OBR’s fiscal warnings can be ignored…for now - Capital Economics
UK Economics

OBR’s fiscal warnings can be ignored…for now

UK Economics Update
Written by Ruth Gregory

The Office for Budget Responsibility (OBR) today sent a clear message to the government that regardless of the speed of the recovery, the government debt to GDP ratio is on an unsustainable path. Even so, we suspect that soaring debt levels will be dealt with later and more gradually than many expect.

 

  • The Office for Budget Responsibility (OBR) today sent a clear message to the government that regardless of the speed of the recovery, the government debt to GDP ratio is on an unsustainable path. Even so, we suspect that soaring debt levels will be dealt with later and more gradually than many expect.
  • The OBR’s “Fiscal Sustainability Report” sets out three alternative scenarios for the economy (“upside”, “central” and “downside”). In the upside scenario, the OBR assumes that activity recovers its pre-virus level by Q1 2021, the unemployment rate peaks at 10% in Q3 and that long-term scarring is avoided. In the central scenario, the pre-virus peak is recovered by the end of 2022, the unemployment rate rises to 12% by Q4 2020 and long-term scarring effects reduce output in the medium term by 3%. In the downside scenario, output only returns to the pre-virus peak by Q3 2024, the unemployment rate surges to 13% in Q1 2021 and scarring effects reduce output by 6%. Both the OBR’s central and downside scenarios are more pessimistic than our own forecasts. (See Chart 1.)
  • Based on the combined effect of the changes to its economic forecasts and the ever-growing number of policy measures, the OBR has been forced to raise its “central” borrowing forecast for 2020/21 yet again, by £23.5bn from £298.5bn (15.2% of GDP) in May to £322bn (16.4% of GDP). Public sector net debt is projected to reach 104.1% of GDP in 2020/21, up from the OBR’s May projection of 95.8%. And based on the medium-term starting points implied by the three scenarios, Chart 2 shows what the OBR expects to happen to the debt-to-GDP ratio over the next 50 years. Even in the upside scenario, the debt ratio ratchets upwards to over 300%. In the downside scenario, the debt ratio surges to 500%.
  • As a result, the OBR is sending a clear message that whatever the performance of the economy, the government debt ratio is on an unsustainable trajectory and that at some point “there will be a need to raise tax revenues and/or reduce spending (as a share of national income)”. If anything, public sector borrowing and debt could be even higher than these scenarios suggest. The projections do not account for the £62.9bn of spending (up to £30bn of measures plus £32.9bn of public services funding) announced on 8th July. (See here.) In our forecasts, we expect the deficit to rise to £360bn (17.7% of GDP) in 2020/21. And these projections do not include any further policy support in the next phase of the government’s response to the crisis in the Autumn Budget and Spending Review.
  • Of course, the UK is not alone. If other countries were to publish their own 50-year fiscal projections, then the UK might prove to be in the middle of the pack. It would probably be worse off compared with the US, which has higher rates of potential output, but better off than many European countries, which suffer from weak potential growth rates and worse demographics.
  • And now is not the time to worry about how to pay for all this. Our feeling is that even by the Budget and Spending Review in November/December, the Chancellor will still be focusing on more, rather than less stimulus. And when the government does turn to sorting out the fiscal situation, with interest rates very low, the strategy of eroding debt gradually remains an option. We suspect that the government will try to reduce the debt to GDP ratio mainly by increasing GDP (the denominator) rather than using austerity to reduce debt (the numerator). So while the soaring levels of debt will need to be dealt with, putting the fiscal books back in order may be a task for the decades, rather than the years, ahead.

Chart 1: Real GDP (Q4 2019 = 100)

Chart 2: Public Sector Net Debt (% of GDP)

Sources: OBR, Capital Economics

Sources: OBR, Capital Economics, BoE


Ruth Gregory, Senior UK Economist, +44 7747 466 451, ruth.gregory@capitaleconomics.com