Despite Hammond’s brave words, the future looks grim

The embattled UK chancellor of the exchequer was subject to conflicting pressures when he presented his budget.

Philip Hammond’s colleagues wanted him to respond to the public’s desire for an end to austerity. Yet, at this very moment, the Office for Budget Responsibility finally admitted that the UK’s future is almost certainly not what it had expected it to be.

Given the constraints imposed by his own fiscal targets and the grim economic prospects, Mr Hammond arguably did the best he could, at least politically. But he did so by benefiting from some accounting tricks as well as by reducing his margin of future manoeuvre. That is not surprising, but risky.

Far and away the most important development was the OBR’s decision to lower growth forecasts. It now expects economic growth to average 1.4 per cent a year over the next five years.

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Reduction

The main reason for this is a dramatic reduction in forecast growth of productivity. This reflects no more than the reality of consistent past disappointments. The net effect of its revisions is to lower the estimated level of potential output in 2021-22 by 2.1 per cent compared to the forecast last March. But the losses — an average of 0.5 percentage points annually — will go on accumulating into the future, unless the trend shifts upwards.

In brief, output per head in the UK economy is already about a sixth smaller than it would have been if pre-crisis trends had continued. Now the OBR says the economy will continue to grow substantially more slowly than it used to do for the indefinite future.

The chancellor’s rhetoric about an economy that “continues to confound those who seek to talk it down” cannot disguise the sad realities. Record employment is good. Stagnant living standards are not.

Nor, for that matter, can the realities of Brexit-afflicted Britain be concealed. On this, three points are evident. First, economic growth between the second quarter of 2016 (the time of the referendum) and the second quarter of 2017 was 0.7 percentage points below the OBR’s March 2016 forecast.

Second, as the OBR states, “The slowdown in UK GDP growth so far this year contrasts with a pick-up in other advanced economies”.

Finally, the medium-term impact of Brexit will, quite certainly, be one of lower net immigration and less trade. This will surely lower investment, competitive pressures and output below what they would otherwise have been.

Direction

Brexit then is already damaging. It is likely to become more so. The question is of degree rather than of direction. The OBR itself has to be agnostic on what Brexit will mean. But it is possible for us to make an educated guess. The conclusion is that its downgrades to potential growth might still not go far enough.

If we turn to the forecast for the fiscal deficit (net borrowing), we find several offsetting factors at work. The most important is the deterioration in forecast growth, which, as one might expect, worsens the forecast position from 2019-20, inclusive, onwards.

Against this, we see unexpected improvements in the fiscal outcomes for 2016-17 and in the forecast for 2017-18. Moreover, accounting changes, notably the (merely notional) shift of housing associations into the private sector, also benefit the picture. Finally, the chancellor has chosen to make a cumulative net fiscal loosening of £17.7billion (about 0.9 per cent of current annual gross domestic product) between 2017-18 and 2021-22.

Overall, the fiscal prospects are now worse. As the OBR notes, relative to the chancellor’s targets for 2020-21 “our underlying upward forecast revision of £13.7 billion absorbed roughly half the headroom against the ‘fiscal mandate’ shown in our March forecast.” Politically, this decision makes sense. Economically, borrowing more when long-term interest rates are so low is defensible, provided it goes for worthwhile purposes. Indeed, as I have frequently argued, the manic focus on headline debt, rather than on what debt is used to finance, is economically indefensible.

Measures

So what has Mr Hammond bought with his modest fiscal loosening? Has he in fact set out “a long term vision for an economy that is fit for the future”? Hardly: worries about the economy have most definitely not been banished.

Yet there are a number of apparently sensible measures: a bit more spending for transport and research and development; £6.3 billion of additional funding for the NHS — not enough, but desperately needed, both in reality and politically; and, most eye-catching, a plan to build 300,000 houses a year by the middle of the next decade and, more immediately, a decision to exempt first time buyers permanently from stamp duty for properties up to £300,000, with purchasers benefiting from this on properties worth all the way to £500,000.

The proposals on housing are at least aimed at one of the UK’s biggest failures: the slow growth in supply and the high prices that result. Tackling this is a political imperative for the Conservative party if it wishes to be relevant to aspiring young people. It is also a social imperative. Unfortunately, a reduction in taxes mainly raises prices, while measures to expand supply, even if successful, are far too late. It would have been good to see a radical change in incentives, including steep taxation of land with planning permission.

The biggest criticism must be of his caution. The first budget in a parliament would have been the right occasion to address some fundamental policy questions, not just ones relating to Brexit, but also the balance between taxation and spending, and between investment and current spending.

Ageing

It is overwhelmingly probable that, given an ageing population, rising fiscal pressures and slow growth, taxes will have to rise as a share of GDP, in the years ahead. It is also likely that public investment should rise as a share of GDP, to provide support for growth.

It would be good to have seen a discussion of these possibilities. Beyond this, huge effort needs to be put into the analysis and development of policies that might raise productivity. Unfortunately, the poisonous politics of Brexit are emptying the country’s political atmosphere of the needed oxygen.

A divided minority government can focus on little more than this pressing task. Given this, Mr Hammond did quite well. But the UK’s productivity performance and prospects make today’s picture look grim.

– Copyright The Financial Times Limited 2017