eminently credible and achievable. The OBR would not have to accept such an add-on to what would otherwise be a 1.7% rate. But it ought to grant the possibility that the government’s reforms might work, so quoting a range of 1.7-2%. At the top end of the range, this could be just enough to be compatible with Osborne’s 2015/6 mandate.
Then Osborne can say something like: “The OBR indicates that, if our growth plan is as successful as we hope, our fiscal mandate can be met. I am not complacent on this point — growth plans do not always succeed. And so I make the commitment to review progress on the growth plan by the 2012 autumn statement. If, at that stage, the long-term growth of the economy does not seem certain to be raised as much as we hope and believe to be achievable, I undertake to announce additional spending cuts and tax rises so as to meet the 2015/6 target. It is not appropriate to set out any details of such hypothetical rises at this stage, except to note that it would be my intention for there to be an 80:20 ratio of additional spending cuts to additional tax rises, should such be required.”
Such a plan — focused on generating additional growth, accepting the commitment to stick to the target announced, not committing to any additional spending cuts or tax rises at this stage, but committing to the principle of an 80:20 ratio of spending cuts to tax rises if they should eventually be required — would, I believe, be both politically deliverable and acceptable to financial markets. And certainly much better than pretending the target won’t be missed by rolling it forward for a year.