Economy may never recover from banking crisis, warns OBR

Monday, June 14, 2010
By Paul Martin

Francis Elliott, Gráinne Gilmore
June 15, 2010

The economy, more damaged by the banking crisis than previously admitted, will grow more weakly and may never fully recover, the new Office for Budget Responsibility (OBR) said yesterday.

The conclusion adds billions of pounds to the total that George Osborne must find if he is to restore the public finances to health.

Public sector workers were warned yesterday that taxpayers could no longer afford their “unreformed, gold-plated pension pots” as the Lib-Con coalition Government used the first OBR forecasts to step up efforts to prepare voters for next week’s Budget.

Growth is forecast at 2.6 per cent next year and 2.8 per cent in 2012, far below Alistair Darling’s predictions for 3.25 and 3.5 per cent respectively. This leaves Britain’s structural deficit — which is impervious to the economic cycle — bigger than feared over the next five years. It will hit 8.8 per cent of GDP, or £123.7 billion this year, compared with Mr Darling’s forecast of 8.4 per cent of GDP. By 2014-15 it will have fallen only to 2.8 per cent of GDP, the budget office said, rather than the 2.5 per cent anticipated by Labour.

Mr Osborne warned MPs that the figures made more urgent the task of “cleaning up the mess” in the Budget.

The Chancellor will outline a week today how much he intends to raise in new taxes and spending cuts over the next five years. The coalition is committed to “significantly accelerate the reduction of structural deficit”. Treasury sources indicated that Mr Osborne was determined to set an ambitious target despite the higher-than-expected total.

Experts calculate that the OBR’s forecasts mean that he must find £85 billion if he is to balance the books by the end of the Parliament — the commitment he made in January. The Chancellor is likely to want to “spread the pain” between welfare cuts, deeper-than-planned reductions to spending and new tax rises, the Institute for Fiscal Studies said yesterday.

Aides insisted that Mr Osborne remained committed to raising about 80 per cent of the cash through spending cuts and the rest in tax. But with the structural deficit increasing by about £12 billion this year against previous estimates, there was speculation that a further £2.4 billion would be needed from new taxes.

Nick Clegg became the latest senior figure to prepare the ground with a warning on the need for reform of public sector pay and pensions. “Private sector workers have already seen final salary schemes close, while returns from defined contribution schemes fall. So can we really ask them to keep paying their taxes into unreformed, gold-plated public sector pension pots? It’s not just unfair, it’s not affordable,” the Deputy Prime Minister said.

The task of convincing voters was made harder by the OBR’s finding that the Government would have to borrow £23 billion less than feared. Higher tax receipts and less cautious predictions on unemployment and VAT payments helped to trim the projections. The budget office said that the Government would borrow £155 billion — or 10.5 per cent of GDP — this year, down from Mr Darling’s forecast for borrowing of £163 billion, or 11.1 per cent of GDP. But by 2014, it expects borrowing to be £71 billion, down from Mr Darling’s prediction of £74 billion.

That led the former Chancellor to demand an apology from David Cameron for his remarks that Labour had left the country’s finances in a “worse state than we had thought”. The OBR report “far from providing the cover for the Conservatives and Liberal Democrats for cuts and tax rises next week” was a reminder that “growth is still fragile”, Mr Darling said. “Confidence is being affected by the scaremongering that we see from the Prime Minister and the Chancellor,” he added.

Mr Osborne said that Sir Alan Budd’s OBR panel had “understated” the deterioration in the nation’s finances and that borrowing was less bad than feared, in part because interest rates had fallen as markets became convinced that the deficit would be properly addressed by the coalition.

Economists warned that the Budget was likely to be tough. Howard Archer, the chief UK and European economist at IHS Global Insight, said that policymakers were preparing taxpayers for “the nasty medicine that the UK economy has to take for a long time”.

But the budget office said that the financial crisis had taken a bigger toll on the economy than the Treasury had admitted, calculating that the economy’s trend rate of growth — the growth that it can achieve before stoking inflation — would be 2.1 per cent in 2014, down from the previous assumption of 2.75 per cent. This is expected to drag total economic output down by £122 billion by 2014-15, making the hole left by the financial crisis about £30 billion bigger than Mr Darling estimated.

The OBR forecasts included official data never before released. Spending on public sector pensions is due to more than double over the Parliament, from £4 billion this year to about £9.4 billion in 2014-15.

Social security is expected to climb by more than £20 billion, from £169 billion this year to £192 billion in 2014-15, and the cost of servicing the country’s debt is due to rise from £42 billion to £67 billion in four years, — slightly under the £70 billion of which Mr Cameron gave warning. Britain’s EU contribution will rise from £8 billion this year to £10 billion a year by 2015.


So, more economists and more opinions. How will that help?
The idea is that the Office for Budget Responsibility (OBR) will give much more credible forecasts for growth and government finances than the Treasury. There will be “less politically motivated wishful thinking”, the Institute for Fiscal Studies said. The OBR will impose hard discipline on the Chancellor by setting the basic framework upon which he builds his tax and spending plans. It may also provide the material to shield governments from public attack when they have to make unpopular financial decisions.

Will the OBR forecasts be any more accurate than Darling’s?
Probably not. Sir Alan Budd, OBR chairman, emphasised the fallibility of the new organisation, only promising: “Our best shot at an impossible task.” Uncertainties in the real world usually make a mockery of the most careful predictions. But ministers have to start somewhere when making policy.

Don’t the IMF, OECD and City banks already supply outside forecasts?
Yes, but the OBR’s forecasts will be used by the Government to shape policy. The new body will also have a potential weapon — it will be able to cast doubt publicly on government policy. One job of the OBR will be to regularly issue a formal opinion on whether the Chancellor has a better than even chance of meeting his own fiscal mandate. However, the mandate has yet to be spelt out.

Who’s calling the shots at the OBR?
There is a three-man team. Sir Alan Budd served as an economic adviser to the Treasury between 1970 and 1974, returning in 1991 as chief economic adviser until 1997 when he became a founder member of the Bank of England’s interest rate-setting committee. His lieutenants are Geoffrey Dicks, a former economist at Royal Bank of Scotland, and Graham Parker, a retired veteran from the Inland Revenue and Treasury.

What does yesterday’s report say?
That the OBR thinks the British economy will grow more slowly than Labour predicted and that the deficit will be cleared a bit more quickly.

But if the economy is more sluggish, won’t public finances be worse?
Normally, yes. But Sir Alan has made less conservative assumptions than the old Treasury team. He believes the Treasury was too pessimistic about evasion and collection of VAT. This alone means the taxman will over five years collect £10 billion more than predicted, he says.

A bit convenient, isn’t it?
The old Treasury team built prudent cushions into their assumptions. Sir Alan believes his central forecast should reflect the most likely outcome. His figures are also due to projecting the better-than-expected income tax receipts of the past two months into the future — he says only a minor portion of this unexpected windfall was due to people bringing forward income to dodge the higher tax rates.

How did it play in Westminster?
Labour seized on the improvement to the public accounts compared with three months ago. The coalition pointed to the much slower economic growth predictions and to Sir Alan’s view that the structural deficit — the underlying shortfall which won’t be corrected by a return to growth — is worse. George Osborne, the Chancellor, still has enough ammunition to justify some harsh austerity measures next week.

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