The Spending Problem

It's almost certain that tomorrow's budget projections will incorporate yet another downgrade to growth expectations. Which means that the current plans for public spending have become even less affordable.

Since George's' first budget in June 2010, the Office for Budget Responsibility (OBR) has downgraded its growth forecasts almost every time it's opened its mouth. For 2015-16 - the last year of the current Parliament - it originally forecast GDP would be £1902bn. By last December, it had cut that to £1763bn, a reduction of over 7%. Some of that is accounted for by lower projected inflation (amazingly), but most reflects a real terms GDP reduction of 6%.

So by 2015-16 our national income will be 6% less than George expected back in June 2010. Yet far from trimming his spending budget, he's still planning to spend almost as much.

Back in June 2010, spending in 2015-16 was projected to be £757bn (Total Managed Expenditure - TME). So if he'd cut his cloth in line with the poorer outlook for national income, he should now be planning of spending closer to £700bn. Instead of which, spending is actually projected at £745bn.

Here's a chart of successive spending projections (TME). The top line is Labour's final effort (projection out to 2014-15), the others are successive coalition plans:

As we can see, the June 2010 budget cut Labour's planned 2014-15 spending by 5% in cash terms. And as we can also see, the latest coalition plans have cut it a little further (by about one percent). That's all to the good, but the problem is that with the outlook for GDP so much worse than George initially thought, it needs to go further.

When the coalition took over, public spending was running at 47% of GDP. That was far higher than government revenues at 37%, and wholly unsustainable: as ministers kept telling us, it meant government was borrowing one pound in every four it spent. The plan was to get public spending down under 40% of GDP by 2015-16, and to increase revenues to 39%. Which they reckoned would leave borrowing at a comfortable level.

Unfortunately, things haven't panned out like that. With weaker growth, revenue is falling short and borrowing is significantly overshooting.

Of course, there are plenty of people who say we could solve the problem without further spending cuts. For example, we could tax the rich: except as we've blogged many times, there aren't enough of them. Moreover,  we should note that no government in at least the last 50 years has ever managed to raise much more than about 38% of GDP in tax revenues - that seems to be the limit of acceptability and/or practicality (see BOM book).

Or maybe we could borrow more. Except with inflation a looming problem, and Sterling subject to attacks of the vapours, those fickle bond and currency investors could well take it the wrong way. Especially when we understand that the only reason the coalition's spending totals have stayed within their initial projection is that debt interest has so far been lower than forecast (saving an expected £9bn next year alone). We really cannot afford to upset the gnomes of Zurich, or anywhere else.

But surely, you say, once the economy recovers back to full strength, revenue will rise and these problems will take care of themselves.

Yes, if only.

The problem is that we can't be at all sure what full strength means any more. Back in 2008 the economy suffered a heart attack, and although the jump leads got it back upright again, it's still hobbling around and avoiding strenuous exercise. It may no longer be capable of scaling the peaks it sprinted up during its Ben Johnson years of unlimited debt steroids.

The OBR tries to work out if and how quickly we can expect a full recovery, by assessing potential output both now and in the future. But it's the first the recognise the problems:

"The amount of spare capacity in the economy (the ‘output gap’) and the growth rate of potential output are key judgements in our forecast. Together, they determine the scope for actual growth as activity returns to a level consistent with maintaining stable inflation in the long term. The size of the output gap also determines how much of the fiscal deficit at any given time is cyclical and how much is structural. In other words, how much will disappear automatically, as the recovery boosts revenues and reduces spending, and how much will be left when economic activity has returned to its full potential. The narrower the output gap, the larger the proportion of the deficit that is structural, and the less margin the Government will have against its fiscal mandate, which is set in structural terms... 

But neither the level of potential, nor the pace of recovery, are possible to estimate with confidence, not least because the former is not a variable that we can observe directly in the economic data."

Here's its summary table on potential output growth:

Many people (probably including the OBR) wonder if they are being too optimistic on these key judgements. For example, it assumes that the potential growth of labour productivity in the future will be 1.9% pa, whereas the average growth over the last 15 years is only 1.4% - and since 2008 it's actually fallen.

The horrible reality is that the economy now looks a lot weaker than when the coalition came to power. And with a weakened poorer economy we cannot afford to maintain their initial spending plans. GDP is going to be much lower than he assumed then, but he hasn't cut his spending plans. George needs to recognise that tomorrow and tell us how he's going to address the problem.