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're running out of time to stop a hard Brexit - and the consequences are terrifying

Liam Fox has nothing to say and Labour has thrown the towel in. 

Another day goes past, and still we’re no clearer to finding out what Brexit really means. Today secretary of state for international trade, Liam Fox, was expected to use a speech to the World Trade Organisation to announce that the UK is on course to leave the EU’s single market, as reported earlier this week. But in a humiliating climb-down, he ended up saying very little at all except for vague platitudes about the UK being in favour of free trade.

At a moment when the business community is desperate for details about our future trading arrangements, the International Trade Secretary is saying one thing to the papers and another to our economic partners abroad. Not content with insulting British businesses by calling them fat and lazy, it seems Fox now wants to confuse them as well.

The Tory Government’s failure to spell out what Brexit really means is deeply damaging for our economy, jobs and global reputation. British industry is crying out for direction and for certainty about what lies ahead. Manufacturers and small businesses who rely on trade with Europe want to know whether Britain’s membership of the single market will be preserved. EU citizens living in Britain and all the UK nationals living in Europe want to know whether their right to free movement will be secured. But instead we have endless dithering from Theresa May and bitter divisions between the leading Brexiteers.

Meanwhile the Labour party appears to have thrown in the towel on Europe. This week, Labour chose not to even debate Brexit at their conference, while John McDonnell appeared to confirm he will not fight for Britain’s membership of the single market. And the re-election of Jeremy Corbyn, who hardly lifted a finger to keep us in Europe during the referendum, confirms the party is not set to change course any time soon.

That is not good enough. It’s clear a hard Brexit would hit the most deprived parts of Britain the hardest, decimating manufacturing in sectors like the car industry on which so many skilled jobs rely. The approach of the diehard eurosceptics would mean years of damaging uncertainty and barriers to trade with our biggest trading partners. While the likes of Liam Fox and boris Johnson would be busy travelling the world cobbling together trade deals from scratch, it would be communities back home who pay the price.

We are running out of time to stop a hard Brexit. Britain needs a strong, united opposition to this Tory Brexit Government, one that will fight for our membership of the single market and the jobs that depend on it. If Labour doesn’t fill this gap, the Liberal Democrats will.

Tim Farron is leader of the Liberal Democrats.