Sunday, November 27, 2016
Why Brexit will mean a bigger debt burden
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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My regular column is available to subscribers on www.thesundaytimes.co.uk This is an excerpt.

In announcing that Wednesday’s autumn statement will be the last (at least until a future chancellor decides to reinstate it), Philip Hammond abandoned one tradition.

He has, however, established another. This is that when he presents and responds to new forecasts from the independent Office for Budget Responsibility (OBR), as he will be required to do twice a year, it can be guaranteed that a storm of criticism will be unleashed.

In the toxic post-Brexit vote environment that we are in, we have already had plenty of prattle, as some Tory MPs and unnamed ministers queued up to attack the OBR for predicting that Brexit will mean somewhat slower growth and significantly higher debt and deficits. Most of those doing the attacking, I suspect, will not even have opened the OBR document.

Next year, when we will have two budgets, the last spring budget in March and the first of the new autumn super-budgets in November, I suspect we will see some more of this. The fact that Brexit, as well as causing an inflation-inducing drop in the pound, will mean more government borrowing and higher public sector debt is unsurprising. It was pointed out, including here, on many occasions before the referendum, and it is happening.

The striking thing about the OBR’s forecasts, notwithstanding the attempts by critics to undermine it, is that they could have been a lot gloomier. It sees a temporary and modest slowdown in growth to 1.4% next year, picking up to 1.7% in 2018 and 2.1% (in line with its pre-referendum forecast) in 2019.

Its predictions for growth are thus above-consensus and, incidentally, stronger than those from the Bank of England. It could have been a lot gloomier, particularly about prospects towards the end of the decade. Its forecast is supposed to be based on government policy, so naturally it asked the government for its policy on Brexit. In return it was sent two anodyne paragraphs from Theresa May speeches, which said nothing more than that the government will aim to achieve the best of all possible worlds. To assume a normal rate of growth in 2019 on the basis of a policy vacuum was more than generous to the government.

The OBR, similarly, is not as gloomy about inflation as most forecasters, some of whom think it will hit 4%. It sees a peak of 2.6%.

Nor has the OBR laid it on thick when it comes to the details of the forecast. At a time when business organisations fear sharp weakness in investment, notwithstanding its small rise in the third quarter, the OBR’s forecast – a tiny 0.3% drop in business investment next year followed by a 4.1% rise in 2018 – are optimistic.

In terms of longer-term damage, in the absence of a Brexit vote the OBR was ready to revise up the economy’s growth potential because net migration was clearly rising at a rate well above the “tens of thousands” targeted by David Cameron’s government. Now, in the light of the referendum it has abandoned that upward revision and revised growth potential lower, on the assumption that net migration drops gradually to 185,000 a year, from 330,000 last year.

The biggest uncertainty about the economic outlook as it affects the public finances is productivity. The lower productivity growth – output per hour – the weaker the prospects for tax revenues. Fathom Consulting points out that the OBR has been assuming a gradual return to normal rates of productivity growth since its inception in 2010. It is doing so again, predicting that by the end of the decade productivity will be growing by 2% a year. Other forecasters say this will be hard to achieve given the recent record of disappointingly weak productivity and the likelihood that one of the drivers of productivity growth – international trade – will be hit during the government’s efforts to negotiate new trading arrangements.

The chancellor’s £23bn national productivity investment fund (NPIF) showed that his priorities are right: infrastructure will be one of the keys in the long-term to raising productivity. Long-term is, however, the operative word here.

So the OBR’s prediction of a £122bn deterioration in the public finances by 2020-21, of which just under half, £59bn, is directly attributable to Brexit, looks reasonable, even cautious. Public sector debt, on its forecasts, will top £1.9 trillion by the end of the decade, up from £500bn 10 years ago and £1 trillion in 2010. The Brexit effect is an addition to government debt we could have done without.

Nor is the pressure over for further additions to debt and deficits. Hammond fought off Downing Street demands to do more this time, but that was just one battle in what will be a long war. When the squeeze on real wages hits next year, it will revive the disappointment over income growth that has led to so much disenchantment.

As Paul Johnson, director of the Institute for Fiscal Studies, memorably put it, in the wake of the autumn statement: “Real wages will, remarkably, still be below their 2008 levels in 2021. One cannot stress enough how dreadful that is – more than a decade without real earnings growth. We have certainly not seen a period remotely like it in the last 70 years.”

People will say that that is not what they voted for in June, or indeed were promised. But reality is sinking in. Markit’s UK household finance index, using data from Ipsos-Mori, asked people in July whether they expected economic prospects to be better or worse over the next 10 years as a result of Brexit.

In July there was optimism. In the North East, for example, a net 7.5% of people thought the next 10 years would be better for the economy as a result of Brexit; now a net 19.1% believe it will be worse. In the South East net optimism of 8% in July has turned into net pessimism of 30.4%. Across all income groups there is pessimism about prospects. Only the oldest age groups are positive, though by a smaller margin that they were.

The backdrop to this, as well as that provided by the IFS, was the conclusion by the Resolution Foundation, a think tank, that the poorest third of households face falling living standards over this parliament, with overall living standards stagnating. It is a pretty grim backdrop and one which might require an easing up on welfare cuts.

The chancellor, who has also been criticised for not responding to the crisis in social care, within an overall squeeze on NHS funding, has left himself some room for manoeuvre – about £27bn – within his looser fiscal rule of getting the budget deficit below 2% of gross domestic product by the end of the parliament. That would mean yet higher government debt. He may well have little choice.