The country is living beyond its means. The budget deficit is high and national debt is set to rise significantly. That’s the main take-away from today’s two-yearly risk assessment report from the Office for Budget Responsibility (OBR).
Ideally, such risk reports should be annual and become the centrepiece of our policy debate on the fiscal outlook.
Instead – and as highlighted by the latest five-yearly external review of the OBR earlier this year – our fiscal focus is too short-term, obsessed by a focus on the ‘fiscal headroom’. That external review was carried by fiscal experts from the Netherlands (and I was one of the outside experts consulted). The Chancellor could have seized upon it as a credible reason to shift away from her self-imposed fiscal rules, but she didn’t. Rather, we are stuck with them and our back to front process where economic forecasts with a large margin of error dictate tax and spending plans to meet these rules.
This is not a criticism of the OBR, but of the process. The OBR is a welcome and necessary part of the UK’s economic policy infrastructure, but we are presenting it as an omniscient body that should be the first port of call for policy, which wasn’t the intention and isn’t what the OBR wants to be seen as.
As we see today, with this report, the OBR plays a central role in laying bare the mess that lies ahead unless politicians stop prevaricating and take necessary policy action.
We are heading for a debt-trap, where national debt will exceed the size of the economy and keep rising as growth will be weak, and less than the interest we pay on our debt. We would need to run primary surpluses, after allowing for interest payments, to prevent deterioration. That scenario seems unlikely. We have only run seven budget surpluses since 1969, and in three of those Gordon Brown disguised what was happening through off-balance-sheet items, for which a high cost is being paid now.
As the OBR outlined today, we have a recent track record of disappointment. To be fair, the economy has been hit hard by two generational shocks, with the financial crisis and the Covid pandemic. But even allowing for those, policy outcomes have been poor.
Globally, debt levels are high. One alarming feature of today’s OBR report was the poor relative position of the UK. As bad as the global picture is, we are with the under-performers.
Take the budget deficit, which adds to the debt. Of 36 advanced economies, we have the fifth worst picture. France, the US, Slovenia and Israel are worse. As for debt, we are the sixth worst, after Japan, Greece, Italy, France and the US.
What the OBR didn’t say – and which should alarm but also discipline us – is that both France and the UK are more dependent than other G7 countries on foreign investors to buy their debt. Keeping international investors and the financial markets onside is critical. This helps partially explain Rachel Reeves’ difficult position. It also means that if Westminster doesn’t act at some stage – decisively – the markets will demand action.
We may have a stay of execution over the next year or so, with modest growth and lower policy interest rates. But we can’t take this outlook for granted.
Interest rates may even fall far more than the markets expect, if the Budget sees significantly higher taxes. But even if they do, a risk premium may be factored into longer-term borrowing yields, limiting the extent to which they decline. Also, if US borrowing costs stay high that will have a bearing on us, too.
The central part of today’s report was the risks associated with the UK’s ageing population and with climate change.
Take demographics. As the OBR stated:
Over the long term, the demographic pressures of an ageing population and rising costs of healthcare and other age-related expenditures are still, on current policy settings, projected to push borrowing above 20 per cent and debt above 270 per cent of GDP by the early 2070s.
It’s hard to see how the triple lock can survive much longer. As the OBR highlighted, volatility in earnings and inflation has seen its expense soar in recent years. Another highlight was that even with a higher retirement age, the cost of the state pension is set to rise from 5% of GDP now to a hefty 7.7% in half a century.
Worryingly, given our reliance on overseas investors, the shift of pensions from defined benefit to defined contribution plans, will see pension scheme holdings of gilts fall by 18.6%, from 29.5% to 10.9%. Who will make up the shortfall and at what borrowing yield?
There is something to be said for a 50-year risk assessment. It should focus attention on what lies ahead if policy does not change. Moreover, it allows time to act, with thought through policies. Against that, and as we have seen frequently after previous such OBR risk reviews, that had equally alarming projections as in this latest report, the time period is seen as being sufficiently far ahead to not tie policy makers hands.
But if this Government or its successors don’t act soon enough, then the markets will force them to. It is far better to act now.
Naturally, default is not an option, neither is inflating the debt away, although a watered down version was tried through quantitative easing, with damaging consequences. That leaves five options to get the fiscal numbers into shape: growth, reform, tax, austerity and borrowing.
The root cause of the problem is weak growth. Addressing this takes time, as does reform. Public spending needs to be brought under control. Current politics, however, rules out curbing spending and borrowing, which are already high. So, the Chancellor’s focus will turn to tax. That’s the problem. The tax burden is at a post-war high and still rising. Incentives are being steadily eroded, distorting work, saving, investment and enterprise. Marginal tax rates are high. Tax simplification is needed.
Today’s report from the OBR should be the focus of our fiscal policy debate. It highlights the poor and deteriorating direction of travel for the public finances.
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