The Office for Budget Responsibility makes its first report

Today marks something of a change for the public finances of the United Kingdom. Up until now incumbent governments have not only set out their economic policy but Her Majesty’s Treasury which of course is under their control and influence is responsible for publishing economic forecasts going forward. There has been a clear moral hazard here as there is always the temptation to over-estimate such things as economic growth and understate more unfavourable numbers such as the balance of payments deficit. So the establishment of  an Office for Budget Responsibility to be in charge of economic forecasts should have the impact of improving the credibility of official forecasts although it will depend on who gets the job going forward. as if you look at the Monetary Policy Committee it has been criticised on the grounds that later appointees to it were influenced by the incumbent government. In my opinion Sir Alan Budd looks a solid and decent choice to be the interim chairman. Before I move on to examine its prospective role I would just like to update a statistic I have been following, the Dow Jones Industrial Average closed up around 35 points on Friday so it is now 23 out of the last 30 days it has had a triple-digit move on a closing basis.

What will the Office for Budget Responsibility do?

The Office for Budget Responsibility (OBR) will make independent assessments of the public finances and the economy. It will have direct control over the forecast and make all the key judgments that drive the official projections. It will have full access to the necessary data and analysis produced by the Treasury.

The OBR will also present a range of outcomes around its forecasts to demonstrate the degree of uncertainty. Based on these range of outcomes, in each Budget and Pre-Budget Report the OBR will confirm whether the Government’s policy is consistent with a better than 50 per cent chance of achieving the forward-looking fiscal mandate set by the Chancellor.

The OBR will also have a role in making an independent assessment of the public sector balance sheet, including analysing the costs of ageing, public service pensions and Private Finance Initiative contracts.

So the definition seems solid and I particularly approve of the fact that the costs of aging and public service pensions will need to be taken into account. I realise that I am bound to have readers who are hoping to retire and benefit from a public service pension so I wish to make it clear that what I want is the true costs of these schemes to be independently established. It is not the fault of those who will receive such pensions but the fact is that the vast majority of public sector pensions in the UK are completely unfunded and thus an unspecified liability. It is also true that particularly at current levels of interest and annuity rates such pensions are extremely expensive. If you do not believe me then simply look at the private-sector equivalents or final salary pensions. These have to be funded and many employers have ended them simply because they are too expensive to fund. Also I will be pleased to see an independent body look at the Private Finance Initiative. There have been lots of issues with it and as a Londoner it has been quite apparent that there has been for example to say the least issues with its use on the London Underground tube system.

What would I like from this body?

Firstly the hope is that the new OBR will have the effect of improving the credibility of government forecasts and accordingly by improving credibility help UK government debt. To do this it will need to do the following.

1. Publish clear forecasts and for the first one give a detailed explanation of the differences between it and the forecasts made at the time of the Budget (March 2010).

2. Publish its forecasts as to the link between public finances and economic growth. 

3. It would be helpful to see how much fiscal tightening was planned by the previous government as it was rather vague on this subject. After all we need to know where we are starting from.

4. It needs to declare what it feels the impact of fiscal tightening will be on UK economic growth. This is perhaps the first friction line between the OBR and the government which established it.

5. Those who are aware of my view on economics statistics  will be waiting for the next point. The OBR should publish with its numbers either “confidence intervals” or some other measure of variability and make it clearly understandable unlike the fan charts used by the Bank of England.

6. A worrying trend has come into UK economic thought. This is called the structural fiscal deficit. In theory it is easy to construct but in practice just like the “output gap” theory which has so bedevilled the Bank of England in its monetary policy it is a much more tenuous concept. I would go so far as to say that in practical terms it is virtually meaningless and impossible to measure. I have noticed the growth of its use with some alarm. To my mind economic statistics are simply not accurate enough for this purpose. So I hope that the OBR will de-emphasise such a measure.

What can we expect today?

Firstly we can expect a reduction in growth forecasts going forwards. I have written before on the subject of these simply being too optimistic. If you think about it a good forecast is one where a positive surprise is as likely as a negative one. Uk growth exceeding 3% does not have much chance of a positive surprise if you look at our track record! I will be waiting to see the impact of this which may not be much for this year as it we have had some improving numbers to offset it but by 2014 and 2015 it may have a significant impact on the numbers.

Some seem to think that such changes might affect investors. If so they must be rather stupid investors if you think about it. The fact that our growth forecasts have been over-optimistic have been apparent and well publicised for some time. Reality will be unchanged today, what we will see (hopefully) is the removal of some political spin. If the removal of political spin unsettles investors then we do have more problems than I thought!

Conclusion

I hope that this new body will take some or even all of the politics out of official economic forecasting in the UK. If you look internationally and see what happened on a change of government in Greece this is outright a good thing. If Greece had possessed such a body her previous government would not have been able to damage her finances so badly and conceal this. It is starting to look if something similar has happened in Bulgaria.

However this is not quite as much a sea-change as the establishment of an independent (it was then…) Monetary Policy Committee in 1997 to set UK interest rates. For the United States Congress has a well-respected independent body (the General Accounting Office) for establishing economic forecasts and sadly it has not prevented considerable deterioration in her public finances.

Also the real challenge for the OBR will come in 4/5 years time when this government (assuming it survives…) will be wanting to put a positive spin on its own record and such a desire will clash with the forecasts of the hopefully still independent OBR.Whether the current administration will have such conflict between its Chancellor and its Prime Minister that the Chancellor manipulates the numbers to prevent a pre-election spending spree I do not know. But if such rumours are true then as the years go by history may reflect more kindly on Alastair Darling than his predecessor.

I will be updating this article as news arrives from the OBR today.

The Report– some initial thoughts

Were our previous figures sustainable and credible?

According to the OBR they were. If you reduce this to a football terrace chant,are you Greece (or Bulgaria or New Jersey) in disguise? The OBR thinks not.

However my eyes did alight on its comments on the Private Finance Initiative.

The total estimated unitary charges payable under PFI for 2010-11 are £7.8 billion.the end of 2009-10, the capital cost of signed PFI projects was approximately £56 billion, of which approximately £13 billion (23 per cent) is on-balance sheet and counted within departmental budgets. contracts are on-balance sheet, they will affect published figures for public borrowing and debt, and therefore a simple analysis of fiscal sustainability. But, as the discussion above indicates, off-balance sheet PFI contracts represent a commitment to future spending and are therefore also relevant to sustainability

The remaining £43 billion (77 per cent) is not.To the extent that PFI contracts are on-balance sheet, they will affect published figures for public borrowing and debt, and therefore a simple analysis of fiscal sustainability. But, as the discussion above indicates, off-balance sheet PFI contracts represent a commitment to future spending and are therefore also relevant to sustainability.

So there is an issue over £43 billion of debt which to my mind should be included preferably immediately in our national debt figures. So the OBR has done us a service by identifying the numbers, a better service would be to have included them in the national debt figures.

Economic Growth

Our forecasts going forwards have been reduced from the 3 to 3.25% previously assumed to 2.6% next year followed by 2.8%,2.8% and 2.6% in the succeeding years. So an improvement if only a small one.

Forecasts for Fiscal Deficits and National Debt

Rather than increasing ( as you might expect from the lower growth figures) these if anything are similar to lower than previous expected. From this fiscal year when we expect to borrow some £155 billion our fiscal deficit is expected to be. £127 billion,£106 billion,£85 billion and £71 billion.  These compare with the March Budget figures which went £163 billion, £131 billion……£74 billion. To quote the report.

Our central forecast is for PSNB in 2010-11 to be £8 billion lower than in the March Budget since some of the underlying strength in the tax base in March and April is likely to 

continue into next year.By 2014-15 PSNB is forecast to be £3 billion lower than in the March Budget.

The first question will be how have they done this? Well officially they tell us that they expect much of the increase in tax receipts seen in 2009/10 to continue and the impact of this depresses the numbers to offset the reduced growth forecasts.

the relative strength in receipts seen since the Budget. We assume that a portion of this is a temporary windfall which will be reversed in 2010-11. The remainder could represent greater underlying strength in the receipts base than assumed at the March Budget, and so raises expected receipts through the forecast

And since the Budget there has been less public expenditure than forecast of around £4 billion, which is something they also assume will continue. These are clear-cut if debateable but there are two issues with these numbers which illustrate the dangers of this sort of analysis and its weaknesses.

Gilt Yields

Regular readers will be aware that I feel that we are currently in an incredibly fortuitous position with regard to yields on our government bonds or gilts. Currently our ten-year gilt yields are around 3.5%. Not only is this historically very low but countries in a not dissimilar situation to ourselves (think of the favourites for the world cup) have seen theirs move from below ours to 1% point over. Now look at what the OBR has assumed.

Gilt rates are also assumed to move in line with market expectations. Rates used in this forecast are the average for the ten working days ending 25 May 2010

In other words we are using (what I feel are very favourable) current gilt yields in these numbers. In case you are wondering what impact changes in them would have the OBR has calculated an estimate.

The approximate ready-reckoner effect on net borrowing of a 1 percentage point rise in gilt rates throughout the forecast period would be around £8 billion in 2014-15 through higher debt interest spending. 

I will return to this figure another day as on first sight it looks much too low to me ( I think that they must mean £8 billion a year at the end of the period).

Oil Prices

Again oil prices for the future are assumed to be what the market expectations of them are now. Anybody who ever looks at oil prices knows that prices several years forward are very rarely what they are expected to be! However in this instance it is hard to know what else they could do.

Conclusion

With the caveats highlighted above this should improve the transparency and credibilty of UK public finances. I particularly welcome the way that the Public Finance Initiative has been highlighted and hope that it is not long before it is fully put on balance sheet where it belongs.

Just to be clear these numbers do not include the £6 billion of cuts announced for this year by the new UK government, or any other changes promised by them so far in their Coalition Agreement. If you believe their rhetoric then the new government will  want a number significantly lower than a  structural deficit of 2.8% of GDP by 2014-15. So even though there are bigger fans of applying the theory of structural deficits to an often inconvenient reality, in this instance it is likely to do little harm and may even be helpful.

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15 thoughts on “The Office for Budget Responsibility makes its first report

  1. Inflation expectation is an important component of government spending plans.If the OBR truly answers to no-man I would expect to them look critically at the MPC’s statements and actions.

    • Hi Andy
      They have taken the easy way out in this area.
      “CPI inflation stays above 3 per cent in the near term, before easing and falling back
      below target in 2011, after the VAT rate change drops out of the annual
      comparison. CPI inflation then rises, reaching the 2 per cent target by the end of
      2012.”
      As to whether they would ever challenge the MPC it is an interesting idea I agree…. Also the idea of the impact VAT rate changes may well need some revision after the June 22nd Budget.

  2. Hi,
    I can see that there are a few economic theories governing our future now – output gap plus structural deficit. How have the OBR calculated the minus 4% capacity loss and the revised trend growth.What are the key assumptions and where does the £200bn QE boost appear in the growth estimates.

  3. I would be happier with the OBR if it were some kind of independent trust financed by a non government, non political body (if such exists). The problem with a quango is that its funds come straight from government. Independence of thought tends to be in inverse proportion to the pressure under which the government of the day finds itself. Do you think the OBR will go the way of the MPC when things get tough?

    • Hi Carys, I think the answer to your question is “Yes”. There are if you look carefully signs that it already has “gone the way of the MPC” in some of its statements. You probably asked the question because you had already noticed it?

  4. The IFS Green Budget 2010 talked of the economy being reduced by 7.5% as a result of the financial crisis with a downside of 10% with lower projections of trend growth. Are we to compare this stat with the OBR’s 4%.Seems a big divergence..

    • Not quite I think as they are not the same concept. The IFS is talking of an output loss for the economy of between 7.5% and 10% whereas the OBR is talking of an output gap and has therefore implicitly implied that around 3.5% of output has been lost for good. As a theoretical exercise it can be useful to consider an output gap but in practice the concept has performed poorly as a policy tool in the UK in the credit crunch as it is almost impossible to measure with any accuracy…

      In essence it is a guess. I notice that you asked earlier about trend growth to which I give the same answer it is a useful theoretical tool but when you come to the practicalities however complicated your maths and powerful your computer it is only as good as the assumptions you have used aka a guess albeit hopefully an educated one!

    • Hi Robert
      It is not such a daft question at all. Economists like to surround the deficit with a lot of theoretical constructs but however you define it there are only 3 routes out.
      1. Economic growth
      2. Raise taxes
      3. Cut public spending.

      The structural deficit is that part of the deficit which is considered to be impervious to the economic cycle. The OBR measured it today at 8.8% of our GDP. It sounds nicely accurate doesn’t it? But it is not a bad definition of spurious accuracy and inspite of its popularity currently is not far off a dead end in my view. If I was of a more cynical disposition than I am I might feel that it is popular amongst politicians because it is smaller than the actual deficit…

      • Thanks for the explanation. So what gets paid off first, the budget deficit or the structural? And if it’s the budget (which is what I think I’m interpreting from all the economic commentators), at what point in time is the structural paid off?
        Thanks again.

        • No problem
          The stuctural deficit is simply a name for part of the budget deficit. Politicians and some economists will say that it is the structural deficit which is paid off first but in reality it makes little difference…

  5. Hi,

    i’ve read various articles on the web regarding this. In terms of borrowing, some commentators have said that anticipated borrowing is down ‘slightly’, others have said it is £32bn lower than Darling predicted before the election. Please can you explain what the OBR report is telling us with regards to borrowing for this parliament?

    Thanks

    mike

    • Hi Mike and welcome
      I wrote on my update today the reasons for the numbers overall ending up lower than they were in the March Budget forecasts, inspite of the OBR lowering the economic growth forecast (which on its own would raise them)..
      So for the fiscal years going forwards the OBR expects us to borrow, £155 billion, £127 billion, £106 billion, £85 billion and £71 billion respectively. Whereas the Treasury’s March numbers were £163 billion, £131 billion, £110 billion, £89 billion and £74 billion respectively. That is a total difference of £23 billion should this Parliament go the maximum 5 years. However I wouldn’t get too hung up on the numbers for later years as there are things which can change for this year let alone further out….

  6. In my view it doesn’t scream that the figures were “cooked” by the previous government. Technicians in this field, acting honestly, will take a different set of assumptions and arrive at a different set of conclusions. In many cases the range of those forecasts will be within reasonable parameters. That seems to have happened here. I’m left shrugging my shoulders.

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