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 Images
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The future of policing is still at risk even after George Osborne's U-Turn

The police have avoided the worst, but crime is changing and they cannot stand still. 

We will have to wait for the unofficial briefings and the ministerial memoirs to understand what role the tragic events in Paris had on the Chancellor’s decision to sustain the police budget in cash terms and increase it overall by the end of the parliament.  Higher projected tax revenues gave the Chancellor a surprising degree of fiscal flexibility, but the atrocities in Paris certainly pushed questions of policing and security to the top of the political agenda. For a police service expecting anything from a 20 to a 30 per cent cut in funding, fears reinforced by the apparent hard line the Chancellor took over the weekend, this reprieve is an almighty relief.  

So, what was announced?  The overall police budget will be protected in real terms (£900 million more in cash terms) up to 2019/20 with the following important caveats.  First, central government grant to forces will be reduced in cash terms by 2019/20, but forces will be able to bid into a new transformation fund designed to finance moves such as greater collaboration between forces.  In other words there is a cash frozen budget (given important assumptions about council tax) eaten away by inflation and therefore requiring further efficiencies and service redesign.

Second, the flat cash budget for forces assumes increases in the police element of the council tax. Here, there is an interesting new flexibility for Police and Crime Commissioners.  One interpretation is that instead of precept increases being capped at 2%, they will be capped at £12 million, although we need further detail to be certain.  This may mean that forces which currently raise relatively small cash amounts from their precept will be able to raise considerably more if Police and Crime Commissioners have the courage to put up taxes.  

With those caveats, however, this is clearly a much better deal for policing than most commentators (myself included) predicted.  There will be less pressure to reduce officer numbers. Neighbourhood policing, previously under real threat, is likely to remain an important component of the policing model in England and Wales.  This is good news.

However, the police service should not use this financial reprieve as an excuse to duck important reforms.  The reforms that the police have already planned should continue, with any savings reinvested in an improved and more effective service.

It would be a retrograde step for candidates in the 2016 PCC elections to start pledging (as I am certain many will) to ‘protect officer numbers’.  We still need to rebalance the police workforce.   We need more staff with the kind of digital skills required to tackle cybercrime.  We need more crime analysts to help deploy police resources more effectively.  Blanket commitments to maintain officer numbers will get in the way of important reforms.

The argument for inter-force collaboration and, indeed, force mergers does not go away. The new top sliced transformation fund is designed in part to facilitate collaboration, but the fact remains that a 43 force structure no longer makes sense in operational or financial terms.

The police still have to adapt to a changing world. Falling levels of traditional crime and the explosion in online crime, particularly fraud and hacking, means we need an entirely different kind of police service.  Many of the pressures the police experience from non-crime demand will not go away. Big cuts to local government funding and the wider criminal justice system mean we need to reorganise the public service frontline to deal with problems such as high reoffending rates, child safeguarding and rising levels of mental illness.

Before yesterday I thought policing faced an existential moment and I stand by that. While the service has now secured significant financial breathing space, it still needs to adapt to an increasingly complex world. 

Rick Muir is director of the Police Foundation