Sunday, August 28, 2016
Hammond faces a steeper climb up debt mountain
Posted by David Smith at 09:00 AM
Category: David Smith's other articles


My regular column is available to subscribers on This is an excerpt.

It is back to work, in my case after escaping to the Outer Hebrides, where the people were a lot friendlier than the weather and where I discovered that Breakfast means Breakfast.

On the return-to-work theme, much has been made of Theresa May’s challenging in-tray, and the fact that the new prime minister has a lot on her plate. But do not underestimate the tricky terrain faced by Philip Hammond, the new chancellor, and the Office for Budget Responsibility (OBR), which will help frame his decisions this autumn.

Hammond, who has been described as “swashbuckling” by the Financial Times, perhaps for the first time in his life, has been helped by the fact that the immediate post-referendum shock has been contained. The actions and assurances of the Bank of England and the swift transition to a new government helped a lot; do not forget that we could now have still been in the middle of a Tory leadership contest.

So did the plunge in the pound, probably not mainly by boosting exports but by encouraging more foreign visits to bargain-basement Britain, as predicted here. Selling Swiss watches to tourists has been good business, while retailers in general have done better than they feared. For a fuller reading of the economy’s performance this summer, we will this week get the first of the purchasing managers’ surveys for August, following their plunge in July.

The welcome absence of an immediate crisis only partly eases the pressure on the chancellor, however, and barely makes the OBR’s task any easier. It, remember, has the job of assessing the outlook for the public finances, not just in the short-term, but also in the medium and long-term. It will have to make assumptions about Britain’s post-Brexit future, including future trading relationships, at a time when the government is only starting to grapple with these questions.

Hammond’s autumn statement, drawing on the OBR’s work, has become the key focus for the government’s economic policy approach in this parliament. As Paul Johnson, director of the Institute for Fiscal Studies, has pointed out, we thought George Osborne’s autumn statement last year had performed that role, but things have moved on. The king is dead, long live the king.

An expectation has built up that the chancellor’s promised autumn “reset” of policy will include a sizeable fiscal stimulus, a growth-boosting “giveaway” in the form of additional infrastructure spending, tax cuts, or both.

This is despite the fact that, according to most economists, the prospect is for bigger budget deficits and more government debt even if he chose to do nothing. The latest Treasury compilation of independent forecasts has growth of 0.7% next year, down from 0.8% last month and 2.1% in June. 2017 was always expected to be the year of greatest weakness, with business investment and employment subdued and households suffering an income squeeze as a result of the rise in inflation resulting from sterling’s fall.

Slower growth, in turn, feeds through to higher borrowing, and thus more debt. In June, the average forecast was that borrowing this year (2016-17) would be £61.7bn, falling to £46.7bn next year, 2017-18. Now the predictions are for £66.9bn and £59.8bn respectively.

Should Hammond, knowing that Osborne’s old target for a budget surplus by the end of the decade had been dumped by May even before she appointed him chancellor, throw caution to the wind? Should he go for a package of big personal and business tax cuts, as well as a significant infrastructure boost, to show that Britain is determined not to succumb to gloom? After all, those once-cherished AAA sovereign debt ratings have now all gone.

Well he could, but there will be plenty of voices, including in the Treasury, who will advise him not to. The situation we are in now is in no way comparable to the global financial crisis but there are lessons to be learned from that period. Back then, Alistair Darling unveiled a modest fiscal stimulus to offset the so-called demand effects of the downturn, mainly in the form of a temporary cut in VAT from 17.5% to 15%.

What was not fully realised was that the crisis also inflicted damage on the supply-side of the economy, hence subsequent very weak productivity growth and progress in reducing the budget deficit being slower than hoped.
The OBR, in framing the outlook for the economy and the public finances will be required to take into account both the demand and supply-side effects of leaving the EU. Assessing the latter, as noted, could be the trickiest of tasks.

For those urging a cautious approach on the chancellor, however, there is likely to be plenty of ammunition. These demand and supply-side effects imply significantly higher government borrowing for the rest of this decade, after which demographic factors in the form of an ageing population kick in and, as the OBR has previously warned, put further upward pressure on borrowing and debt.

Allan Monks, an economist with J.P. Morgan, has tried to pull all this together. Even assuming that the OBR is not as gloomy as the Bank on the hit the economy, and its supply potential, and assuming Hammond unveils a modest fiscal stimulus in the autumn, he comes up with numbers in which borrowing stays close to 4% of gross domestic product until 2018-19, before dropping to just under 3% of GDP in 2019-20 (which was intended to be the first of Osborne’s surplus years).

The cumulative addition to borrowing over the next five years, including this year, is more than £200bn, at today’s prices. For those concerned about government debt, there could be quite a bit more of it.

For this reason, we may see a more cautious approach from the chancellor this autumn than some hope. Yes there will be more infrastructure spending, but perhaps with the government as the enabler of private sector spending – permitting new airport runways for example – than spending itself. Given that the challenge is not just a short-term one, temporary tax cuts do not seem like an obvious thing to do. But it is early days. Guidance at the moment is that the autumn statement might not be until the last week of November. That is a long time in politics - and in economics.