Mr Carney, your adopted country needs you! That, it seems, is the main message from the Chancellor of the Exchequer’s Autumn Statement.
If George Osborne’s fiscal plans are ever to add up, he will need all the help he can get from the Bank on the other side of London. The chancellor of the exchequer’s austerity measures in themselves will do little, if anything, to support growth yet he desperately needs growth to make his fiscal numbers add up.
Thankfully, according to the Office for Budget Responsibility (OBR), the UK still has plenty of spare capacity. The output gap – the difference between actual and “potential” levels of gross domestic product – will increase to 3.5 per cent in 2013 and, even with an assumed recovery in economic growth in later years, will still stand at a whopping 1.9 per cent in 2017.
From the chancellor’s point of view, these projections are more than a little handy. He can claim that, despite a still-uncomfortable headline fiscal position, the cyclically-adjusted path is not so bad. Indeed, within the Autumn Statement, the cyclically-adjusted deficit magically disappears by 2016-17.
Chancellors of the exchequer typically assume an air of omniscience unbecoming in mere mortals. By doing so, they can assume their fiscal problems away. It was a strategy pursued with some considerable success by Gordon Brown before things went rather horribly wrong. Mr Osborne is in danger of following the same well-trodden path.
He can claim his forecasts come from the independent OBR, of course, but his fiscal numbers only make sense if the UK economy eventually bounces back. He’s used that approach for a number of years now. Unfortunately, it’s not working.
To see why, consider the forecast errors made by the OBR since its first foray into the predictions business in the middle of 2010. Back then, it projected growth of 2.3 per cent in 2011 followed by gains of 2.8 per cent, 2.9 per cent and 2.7 per cent over the following three years. By 2015, it thought output would be only 0.9 per cent below potential. Thanks to these gains and, alongside them, a dose of austerity, the cyclically-adjusted balance on the current budget was supposed to be in surplus to the tune of 0.3 per cent of GDP by 2014-15.
We now know, of course, that these projections were hopelessly optimistic. Over the last two years there has been hardly any growth. The OBR is now a little less gung-ho about the future. Yet, despite this new-found caution, and despite a much bigger than expected level of public sector net borrowing in future years, the Chancellor still has no difficulty meeting his medium term target for the cyclically-adjusted current surplus. True, the surplus turns up two years later than originally planned but, nevertheless, it’s still there. Yet we have an economy that has gone from bad to worse.
Mr Osborne is able to generate a surplus only because the OBR assumes that the continued growth shortfall is mostly cyclical in nature: near term losses will be offset by longer-term gains. Yet while the output gap charade works perfectly well as a device to keep Mr Osborne’s cyclically-adjusted deficit on track, it totally fails to deal with what is fast becoming a relentless increase in government debt as a share of GDP.
Imagine that the OBR’s forecasts over the next two or three years prove to be as excessively optimistic as they have been in the recent past. Under those circumstances, the debt to GDP ratio would be heading through 90 per cent of GDP, 20 percentage points above the estimates provided in 2010. Borrowing would also be significantly higher. The only way to make the numbers “add up” would be to assume – again – that all the weakness was cyclical. The OBR would have to claim that the output gap was getting bigger in each and every year.
This is where Mr Carney comes in. Mr Osborne has been at pains to emphasise that plan A is still intact. He is promising continued austerity, at least for those at the top and bottom ends of the income scale, even if the middle isn’t being squeezed quite so much. Yet he also desperately needs growth. If fiscal policy can’t do the trick, he’ll have to rely on monetary policy instead.
That, at least, is the theory. In practice, however, it hasn’t been quite so easy. The OBR’s relative optimism in 2010 was conditioned on the idea that quantitative easing would work reasonably well. So far, however, despite a near-doubling of QE since then, the results have been disappointing. The hoped-for recovery hasn’t materialised. Moreover, some in the Bank of England now fretting about the emergence of “zombie” companies and banks are wondering whether QE is all it’s cracked up to be. Others, meanwhile, might be wondering whether QE is merely a device to allow the government to miss its fiscal targets without having to face the prospect of higher yields thanks to a perceived increase in credit risk.
Underneath all this is a much more serious problem. It may simply be that our supposedly cyclical problems are, in fact, structural in nature. The credit system isn’t working well. Productivity is in decline. We export too much to the stagnant eurozone and not enough to more dynamic parts of the world. Despite all the austerity, the public sector still absorbs a huge chunk of GDP.
If so, despite his undoubted skills, Mr Carney will struggle to fix Mr Osborne’s problems. Indeed, if he disagrees with the OBR’s assessment of the output gap, Mr Carney may be wise to deny he has the necessary magical powers.