UK Office of Budget Responsibility

I have a semi-finished post on the Keynesians, but could not help but comment on the report from the Office of Budget Responsibility (OBR). The OBR seems to be a good idea but, as you will see, the OBR starts with assumptions and projections that are highly questionable. I will start with their preamble, which is as follows:

In the body of the report we describe certain departures from previous forecasting practice and we emphasise three in particular. The first is our stress on the uncertainty of the forecasts, particularly of the fiscal forecasts. We illustrate this principally by the use of fan charts. The second is that we have based the range of fiscal outcomes around our central view of prospects. The previous Government used deliberately cautious assumptions for some key variables in its fiscal projections. We have departed from that practice and, as we have said, have used other methods to illustrate uncertainty.

So far so promising....

We then move onto to their central forecast for economic growth, which shows the following GDP growth forecasts (for the purposes of this exercise, I will pretend that GDP is a meaningful metric, but you may wish to see my discussion of US GDP to see why it is a dangerous measure):

2011 - 2.6 %
2012 - 2.8%
2013 - 2.8%
2014 - 2.6%

It seems that, the UK is about to enter a period of relatively high growth. However, before we all become too excited, I thought it might be a good time to look at the 'economic growth' achieved during a massive credit bubble (chart from ONS).

Perhaps I am missing something, but it seems that, somehow.....the UK will achieve GDP growth rates that are close to those achieved during a massive credit fuelled bubble. It looks rather problematic, does it not? Where will the growth come from?

If we look at the forecast assumptions, it all starts to become somewhat dubious. First of all, there is that wonderful concept of the 'output gap'. What they do not explain is an output gap of what? The FT definition of the output gap is 'the difference between an economy's current output and the estimated maximum potential output (full capacity)'. This is how the OBR calculated the gap (see appendices of report for details):

1. the productivity gap accounts for around ½ percentage point, reflecting both the large fall in actual output per hour over the recession and a judgement that underlying trend productivity has been adversely affected by the financial crisis;
2. the fall in average hours in the recession implies an average hours gap of just over 1 per cent;
3. just over 2 percentage points is attributable to the employment rate being below its estimated trend level. This is broadly consistent with the degree of spare capacity implied by indicators of recruitment difficulties.

These are some almighty assumptions in there, and the report does not say a gap in output of 'what'? To their credit, they do acknowledge that this is a somewhat difficult metric to calculate, but nevertheless they do not explain what sectors have the 'output gap'. Whilst there might be a notional maximum output, it is not clear how this translates into future output. If we think of the 'growth' during the bubble period, as I identified in my essay 'A Funny View of Wealth', there was no increase in output of genuine wealth creation, just 'growth' associated with debt fuelled consumption.

If we think of the way in which the economy grew, to service debt fuelled consumption, this implies that the 'output' that is not being utilised is in these sectors. For example, where consumer spending has fallen, there will be underutilised capacity in the retail sector (e.g. empty commercial property). How can this output be returned towards its notional maximum? The only way that this output might move to its maximum, in the short to medium term, would be if there was another credit boom - a highly unlikely scenario. The point is that, the output gap assumes that there is capacity in the right sectors ready to expand towards maximum capacity, but what if the capacity is in the wrong sectors?

Even if looking at, for example, employment, are the unemployed in a position to rapidly transition from their experience in one sector into another sector. For example, if we look at the expansion of the government pay roll (estimated at about 1 million over the last ten years), if reducing that payroll, what kind of retraining would be needed to make these workers productive in other sectors of the economy? Equally, how easy is it to take a person who has worked in the service sector, for example a shop supervisor, and redeploy them into manufacturing? That person may have potential for 'output', but in what?

Then there is the macro-picture provided by the OBR. They have noted that the emerging economies are looking stronger than the US or Europe, and that Europe is the UK's main trading partner. I will quote their analysis in full, as it is actually very vague:

The forecast for UK export markets growth (a measure of world trade weighted to reflect the geographical pattern of UK exports) is weaker than that for world trade throughout the forecast period, particularly in 2010 and 2011. This reflects the relatively weaker outlook for advanced economies compared with emerging countries and, in particular, the UK’s main trading partner, the euro area. UK export markets are forecast to grow by 4 per cent in 2010, 4¾ per cent in 2011, and by close to 6½ per cent thereafter, in line with its long-run average.

If Europe continues its turbulent ride, with potential for yet further weakening of the European economic situation and weakening (or collapse) of the Euro, where this ongoing growth might come from is not specified. Is it going to be the US, Asia or where? They later suggest that, they have based their assumptions on survey evidence, but there is no clarity on the 'where to?' question. On this, the report offers no explanation, which suggests this is nothing more than an optimistic guess, based upon currency devaluation. Whilst agreeing that devaluation has potential to drive exports, how will this work in a world of a devaluing Euro? Our most significant trading partners are seeing their own devaluation, and they are also significant competitors in export markets. Is the devalued pound enought to pull the UK out of its problems, when the US is still in trouble, the EU is in trouble, and even China is now slowing.

Then we come to domestic demand, and I have to start with a quote from their report:

The central GDP forecast embodies a rebalancing between external and domestic sources of demand. Private sector demand contracted sharply in the recession, while government spending contributed positively to GDP growth. Although recent data suggest that private sector final demand has started to recover, we expect it to remain relatively weak in 2010. For this year it is government consumption and inventory accumulation that make the largest contribution to growth. Over the year as a whole, we expect GDP growth to remain subdued, with output rising by 1¼ per cent. On a quarterly basis, growth increases from 0.3 per cent in 2010Q1 to 0.6 per
cent in Q2 and holds in the 0.6-0.7 per cent range throughout 2010 and 2011

That's right, government debt fuelled consumption is a major contributor to GDP 'growth'. This is, yet again, debt fuelled consumption being measured as 'growth'. Sure, we can keep on borrowing more and more, and sure, that borrowing will (in the short term) create lots of activity. But it can not be sustained, as borrowing has to be finite. However, the picture becomes seriously muddy in the following paragraph:

GDP growth rises to 2½ per cent in 2011 and again to 2¾ per cent in 2012 as credit
conditions ease and uncertainty subsides. All components of private sector demand are expected to strengthen, while government expenditure detracts from growth. Private consumption growth is forecast to rise from ½ per cent in 2010, to rates slightly below its long-run average and below the rate of GDP growth. Investment remains weak in 2010, but then recovers strongly as the recovery in business and dwelling investment gathers pace. Investment is expected to grow by around 8 per cent from 2012. This, together with a relatively stable household saving ratio, means the private sector financial surplus eases slightly throughout the forecast, as the government deficit contracts.

The first point in the above is a grand assumption. Why will credit conditions ease and uncertainty subside - we do not know because it is simply given as an assertion. What follows is built upon this assertion. For example, dwelling investment means (presumably) a return to significant growth in the property market, meaning that (once again) the UK economy is going to be built upon residential property. But where will the money for growth in this sector originate from?

If you view their projections for employment, from 2010 - 2011, they are forecasting an increase in employment from from 28.8 million to 29 million, and thereafter increases by 300,000 per year. There is no substantive reason given for this increase in employment, except that presumably this will follow from GDP. However, although it is not absolutely clear in the report, presumably the increase in employment is calculated in the GDP growth. If so, we have a partially circular calculation.

With regards to the corporate sector, they are placing a considerable weight on business investment to drive GDP growth upwards. In a chart of GDP expenditure share, they show net trade as an ongoing negative, government spending in decline, consumer spending in decline (and argue that consumers will increase savings), and that business investment spending will be on the increase. As an explanation for why, they offer a chart that shows business investment in the recovery from the 1980s and 1990s, implying that business investment will plot the same course in this 'recovery'. There are two problems here; first they assume they are seeing a recovery (when the economy is still being propped up by government debt based spending), and secondly they are assuming that we are in the same world as the 1980s/90s.

With regards to the latter, the world in the 1980s and 1990s was not in the midst of a global crisis. Our next door neighbours in Europe, our main trading partners, were not on the brink of crisis. The world was a very, very different place. At that time, there were not the massive emerging economies creating a hyper-competitive environment. As such, why should a pattern of activity from a completely different set of circumstances apply now?

Whilst they present a case that consumer savings will present a growth in the funds available for investment, the question of 'invest in what?' is not addressed. One problem is that there is no certainty that such savings will be invested in the UK. Another is that, before a business invests, it must see opportunities for profitable investment, and it is not clear where these might be. By the OBR's own reckoning, export growth is going to be relatively small, presenting few opportunities for investment, and again we come to the question of the output gap. According to their arguments, presumably, there is considerable slack in capacity for exports, and this slack will need to be utilised before any further investment.

Then there is domestic demand as a potential driver of business investment. However, if consumers are moving from consumption to saving, then it is not clear that this sector would encourage business investment. In fact, quite the opposite will take place. The same goes for government expenditure, which will be reducing over the period of their forecast. Again, there will be no impetus for investment from this source.

We then come to housing. Is this going to be the source of business investment? If so, then it appears that we are destined to repeat history, and have an economy built upon residential property investment. This is, of course, an unsustainable investment path, and offers no long term route out of the problems that are apparent in the UK economy. The route for the UK to pull itself out of trouble must be the export of goods and services, the route to generating income with which to pay debts owed to creditor countries.

What we can see in this report is an assumption that the world is simply going to return to the pre-crisis economic system. The assumption that the UK will follow the same path out of the current economic problems as took place in previous decades says it all; nothing has really changed and the economic crisis is just a blip in the path of normality. The assumption that underpins this report is that everything will return to 'normal', despite the fact that the structure of the world economy has changed, and is in the process of further change. It is a naive and forlorn hope.

Whilst applauding the principle of the OBR, I can not help but return to the chart above which shows the GDP growth in the credit boom of the pre-crisis years. If, we are returning to such growth levels, there must be a new factor that explains where such growth might come from. On reading this report, I can only conclude that the OBR thinks this will happen, because it will just happen. The lack of acknowledgement of the structural problems in the UK economy, and the world economy, makes the report questionable. The UK economy, over a period of over ten years, has seen 'growth' being built upon credit (both government and private), and this has left the UK economy structured to accommodate this credit based consumption. A decline in the value of the pound is not going to see a magic restructuring of the economy in the way that they imply. At some point, the credit fuelled structure must go, and that must mean a period of painful transition.

Is it really possible that the UK economy will just return to 'normal'? I do not believe so. After all, normal was conumption of more than was produced.