Weak growth may force Chancellor into further austerity

George Osborne on a visit to Brompton Bicycle Ltd (Photo: PA)

Well there’s a thing. Among the list of excuses for another poor set of GDP growth figures are, bizarrely, Olympic ticket sales. May’s ticket sales, which at around £300m are equivalent to 0.1pc of GDP, apparently don’t count as spending until the event actually takes place in the third quarter of next year. But they would have taken money out of people’s pockets which might otherwise have been spent on other things, so there’s a double negative.

In all, the Office for National Statistics estimates that special factors – which it lists as the additional bank holiday for the royal wedding, the royal wedding itself, the after effects of the Great East Japan earthquake, the first phase of Olympic ticket sales, and record warm weather in April – cost approximately 0.5pc points of growth. If this is added back, then the 0.2pc growth announced on Tuesday for the second quarter doesn’t look so bad.

All the same, it’s quite bad enough, and the truth of the matter is that there are always once off special factors battering the economic statistics. They were not obviously more intense in the last quarter than any other. Why not just put the whole economic crisis down to special factors and be done with it?

The bottom line is that you would expect to see some recovery momentum building by this stage of the cycle, and we are not getting it. Indeed, if anything the outlook is worsening, both domestically and internationally. What can the Chancellor do about it? As I wrote in my column for Tuesday’s print edition of the Daily Telegraph, his options are regrettably limited.

There’s little if any scope for significant tax cuts to support the consumer part of the economy, though as I’ve written before, the Chancellor could reasonably indulge in a number of revenue neutral measures that would boost investment such as reversing the higher 50pc tax band and reintroducing taper relief on capital gains.

But big measures, such as a reversal of the VAT increase, would only knock deficit reduction off course, which in today’s febrile financial conditions would be extraordinarily dangerous.

If there is one thing the Government must do, it is maintain its commitment to fiscal austerity. If the deficit isn’t tackled, interest rates will rise, market confidence would be undermined, and future growth would be severely damaged. Britain and many other advanced economies have no option but wear the hair shirt for a prolonged period of time. Any attempt to wriggle out of this corrective adjustment to the excesses of the boom is the path to ruin.

The one positive in all this is that despite the increasingly weak outlook for growth there’s still every chance of the Government meeting its target of eliminating the structural deficit by the end of the parliament. Perhaps surprisingly, this target is quite insensitive to changes in the growth outlook. Even at rates of growth quite a bit lower than the Office for Budget Responsability has been predicting the target ought to be met.

How to explain this apparent paradox? The Government’s fiscal mandate requires “cyclically adjusted current balance by the end of the rolling five year period” (2015-16), in other words, total public sector receipts need to exceed total public sector spending (minus spending on net investment) after adjusting for the temporary effect of any spare capacity in the economy. The Government has supplemented this mandate with a target for public sector net debt as a percentage of GDP to be falling at a fixed date of 2015/16.

It follows that judgements around how much spare capacity there is in the economy – the output gap – will have a big effect on the cyclically adjusted current budget balance by the end of the parliament. The smaller the output gap, the larger the amount of the deficit that is structural and the less margin the Government has against its fiscal mandate. Conversely, if the output gap is wider, less of the deficit is strucutral and the Government has more margin against its mandate.

Well, the OBR has tested its finding that the government stands a high chance of meeting its fiscal mandate against a persistently weak demand scenario, and finds that lo and behold, the Government would still meet the mandate in such circumstances. It is not entirely clear why this is the case, as logically you would expect weaker growth than expected to act as a significant drag on public finance recovery. The best explanation is probably that unemployment has not risen as much as you might expect for such a deep recession, and that the effect on tax receipts and welfare spending of slow growth will therefore not be as damaging as we’ve seen in the past.

In any case, the OBR reckons that the output gap would have to be 1.5pc of GDP lower than assumed for there to be a significant risk to the fiscal mandate and the plan to eradicate the structural deficit. But what if it is lower, as some economists believe? The longer weak growth persists, the more likely it is that there really isn’t much spare capacity in the economy.

Indeed, the idea that capacity may have been permanently destroyed by the recession may itself be false; it may never have been there in the first place. If it turns out that virtually all the above trend growth of the boom was the result of credit and leverage, as seems ever more probable, then the output gap is going to be much lower than officially assumed and possibly even non existent.

In those circumstances, the UK economy really is in trouble. If the structural deficit is much larger than the Chancellor currently assumes, he would be forced into additional austerity measures to close it. If he doesn’t take them, the country’s triple A credit rating would be in jeopardy, as its debt dynamics would look correspondingly worse. More troubling still, he’d have to take such action without being able to rely on compensating monetary action from the Bank of England. To the contrary, the Bank would quite rapidly have to normalise interest rates, whose present highly accommodative disposition is based on the idea that there’s oodles of spare capacity slopping around the economy to soak up any inflationary pressures. Not pretty.