On Wednesday 29 November 2017, PRIME’s director, Ann Pettifor, gave evidence at the Committee’s invitation to the UK Parliament’s Treasury Select Committee, together with Professor Jagjit Chadha, Director, National Institute of Economic and Social Research and Paul Johnson, Director, Institute for Fiscal Studies. A verbatim report of the discussion can be found on the Select Committee’s website here.
Below we publish PRIME’s written evidence to the Treasury Select Committee. In it we sympathise with the Office for Budget Responsibility’s difficulty in forecasting the impact of Brexit, given that the government has offered so little information on the goals and likely outcomes of Brexit negotiations. However, we are critical of the OBR’s (microeconomic) approach to the British Budget and wider economy, and of its position on the output gap. Above all, we argue that OBR forecasts rely on projectionsof productivity, while for economists at PRIME, productivity is largely a residual – an outcome of economic policy, not a cause of economic weakness.
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The OBR’s approach to forecasting the impact of Brexit?
At the outset we wish to express some sympathy with the OBR’s challenge in forecasting the economic impact of Brexit, given how little information or justification was provided by government to OBR staff. As stated in the November 2017 forecast their request for the government’s own more detailed assumptions and analysis led simply to a referral to the Prime Minister’s Florence speech and the White Paper on trade. This is an extraordinarily inadequate basis for forecasting the economic impact of Brexit. As the OBR itself avers, it has been given by government “no meaningful basis on which to form a judgement as to (the negotiations’) final outcome.”
This means that even now, at this late stage, the OBR, for the most part, has chosen to fall back on its own very general, and to our minds, inadequate set of assumptions set out in previous forecasts.
Before we go further on the Brexit issue in particular, we wish to comment on the OBR’s forecasting record.
The OBR’s general approach to forecasting
The OBR’s approach to the British economy uses microeconomic reasoning throughout its forecasts to reach macroeconomic conclusions. While we agree that prospects for growth are bleak based on existing (fiscal and monetary) policy, we disagree substantially with the OBR’s position on supply/capacity and the output gap.
Second, OBR forecasts place productivity at the heart of forecasts which rely on projections of productivity. From our perspective productivity is largely a residual. It is an outcome, an indication of the weakness of aggregate demand made worse by the government’s failure to intervene and invest, and its austerity programme.
Third, the OBR consistently underestimates the impact of the “negative multiplier” (the contractionary effect of reductions in government expenditure). This, as the IMF has shown, serves to reduce the likely level of GDP. Their approach explains why the OBR have repeatedly failed to anticipate the ongoing weakness of the economy, and why they are not in a position to adequately forecast the full impact of a Brexit shock. While the IMF have revised their assessment of multipliers the OBR have continued to assume – wrongly – a minimal impact for fiscal consolidation. We now have experience of fiscal consolidation across all advanced economies, and they all suggest that multipliers are higher than the OBR assumes.
To conclude: the decline in productivity that OBR economists regard as so ‘puzzling’ is only puzzling because the OBR will not recognise its cause: weakened aggregate demand, made worse by austerity.
Whether the OBR has taken a reasonable approach to the risks (upside and downside) to the forecasts arising from the outcome of the Brexit negotiations, the risks arising from ‘no deal’?
Downside risks
No matter how smoothly negotiations proceed, Brexit is likely to be a shock to the British economy. A ‘no deal’ Brexit will represent a more severe shock.
We feel that at this crucial juncture in the UK’s history there is a responsibility on the OBR to make an assessment of the range of risks, notwithstanding the difficulties they face in understanding government policies and negotiations, with which we sympathise. We are now just sixteen months away from Britain exiting the EU which means that the risks of a no-deal or partial or inadequate deal are rising, and substantial.
We conclude that between government and the OBR there is no proper assessment of the potential risks of an unplanned ‘no-deal’ or inadequate deal Brexit. It further means that there is no consideration of the (to our view necessary) alternative approach of compensating for downside risks by ‘taking control’ of the domestic economy, and increasing government intervention to compensate for a likely Brexit shock, which will take place in the context of an economy operating well below potential, with weakened aggregate demand exacerbated by political uncertainty.
Upside risks
We do not consider that the OBR has failed to consider foreseeable ‘upside’ risks, since within the planning horizon (5 years) there are bound to be difficult adjustments. The OBR have actually made only modest assumptions which implicitly assume a smooth and agreed exit process.
The assumption that trade intensity will decline steadily and gradually, over a period of ten years, from April, 2019 and that exports and imports will be affected equally during this adjustment?
An assumption that trade intensity “will decline steadily and gradually, over a period of ten years, from April, 2019” is in our view among the more unlikely outcomes of Brexit. We find it extremely hard and probably not meaningful to predict ten years ahead, but it is in our view a central forecast probability that there will be a more pronounced impact in the five years 2019-2024, as exporters and importers and producers adjust to whatever the new trading regime may be. Again in terms of assessing the realistic range of risks we feel the OBR has not adequately drawn attention to them.
We would not criticise the central assumption that exports and imports would be affected equally, but again, obviously there is a range of possibilities which would have a differential impact on the overall economy.
But conversely if policymakers decided to protect aggregate demand through domestic policy, the OBR is unlikely to be able to capture that impact.
Impact of migration?
We do not have a view on whether the OBR’s use of ONS projections of migration are valid.
Conclusion
From our perspective there is then a double risk that is not addressed by the OBR: the general flaws in OBR forecasting, which lead to an under-estimate of the economy’s potential/capacity. This approach in turn reinforces government’s determination to pursue further fiscal consolidation. These combined approaches are particularly dangerous at a time that Britain faces the likelihood of a shock to the UK economy. A no-deal Brexit is likely to seriously magnify any such shock. Given this possibility, it is of grave concern that the OBR has failed to provide the Treasury with a wider range of possible outcomes in its Economic and Fiscal Outlook of November, 2017, which in turn, as the Budget confirms, has encouraged Treasury’s determination not to use its firepower to prepare for the Brexit shock.
