The OBR, fiscal consolidation and the economy

By Sam White

Ouch. The Office of Budget Responsibility has very publicly slapped down the PM.  That’s not something you see every day.

In seeking to explain why “growth has been depressed” in a speech this week, David Cameron claimed the OBR “are absolutely clear that the deficit reduction plan is not responsible”.

The problem is, that isn’t the view of the OBR.

Chairman Robert Chote’s swift response came in a letter to the PM bluntly contracting him: “to summarise, we believe that fiscal consolidation measures have reduced economic growth over the past couple of years”. (my underline)

In my experience of him, Robert Chote has always been credible and measured.  The OBR has moreover shown admirable self-restraint in the face of considerable fast-and-loose behaviour by George Osborne and David Cameron and largely managed to turn the other cheek (I’m thinking particularly of the games played by Osborne to understate long-term tax receipts from the 50p rate).  The fact Robert Chote felt compelled to come out so publicly shows how far from reality the PM’s claims on the economy actually are.

This was not an off-the-cuff remark by the PM; this was part of a prepared speech.  If he wasn’t seeking to mislead people, it means he genuinely didn’t understand his own economic plan.  Neither alternative should fill us with confidence, but the latter would be far more worrying.  Could it really be when George Osborne sold him a political plan to try to get the deficit problem out of the way before the next election, by cutting very early and very fast, Cameron didn’t understand how that would affect the economy?

I hope not.

Politically, the PM is of course seeking to argue everything else is to blame for the lack of growth, except the pace of his fiscal plan.  This continues the theme George Osborne likes to reprise, seeking to blame the weather, the Olympics, the Royal Wedding, Europe, too many days ending with ‘y’ (OK, I made the last one up).

So what’s the underlying economic point?  The question is how much cutting government spending reduces economic growth.  Specifically, for each pound reduction in government spending, how many pounds are you reducing the total size of the economy by?  The so-called ‘multiplier’ – the higher the number, the more harm to the economy from a cut.

The IMF used to say the impact was between 0.4 and 1.2 (i.e. for every £1 cut, it reduced GDP between 40p and £1.20).

The OBR in its letter explains that it is using a range from 0.3 to 1.0 depending on what type of action is taken.  They accept the multiplier effect, but are a little less pessimistic about the downward impact on growth than the original IMF figures.

However, the interesting development last autumn was the IMF revising their view.  The IMF October World Economic Outlook points out that “the evidence increasingly suggests that, in the current environment, the fiscal multipliers are large.”

The IMF go on to say “actual multipliers may be higher, in the range of 0.9 to 1.7.”

So the mounting evidence is the impact of cuts on the economy is larger than previously thought, not smaller.

What is so fascinating about David Cameron’s claims yesterday is he seems to be trying to say that the answer is 0.  No impact on growth.

During my time in the Treasury we spent a lot of time with officials thinking about the multiplier effect of government spending.  How much would a fiscal stimulus help the economy during the downturn?  How much would future cuts harm it?  I can’t believe no one has explained how this works to David Cameron.  It would seem an unforgiveable oversight, quite out of keeping with the excellent officials in the Treasury.

So recent evidence suggests the multiplier is bigger than previously thought.  But whatever the precise number is, Robert Chote is clear that “tax increases and spending cuts reduce economic growth in the short term”.  The PM is just wrong to claim anything else.

The OBR estimate the impact has been to “reduce GDP in 2011-12 by around 1.4 per cent”.  And that’s using the relatively conservative multiplier.  It may be a lot higher in the current climate.

The deficit does need to be brought down.  That isn’t the question.  But the timing and manner does matter.  As the IMF’s evidence suggests, ‘in the current environment’ the impact is significant.  You have to have a deficit reduction plan that allows for growth to get going.

This is at the root of the problem with the Osborne approach.  It was always a political plan, not an economic one.  Try and get it done before the next election.  And now, he is ignoring the economic conditions to avoid political discomfort of admitting the plan is not working.

But this comes at a price.  The key thing is that this isn’t some dry economic debate.  This is about the impact on people’s lives.  Many people will be suffering more than they needed to because of the choices this Government has made on the pace of fiscal consolidation.

Sam White was Special Adviser to Chancellor of the Exchequer, Rt Hon Alistair Darling MPmult