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.

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We still have time to change our minds on Brexit

The British people will soon find they have been misled. 

On the radio on 29 March 2017, another "independence day" for rejoicing Brexiteers, former SNP leader Alex Salmond and former Ukip leader Nigel Farage battled hard over the ramifications of Brexit. Here are two people who could be responsible for the break-up of the United Kingdom. Farage said it was a day we were getting our country back.

Yet let alone getting our country back, we could be losing our country. And what is so frustrating is that not only have we always had our country by being part of the European Union, but we have had the best of both worlds.

It is Philip Hammond who said: “We cannot cherry pick, we cannot have our cake and eat it too”. The irony is that we have had our cake and eaten it, too.

We are not in Schengen, we are not in the euro and we make the laws that affect our daily lives in Westminster – not in Europe – be it our taxes, be it our planning laws, be it business rates, be it tax credits, be it benefits or welfare, be it healthcare. We measure our roads in miles because we choose to and we pour our beer in pints because we choose to. We have not been part of any move towards further integration and an EU super-state, let alone the EU army.

Since the formation of the EU, Britain has had the highest cumulative GDP growth of any country in the EU – 62 per cent, compared with Germany at 35 per cent. We have done well out of being part of the EU. What we have embarked on in the form of Brexit is utter folly.

The triggering of Article 50 now is a self-imposed deadline by the Prime Minister for purely political reasons. She wants to fix the two-year process to end by March 2019 well in time to go into the election in 2020, with the negotiations completed.

There is nothing more or less to this timing. People need to wake up to this. Why else would she trigger Article 50 before the French and German elections, when we know Europe’s attention will be elsewhere?

We are going to waste six months of those two years, all because Prime Minister Theresa May hopes the negotiations are complete before her term comes to an end. I can guarantee that the British people will soon become aware of this plot. The Emperor has no clothes.

Reading through the letter that has been delivered to the EU and listening to the Prime Minister’s statement in Parliament today amounted to reading and listening to pure platitudes and, quite frankly, hot air. It recalls the meaningless phrase, "Brexit means Brexit".

What the letter and the statement very clearly outlined is how complex the negotiations are going to be over the next two years. In fact, they admit that it is unlikely that they are going to be able to conclude negotiations within the two-year period set aside.

That is not the only way in which the British people have been misled. The Conservative party manifesto clearly stated that staying in the single market was a priority. Now the Prime Minister has very clearly stated in her Lancaster House speech, and in Parliament on 29 March that we are not going to be staying in the single market.

Had the British people been told this by the Leave campaign, I can guarantee many people would not have voted to leave.

Had British businesses been consulted, British businesses unanimously – small, medium and large – would have said they appreciate and benefit from the single market, the free movement of goods and services, the movement of people, the three million people from the EU that work in the UK, who we need. We have an unemployment rate of under 5 per cent – what would we do without these 3m people?

Furthermore, this country is one of the leaders in the world in financial services, which benefits from being able to operate freely in the European Union and our businesses benefit from that as a result. We benefit from exporting, tariff-free, to every EU country. That is now in jeopardy as well.

The Prime Minister’s letter to the EU talks with bravado about our demands for a fair negotiation, when we in Britain are in the very weakest position to negotiate. We are just one country up against 27 countries, the European Commission and the European Council and the European Parliament. India, the US and the rest of the world do not want us to leave the European Union.

The Prime Minister’s letter of notice already talks of transitional deals beyond the two years. No country, no business and no economy likes uncertainty for such a prolonged period. This letter not just prolongs but accentuates the uncertainty that the UK is going to face in the coming years.

Britain is one of the three largest recipients of inward investment in the world and our economy depends on inward investment. Since the referendum, the pound has fallen 20 per cent. That is a clear signal from the world, saying, "We do not like this uncertainty and we do not like Brexit."

Though the Prime Minister said there is it no turning back, if we come to our senses we will not leave the EU. Article 50 is revocable. At any time from today we can decide we want to stay on.

That is for the benefit of the British economy, for keeping the United Kingdom "United", and for Europe as a whole – let alone the global economy.

Lord Bilimoria is the founder and chairman of Cobra Beer, Chancellor of the University of Birmingham and the founding Chairman of the UK-India Business Council.