Fantasies about output gaps and structural deficits collide with economic reality in the UK

Yesterday was one of the set-piece events of the financial year when the Chancellor of the Exchequer sets out his plans for subsequent years . It is hard these days to tell the difference and relative importance of this vis a vis the actual Budget as in many ways they have morphed into each other. Having established the view on Monday that it would involve a large degree of financial alchemy let me explain how much of this took place.

Financial Alchemy in the Budget

First let me remind you of the two main moves which I highlighted on Monday.

This discussion has put aside up to now another piece of financial alchemy because it has already taken place which is the transfer of the Royal Mail pension fund into the UK government’s accounts. It goes in with more future liabilities than present assets and comes out as a £28 billion gain

It is envisaged that the net coupon income earned by the APF during 2012-13, expected to be around £11 billion, will be transferred to the Exchequer during 2012-13. The excess cash that had accumulated in the APF up to the end of 2011-12 (£23.8 billion) will be drawn down over the course of 2013-14.

So already he had built up a fund of £63 billion to help the numbers with the potential APF contributing possibly remaining at around £11 billion a year beyond 2013/14. As someone once observed pretty soon we will be discussing serious money!

We did see some additions to the list as well. For example the sale of 4G mobile licences which has not actually taken place was brought in with a value of £3.5 billion. As this has been valued between £1 billion and £6 billion it remains to be seen what we will actually get. I hope this time that unlike the recent railway franchise debacle that the sums do add up. It was also assumed that we will get £5 billion of tax revenue from a repatriation of money from Switzerland of which we have received nothing so far! An interesting assumption which even the Office for Budget Responsibility called “highly uncertain”. Indeed on the subject of tax collecting if we can raise an extra £2 billion of taxes by only spending an extra £77 million it makes you wonder why we do not do more of that does it not?

Why was this sort of chicanery necessary?

This is the simplest part of the situation things were not going well on either the deficit reduction front or the overall economy. Indeed before the Chancellor stood up to speak we had received a reminder that the situation remains weak. From Markit.

The UK service sector registered little change in business activity during November as incoming new work fell slightly for the first time in nearly two years. A tough economic climate was commonly reported to have undermined efforts to secure new business.

Whilst a reading of 50.2 does show some albeit very little growth let me add this bit for some perspective.

Business activity rises at slowest rate for 23 months

So we see that what had been a reliable performer for the UK economy looks like it has slowed up.  Unfortunately the release on the construction sector from the day before was not hopeful either.

Business conditions in the UK construction sector deteriorated during November, with output falling for the third time in the past four months amid the steepest new orders decline for just over three-and-a half years.

And just to complete a full deck manufacturing did improve but remained in contraction territory at 49.1.

This morning has seen a continuation of the UK’s disappointing trade performance and let me highlight the trade in goods in 2012 so far.

However, taking the first ten months of 2012 together, the deficit has been running at an average of £8.9 billion a month.This is higher (in current prices) than in 2011 when it averaged £8.4 billion.

Not much sign of Mervyn King’s “re-balancing” there ! As the devaluation took place in 2007/08 perhaps he will be kind enough to update us on when it will take effect.

So we see that on the evidence so far the future looks likely to disappoint in the same way that the recent past has and accordingly the Chancellor will need to pull ever more rabbits out of his hat.

The Structural Deficit

I have criticised this before because it is an amorphous concept which in practice is virtually meaningless. Actually this is the very reason why the UK targeted it as such a concept is ideal for politicians. Let me explain this with reference to yesterday. From the OBR.

We are more pessimistic about the economy’s medium term growth prospects than we were in March.

Okay that seems simple we will be poorer than expected and the numbers for borrowing etc. will be worse. Ahem, not quite…

But most of this downward revision is assumed to be cyclical – and therefore eventually reversible – rather than structural and permanent.

So we are poorer in a richer sort of way according to the OBR and the stroke of a pen everything is better! Well in their fantasies anyway as reality will be unchanged of course.

Actually the OBR is lost in fantasy land

The Chancellor’s continual  repetition of the word “independent” when discussing the OBR yesterday reminded me of Queen Gertrude in Shakespeare’s Hamlet.

Methinks, the lady doth protest too much

In reality as discussed above it already resembles an official lapdog which continually overstates expected economic growth and understates expected inflation. Those bits could be pre-printed for its future forecasts to save time and trouble! Indeed it seems to have lost faith in itself.

The bands show the probability of different outcomes if past official forecasting errors are a reasonable guide to likely future forecasting errors.

It looks as though it could not approve some of the financial alchemy discussed above fast enough.

Policy decisions by the Government and reclassifications have reduced PSNB this year by £16 billion – in particular the auction of spectrum (which is expected to raise £3.5 billion) and the transfer of proceeds from the Asset Purchase Facility (which reduces PSNB this year by £11.5 billion).

I am not arguing the point about the APF funds here simply pointing out that if this was a good idea why weren’t they included from the beginning? Here I do have my own position as I have argued on here many times that UK public-sector borrowing including the effects of financial interventions is an important number and yes it was in it. But I was rather  as the rock group Heart once put it “Alone”……..

As to the OBR let us save the money and scrap it. After all we are supposed to be having a “bonfire of the Quangos” are we not?

Losing the UK’s AAA rating

The French owned ratings agency Fitch waded into this issue yesterday by hinting at a downgrade.

Fitch placed the UK’s ‘AAA’ rating on Negative Outlook in March 2012. The agency will conduct a further formal review of the rating in 2013, incorporating the government’s 2013 budget.

Whilst this may have been a bit of Gallic revenge for the way that “Anglo-Saxon” ratings agencies have downgraded La Republique it is also true that a downgrade of the UK is long overdue. So it is not quite the news that many have presented it as.

Also these days ratings downgrades for sovereign nations are not what they were. If we continue with the the Gallic flavour we can see that the French government bond market has in fact rallied since her recent downgrade by Moodys. So much so that her ten-year bond yield dipped below 2% yesterday a move which it has repeated today.

The Good Points

1. The personal allowance -the amount you can earn before paying income tax- will be raised again to £9,440 in April which will help to take more of those who work out of the poverty trap.

2. The proposed increase in fuel duty of 3 pence planned for January was scrapped. We have enough institutionalised inflation in the UK without adding to it.

3. The reduction in the Corporation Tax rate to 21%. Let’s hope that we actually collect some of it…

4. An extra £600 million for science and innovation which I hope that the latter-day Sir Humphrey Appleby’s do not waste.


In essence yesterday’s Autumn Statement dealt with an uncomfortable and disappointing reality by a combination of financial alchemy and declaring that the future is bright. So there were clear elements of Groundhog day here. But if our economic numbers continue on the this week’s trend then there will be more disappointments to come in the future. In the end reality is real whilst forecasts particularly official ones mostly turn out to be fantasies.

Those who have followed the use of  a similar phrase in the Euro area will be made rightly nervous by the use of this “on the right track” by the Chancellor.

Also whilst there was a welcome change (back) on the rules on income drawdown there were many changes announced to the pension regime. Whilst they are always presented as affecting virtually nobody that is seldom actually true and we are left with the inconsistency of asking people to plan for 20/30/40/50 years with rules that change annually.

I will discuss the issue of benefits and indeed tax threshold indexation or rather lack of in future posts as there is a lot to say, but for now I would point out that the main danger here is a pick-up in inflation.

For those who read this before the Bank of England announcement at midday I do expect some to vote for more QE but probably not enough for a majority. It could be tighter than many think.


This entry was posted in Financial crisis, GDP, General Economics, Gilts, Growth, Inflation, Quantitative Easing and Extraordinary Monetary Measures, UK Inflation Prospects and Issues and tagged , . Bookmark the permalink.
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  • JW

    Hi Shaun

    I think the amount of the public debt now monetised through QE is now about 40%. The BoE will have to vote for some more soon so as to cover all new borrowing requirements. I read in MSM that Osborne is just tinkering around the edges and why doesn’t he do something radical. I wonder when/if the mainstream will ever tell the truth. He is doing something, he is creating inflation in a way that protects the very few. Along with most other western nations.
    Incidentally, the tax anticipated to be taken from pension adjustments is about half the amount he is giving overseas in new ‘green’ aid

  • Rods

    Hi Shaun,

    Another fiddling while Rome burns budget statement.

    In 1997 the UK government spent £250bn, now it is £744bn. GDP has not tripled in this time period and that is the crux of the problem. Since the ConDems came into office there has been no spending reductions, just slower rates of increase, which relied of the sharing of the proceeds of growth, remember that one when they were in opposition. The problem is that there has been no growth.

    The private sector and consumer has been steadily hammered since 1997 with money through tax increases ending up in the non-productive side of the economy. We know that as government spending increases that growth decreases, until you have below trend or no growth. I firmly believe we are in this zone, where even with strong trade winds behind the UK it cannot produce trend let alone above trend growth. With the economic head winds we have at the moment, we could well be heading for a triple dip recession and at best all we are going to have another year stagflation.

    I have seen in the last week a number of 2013 predictions from various banks and other groups and they read like the year before. I think they have through their own austerity just dusted off last years reports and changed the year. Last year they were promising a squeeze in the first six months of the year followed by green shoots and the beginning of an economic recovery in the second. It is the same for 2013. It is also the same old story with the OBR, slow growth next year, better growth the year after and above trend after that. I know we are now into the pantomime season, so the OBR need to be told “the growth years are behind you” and on their record I find Pinocchio more believable, even when his nose is growing!

    What is unbelievable is that discretionary spending , especially in an area the Government admit has virtually no benefits for UK industry and jobs, has increased. Overseas Aid has increased with an additional £2bn being spent on useless windmills in Africa, you couldn’t make it up. When things like this are happening you realize there is no serious intent to get the UKs very serious financial situation under control, with our country and our way of life being in the biggest danger it has been since 1940.

    The fact the Chancellors previous job experience to qualify him for this job, consists of enter the details of the deceased on an NHS database, and refolding towel in Selfridges shows! Most people that have been in business for any length of time would from experience be handling things very differently, not carry on spending,, like no tomorrow, and kicking the can down the road hoping something will turn up.

    Now, from the Euro austerity experience I’m not one to suggest drastic public sector cuts, to accelerate deficit reduction as we would just be following the route of Greece, Spain and Portugal. If Government spending cuts were seriously targeted in their over £100bn of wasted spending and used to make tax cuts, then the money would not be being taken out of circulation, but spent where there is a greater velocity of money so there would be growth. There is a risk to this, that I acknowledge and that is the extra disposable income is just used to pay down personal debt, then this policy would fail. But if the tax cuts were targeting on the income tax threshold, raising it towards a target £12,000, so people on the minimum wages in full time jobs were taken out of the paying tax, then I think you would find the squeeze at this and on anybody below the 40% tax threshold, and probably quite considerably beyond, would be being spent out of necessity to help make up the 13.2% to date real income drop.

    With the current can kicking and the probable loss of our AAA rating, the resultant Sterling crisis, staved off with lots more QE, which leads to hyperinflation storm is on the horizon. The future for us and the real cuts that will have to be made under IMF supervision, will be much more painful than if the hard decisions were being made and implemented now.

  • DaveS

    That 40% is now interest free – the capital will never be repaid and as you said the percentage will keep rising.

    So it makes a mockery of % debt to gdp ratio as we don’t have to service 40% of it with tax revenue or ever pay it back. Really our debt to gdp is more like 40% – happy days we have finally hit Gordon’s golden rule !

    Mervyn has created the ultimate moral hazard – the more QE, the lower the total debt interest – hurrah ! Forget real deficit reduction.

    Now of course we might lose AAA etc when the markets wise-up – but the gilt buyers are primarily Mervyn himself, British government owned banks, the UK operating banks hooked on Mervyn’s welfare subsidies and British pension funds threatened with government raids. I don’t think a Gilt strike is likely – Mervyn/Marc will not allow it.

    If Gilts don’t give, then eventually the pound will and that will in turn trigger full on inflation with wages to follow. Thats the end game.

  • Anonymous

    Correct on the spending. I’d note that it was Ken Clarke who balanced the budget in 1997 and I was disappointed that he didn’t get his old job back. Maybe the LibDems vetoed Clarke’s appointment.

  • Shaun Richards

    Hi JW

    After todays very weak numbers in the UK for production I think that more QE and perhaps a base rate cut are ever more likely.
    Just to confirm the numbers QE covers 32% of the UK Gilt market but if we exclude index linkers as it does not buy them we get to 39% as of the latest annual figures (March 2012).

  • Shaun Richards

    Hi Dave
    One cautionary note. When Moodys downgraded France her inability to do QE -due to her Euro membership- was quoted as a contributory factor.
    So as we have QE and seem willing to do more could we lose our AAA status because we are AAAA or AAAAA?
    Sometimes you really couldnt make it up…

  • Anonymous

    Is HMG strategy to let inflation take the strain by an implicit 3% unoffical target but no indexing of tax bands and 1% uprating on welfare payments thereby skewing the automatic stabilisers so more tax in and less benefits paid?

  • Shaun Richards

    Hi Chris
    Yes I agree. The only way that this would not apply would be if inflation was <1% and we have turned into Japan…
    As for the full effect we will not know that until we see what inflation actually is over these 3 years altho' as I have pointed out in today's post we do know that inflationary expectations are rising

  • Shaun Richards

    Hi Rods
    Todays numbers from the UK (production and inflation expectations) only make all this look worse. Just to add to it we get weak numbers from Germany too. As so often we find reality proving inconvenient for forecasts/fantasies.
    In a more hot off the press effort the US unemployment numbers looked very good initially but the participation rate has fallen (again)…