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How big is Osborne's black hole? The problem is we don't know

The level of austerity required varies hugely depending on how much growth is thought possible.

The most uncertain forecast.
George Osborne stands behind the bar during a visit to officially re-open The Red Lion pub following a major refurbishment in Westminster on February 25, 2014. Photograph: Getty Images

Today's FT story on George Osborne's "£20bn black hole" might appear puzzling at first. With the British economy growing faster than that of any other major western country (albeit after three years of stagnation), shouldn't the public finances be getting better, not worse? On one level they are: borrowing for 2013-14  is currently £4bn lower than last year. But the problem for the Chancellor is that the models used by the Office for Budget Responsibility (the budgetary watchdog he founded in 2010), which the FT has replicated, deem this improvement to be almost entirely cyclical (temporary), rather than structural (permanent). While the body's short-term forecasts have improved, its long-term forecasts have worsened. Osborne's cuts have permanently dented the economy's growth potential. The result is that the structural deficit (the part of the deficit that exists regardless of the level of growth) is now estimated to be even bigger than first thought, and that means even more austerity will be needed to balance the books. 

The problem with all of these forecasts is that they hinge on one highly uncertain judgement: the size of the output gap. The output gap (or the level of "spare capacity") is the difference between current and potential growth. If the gap is thought to be large, then a significant chunk of the deficit can be eliminated over time through growth, rather than spending cuts and tax rises. But if it is thought to be small (the OBR puts it at 1.8 per cent), then even greater austerity is needed. At present, the OBR estimates that the structural deficit will be £85bn this year, while the total deficit will be £111bn (meaning £26bn of austerity is avoided). But the FT''s updated forecasts suggest that the difference between the two might be smaller than thought, hence the warning of a "£20bn black hole". 

The complication for Osborne (and Ed Balls, who has pledged to eliminate the current deficit by the end of the next parliament) is that economists are hugely divided over the potential for higher growth (the Independent's Ben Chu has a useful graph of their differing forecasts here). The Bank of England's Monetary Policy Committee is even more pessimistic than the OBR; it estimates that the output gap is just 1-1.5 per cent, meaning that austerity of £91-97bn will be needed to Osborne to meet his target of running a budget surplus by 2018-19. But the market, on average, is more optimistic than both; it assumes an output gap of 2.7 per cent, meaning the level of austerity required falls to £77bn. Others are even more optimistic. The National Institute for Economic and Social Research (NIESR) puts the output gap at 4.3 per cent, with £60bn of austerity required, at least £30bn less than assumed by the Bank of England. 

The danger highlighted by some economists is that an overly pessimistic estimate could lead to austerity being applied more severely than necessary. As Andrew Goodwin, senior economist at Oxford Economics, has said: "Oxford Economics analysis suggests that the economy has a significantly larger amount of spare capacity than the OBR estimates which, in turn, suggests that the medicine of austerity could end up being applied in a dose higher than the patient actually needs."  This calculation matters as much for Labour as it does for the Tories. The level of growth thought possible will determine the amount the party can spend on its priorities - housing, childcare, employment, skills, health and social care - while meeting its tough deficit reduction targets. If it follows Osborne and uses the OBR's pessimistic forecasts, it could end up with a minimalist manifesto it later regrets. 

Wonkish it might be, but the output gap is probably the most important number in British politics. 

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