Why good news for GDP isn't necessarily good news for the Chancellor

The output gap is a strange and unpredictable beast, writes Nida Broughton.

The Coalition came into Government in 2010 with a plan to repair the public finances and set itself a target to eliminate the structural deficit. The ONS today published figures showing that GDP in the second quarter of this year is even higher than we thought, rising by 0.7 per cent rather than 0.6 per cent. But it isn’t clear if this is good or bad news for the Chancellor’s deficit strategy, because the structural deficit – and therefore the billions of cuts that George Osborne is pencilling in – is determined by small changes in a very slippery measure of the state of the economy: the output gap.

The Government’s structural deficit target is carefully worded to take into account the fact that part of the deficit – the “cyclical” part – will automatically disappear as the economy recovers. From a theoretical point of view, this makes sense: there is little point on focusing efforts on areas of spending that are going to fall anyway. The non-cyclical, “structural” part of the deficit – the part that will remain even when the economy is back on track is surely the part to be concerned about. 

So since 2010, the Office for Budget Responsibility (OBR), whose remit is to report on Government’s performance against its fiscal targets, has set about trying to measure the “output gap” – a measure of how far the economy has to recover.  The output gap is the difference between actual GDP and “potential” GDP. Potential GDP is the level of GDP that the economy could achieve if it were operating at “full capacity”.

But it has become increasingly clear that in practice, the output gap is just too difficult to measure. The OBR’s twice-yearly reports always show a comparison of the OBR’s estimate of the output gap against those made by other forecasters – including banks and independent forecasting houses. This provides a useful sense-check of the OBR’s figures. 

The last OBR report in March, showed, as it always has done, the huge range that different forecasters have come up with in measuring the output gap – ranging from -7.3 per cent to -0.9 per cent for 2013. To put this into context, just a two percentage point difference in the output gap estimate is enough to change the forecast structural deficit in the Government’s target year of 2018 by around £28bn – no small amount when the Government is looking to cut around £33bn after the election.

Earlier this month, the Bank of England, searching for a way to measure the state of the economy as part of its Forward Guidance, decided against the output gap, saying that:

“The output gap is unobservable and difficult to explain, and any estimate would be subject to substantial uncertainty.”

Instead, it plumped for unemployment as a measure. And now even as the economy is showing some signs of life, independent forecasters still can’t agree among themselves on what the positive growth figures mean for the output gap, as shown in the chart below. Of those releasing estimates after July’s surprise good news on growth from the ONS, two thought this meant the economy was now closer to potential. One thought that it was now further away – presumably taking the good news on GDP to be a sign of underlying productivity improvements that mean that the economy’s potential has expanded. And two kept their output gap estimate unchanged. 

Chart: Forecasts of the output gap in 2013

HM Treasury, Forecasts for the UK economy: a comparison of independent forecasts, August 2013

The question has to be asked: how useful is a public spending target that depends on such an uncertain measure of the economy? Perhaps recognising this, or perhaps because it made for a better statistic, George Osborne omitted to mention the “structural deficit” at all in his last Spending Review speech in June, referring instead to the overall deficit. And even though the structural deficit – on OBR forecasts - is due to go into surplus by 2016-17, George Osborne’s planned cuts stretch out to 2018. So does the Chancellor himself still believe in the usefulness of his target?

The Chancellor. Photograph: Getty Images

Nida Broughton is Senior Economist at the Social Market Foundation.

Photo: Getty
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Theresa May could live to regret not putting Article 50 to a vote sooner

Today's Morning Call.

Theresa May will reveal her plan to Parliament, Downing Street has confirmed. They will seek to amend Labour's motion on Article 50 adding a note of support for the principle of triggering Article 50 by March 2017, in a bid to flush out the diehard Remainers.

Has the PM retreated under heavy fire or pulled off a clever gambit to take the wind out of Labour's sails while keeping her Brexit deal close to her chest? 

Well, as ever, you pays your money and you makes your choice. "May forced to reveal Brexit plan to head off Tory revolt" is the Guardian's splash. "PM caves in on plans for Brexit" is the i's take. "May goes into battle for Brexit" is the Telegraph's, while Ukip's Pravda aka the Express goes for "MPs to vote on EU exit today".

Who's right? Well, it's a bit of both. That the government has only conceded to reveal "a plan" might mean further banalities on a par with the PM's one-liner yesterday that she was seeking a "red white and blue Brexit" ie a special British deal. And they've been aided by a rare error by Labour's new star signing Keir Starmer. Hindsight is 20:20, but if he'd demanded a full-blown white paper the government would be in a trickier spot now. 

But make no mistake: the PM didn't want to be here. It's worth noting that if she had submitted Article 50 to a parliamentary vote at the start of the parliamentary year, when Labour's frontbench was still cobbled together from scotch-tape and Paul Flynn and the only opposition MP seemed to be Nicky Morgan, she'd have passed it by now - or, better still for the Tory party, she'd be in possession of a perfect excuse to reestablish the Conservative majority in the House of Lords. May's caution made her PM while her more reckless colleagues detonated - but she may have cause to regret her caution over the coming months and years.

PANNICK! AT THE SUPREME COURT

David Pannick, Gina Miller's barrister, has told the Supreme Court that it would be "quite extraordinary" if the government's case were upheld, as it would mean ministers could use prerogative powers to reduce a swathe of rights without parliamentary appeal. The case hinges on the question of whether or not triggering Article 50 represents a loss of rights, something only the legislature can do.  Jane Croft has the details in the FT 

SOMETHING OF A GAMBLE

Ministers are contemplating doing a deal with Nicola Sturgeon that would allow her to hold a second independence referendum, but only after Brexit is completed, Lindsay McIntosh reports in the Times. The right to hold a referendum is a reserved power. 

A BURKISH MOVE

Angela Merkel told a cheering crowd at the CDU conference that, where possible, the full-face veil should be banned in Germany. Although the remarks are being widely reported in the British press as a "U-Turn", Merkel has previously said the face veil is incompatible with integration and has called from them to be banned "where possible". In a boost for the Chancellor, Merkel was re-elected as party chairman with 89.5 per cent of the vote. Stefan Wagstyl has the story in the FT.

SOMEWHERE A CLOCK IS TICKING

Michael Barnier, the EU's chief Brexit negotiator, has reminded the United Kingdom that they will have just 15 to 18 months to negotiate the terms of exit when Article 50 is triggered, as the remaining time will be needed for the deal to secure legislative appeal.

LEN'S LAST STAND?

Len McCluskey has quit as general secretary of Unite in order to run for a third term, triggering a power struggle with big consequences for the Labour party. Though he starts as the frontrunner, he is more vulnerable now than he was in 2013. I write on his chances and possible opposition here.

AND NOW FOR SOMETHING COMPLETELY DIFFERENT

Emad asks if One Night Stand provides the most compelling account of sex and relationships in video games yet.

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Stephen Bush is special correspondent at the New Statesman. His daily briefing, Morning Call, provides a quick and essential guide to British politics.