Tuesday, 15 June 2010

Fake independence of the 'Office for Budget Responsibility'

by Michael Burke

The appointment of Professor Alan Budd to head the new Office for Budget Responsibility (OBR) is something of an old-boys’ reunion. Both he and David Cameron were advising Norman Lamont and at his side when Sterling was bundled out of the European Exchange Rate Mechanism in 1992. This is a sharp reminder of both the Thatcherite credentials of the new government, as well as its lack of economic competence.

As has been pointed out elsewhere, the idea that this is a politically independent body is belied by the fact that Budd has been performing this role for over a year for the Conservative Party and helped to formulate its attacks on the Labour government. Now he and his officials will be paid for by taxpayers, rather than by the Conservative party, where the expense properly lies. The outcome had been predetermined, with David Cameron having previously announced that the fiscal situation is much worse than the previous government admitted.

'Independent' Forecasts

The OBR’s remit is supposedly to formulate an ‘independent’ forecast for growth and for government finances. However, it will simply be using the Treasury’s existing econometric model of the British economy. This is already the case for Chancellors, who then decide which estimate of growth to use within a range produced by the Treasury. Given its political formation it is wholly unsurprising that Budd’s team has arrived at significantly lower growth forecasts than those contained in the last Budget. GDP growth is expected now to be just 1.3% this year, and an average 2.7% over the 4 following years, barely deviating from that central point. Clearly, the ConDem coalition hopes that all future governments will be similarly hamstrung in formulating taxation and spending policy by a Thatcherite body posing as an independent authority.

Statistically, the OBR projection is one of the least likely scenarios, given both the volatility of GDP growth and the existence of the business cycle. It is characteristic of the failings of the Treasury model itself, which often correctly summarises the relationship between different sectors of the economy – but is incapable of anticipating their dynamic. This is highlighted in the chart below, taken from the Institute for Fiscal Studies. The broken green lines are the Treasury’s forecasts of public borrowing as a percentage of GDP, while the uninterrupted black line is the actual level of that borrowing.

Chart 1

10 06 15 OBR Chart 1

Budd was chief economic adviser to the Treasury in the period 1991-97. As the chart shows, with few exceptions the entire period was characterised by errors of understanding of the path of government borrowing. This is not about the failings of one man, although in others it might induce a greater degree of humility regarding forecasting ability than is currently on display. Instead, the failings of that period were repeatedly made before and subsequently. In effect, the Treasury model which is constantly updated and is being used now by the OBR, fails to capture the cyclical movements in the economy almost entirely. In effect, it is dominated by the idea that economies always return to ‘equilibrium’ in the short-term because of the ingenious workings of the market. So, the green lines assume equilibrium or a return to equilibrium, when much larger, long-term economic trends are at work.

Structural Deficits

The one exception orthodox economics makes to this article of faith in equilibrium is when it repeatedly discovers a ‘structural deficit’ in government finances. This is supposed to be an estimate of the underlying deficit, once the immediate effects of the deficit are removed. It is also known in the jargon as the ‘cyclically-adjusted budget balance’, which simply means the budget balance once the effects of the business cycle are discounted. For some reason in dominant economic thinking, the structural deficit alone is not corrected by the alchemy of the markets, but always requires swingeing cuts in government spending.

Budd & Co. have 'discovered' exceptionally high levels for the structural deficits, even while their own forecasts for the both the total deficit and borrowing are lower than in Alistair Darling’s last Budget. These lower forecasts arise because taxes have improved owing to the modest rebound in economic activity to date, partly spurred on by increased government spending in the 2009 Budget, as SEB has repeatedly highlighted. (It is also shameful that Darling deliberately understated this improvement by £7bn, which could have been used to stimulate the economy further and which might have changed the election outcome to Labour’s benefit ).

The table below is taken from the OBR’s Pre-Budget Report. The key data are contained in the bottom two rows, which show their estimates of the cyclically adjusted deficit and borrowing. The latter is significantly higher because of accumulating debt interest payments.

Table 1

10 06 15 OBR Table 1

It is this ‘structural deficit’ which George Osborne states it is his priority to tackle and which the OBR says is 5.3% of GDP this year, or £75bn. This is greater than the £60bn level of cuts already suggested- even taking into account some of the cuts already planned.

Rewriting the Past, Not Forecasting the Future

But the structural deficit is a fiction. We have already seen that it purports to be an objective assessment of an underlying deficit, in effect a measure of the gap between government spending and revenues with the effects of the business cycle removed. But no authoritative international or domestic body argued that Britain had a significant structural deficit prior to the Great Recession, although they all argue it now. But if it were truly structural it would surely have been visible before the recession, and not simply a function of it.

In the chart below we show two different sets of estimates and forecasts from the EU Commission for the ‘cyclically-adjusted budget balance’ as a proportion of GDP, as well as GDP itself. The EU Commission is a body whose economic outlook is dominated by neo-liberalism, aka Thatcherism. But, unlike some other neo-liberal supranational institutions, it is bold enough to publish its own forecasts and estimates in a regular cross-country format, which makes large-scale and timely comparisons relatively easy.

Chart 2

10 06 15 OBR Chart 2

There are two key points to note. The first is that, even though it is claimed that the estimates of the deficit are structural in nature, removing the effects of the business cycle, they are in fact closely correlated to the business cycle itself. The disastrous widening of the ‘structural deficit’ takes place in the midst of the recession and its aftermath. This is true of all countries surveyed by the EU, and insofar as is known, for all international bodies and their forecasts or estimates.

The second crucial fact is that there is some rewriting of history taking place. In the 2006 estimates and forecasts (the shorter, red line) the 2005 structural deficit was estimated to be 3.2% of GDP, yet by the time of the 2010 estimates this has inexplicably risen to 4.0% of GDP. The same applies to 2006, which rises from 2.7% of GDP in 2006 to 3.5% of GDP in 2010, and so on. In scientific terms, this is known ‘fitting’ the data to the theory. It is dishonest. It is not because new evidence has come to light about tax revenues or spending in 2005, but in order to build a case for a bloated ‘structural deficit’ in 2010 and 2011, and of course a policy of cuts to public spending to rectify it.

For Britain’s neo-liberals, the Thatcherites who are back in charge, it is easy to understand why a falsification of history is important. It simultaneously absolves them of their role in previous economic debacles and sets up the ideological mechanisms for a repeat performance. This is a farcical repetition of economic policymaking- but with dire consequences.

As the Financial Times's economics has suggested, identifying either the ‘structural deficit’, or estimating the impact of changes to government spending are intensely political acts, and can also be an iterative process, one that is returned to time and again because, ‘ if cutting public spending reduces growth, which in turn cuts tax revenues, borrowing still falls short of the chancellor’s fiscal goals and this requires further cuts in public spending etc.’

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