The Office of Budget Responsibility’s updated Economic and Fiscal Outlook, published on Wednesday to coincide with the Spending Review, marks an important moment in the Covid-19 crisis. Chancellor Rishi Sunak struck a downbeat tone, telling Parliament that the ‘economic emergency has only just begun’. Journalists followed his lead, filling news bulletins with talk of impending financial doom: BBC journalist Laura Kuenssberg made headlines for her inaccurate and irresponsible claim that ‘this is the credit card, the national mortgage, everything absolutely maxxed out.’
Part of the reason for this focus on the public finances is that borrowing has risen at a rate unprecedented in peace-time. Loose talk from the chancellor about his ‘sacred duty’ to balance the books has not helped. Another is that the OBR’s economic forecasts have become significantly less rosy since the start of the crisis. Like the chancellor, the OBR has emphasised the need to balance the books, while also noting that this is an imprecise and ambiguous policy target.
In this response to the Spending Review, we argue that the OBR’s forecast revisions are a welcome development. Nevertheless, there is no reason for alarm, and no pressing need to ‘balance the books’. The public debt is – and will likely remain – entirely manageable.
Shortly after the publication of the OBR’s first ‘coronavirus reference scenario’ in April, we published our own fiscal projections for the Institute for Public Policy Research. We presented forecasts using the macroflow model that showed lower growth and higher deficits than the OBR, but argued that the resulting elevated debt levels are unlikely to cause problems. The original forecasts, alongside explanatory notes, can be found here.
The chart above shows the nominal GDP forecasts we published in May, using the six month lockdown scenario which broadly corresponds to the 2020 policy environment. The blue dashed line is the median forecast, with the shaded bands indicating percentiles of the forecast distribution. The chart also includes the OBR’s April forecast for nominal GDP (red dashed line), published as part of the ‘Coronavirus Reference Scenario’. The OBR’s April projections lie outside the range of likely outcomes in our projections.
As noted above, the OBR’s most recent forecasts are considerably less optimistic than the April ‘coronavirus reference scenario’. By toggling the ‘OBR Nov’ entry in the legend, one can super-impose the OBR’s November forecasts on the graph. The solid line represents the OBR’s central scenario, while the dashed lines show the ‘upside’ and ‘downside’ scenarios. The OBR has become more pessimistic over the course of 2020, a process that started with July’s Fiscal Sustainability Report, which also included (for the first time) a ‘downside scenario’ of lower growth and higher debt.
While the OBR now forecasts a lower immediate hit to nominal GDP than in their April scenario, a much weaker recovery than previously forecast means that the OBR's downside forecast for 2021–22 almost coincides with our median projection
The OBR’s revisions to its nominal GDP forecasts are reflected in a similar set of revisions to its taxation and public sector spending forecasts, illustrated in the two charts above (these work in a similar way to the nominal GDP chart: the user can toggle the OBR’s November forecasts using the legend). The charts can also be switched between sterling amounts and percentage rates by toggling the ‘% GDP’ buttons.
While we predicted substantially higher spending than the OBR's April scenario, even this turns out to be an underestimate. Upward revisions to the OBR’s public expenditure forecasts, in conjunction with downward revisions to the OBR’s tax receipt forecasts, result in the upwards revisions to their borrowing forecasts plotted below.
As the reader can observe, the OBR’s November forecasts are now much closer to the macroflow forecasts we published in May. In fact, the more pessimistic forecasts in November’s Economic and Fiscal Outlook – the ‘downside scenario’ – are comparable to our median forecasts for nominal GDP, public spending, tax receipts and borrowing under the six month lockdown scenario, although the OBR remains more optimistic than us on the prospects for medium-run growth, so that our medium-term projections for government spending and the deficit as shares of GDP are substantially higher than the OBR’s.
As a result of these revisions, the OBR’s ‘downside scenario’ for public debt is also similar to the debt forecasts we published in May.
The reader will be unsurprised to find that we share the OBR’s pessimism concerning the economic impact of the Covid-19 crisis. We did not think that there would be a V-shaped recovery in May, and we do not now. For this reason, we welcome the forecast revisions made by the government’s fiscal watchdog over the course of 2020 – rational policymaking requires a clear idea of where we are headed.
In light of this, is it really the case that the government has ‘maxxed out’ its credit card? Is the public debt on an unsustainable trajectory, implying a need to balance the books?
In May, we argued that public debt at the levels implied by the macroflow forecasts did not pose a problem. Our public debt forecast remains less optimistic than the OBR’s – even after their November revisions – and we have seen nothing to change our opinion.
As argued by one of us back in July (slides and video here, here, and here), public debt to GDP ratios of 120%, or thereabouts, do not pose a serious problem with interest rates close to zero. In fact, they do not pose a serious problem with considerably higher interest rates, and a reasonable estimate for the maximum sustainable debt ratio attainable by the UK – i.e. the public debt ratio that the UK could sustain indefinitely without getting into political difficulty – would likely be in excess of 130% of GDP.
It is worth pointing out that this is not an unusual position to take. A well-regarded academic paper by Fabrice Collard and his co-authors estimate a range of maximum sustainable debt ratios for OECD countries; the average of their estimates for the UK is just under 120% of GDP, and their highest estimate is about 160% of GDP. As Collard and his co-authors use an interest rate of around 3.5% to calculate their estimates, compared with OBR forecasts for the gilt rate of under 1% for the foreseeable future, we suspect that their estimates are probably too low.
Jason Furman, former chair of the Council of Economic Advisors under President Obama, has made a similar argument for the USA. Based on a long-run target interest-to-GDP ratio of around 1%, he argues that a reasonable sustainable debt level would be in the region of 150% of GDP.
Instead of providing their own estimates of the government’s maximum sustainable debt ratio, and evaluating alternative fiscal policies on this basis, the OBR persists in its focus on ‘balancing the books’. In November’s Economic and Fiscal Outlook, it estimates that this would require a consolidation of £27 billion (to close the current primary deficit), £80 billion (to close the primary deficit), or £102 billion (to close the overall deficit), all by 2025-6.
But ‘balancing the books’ is not necessary, and hardly any governments do it. Instead, stable or slowly decreasing debt ratios outside crisis periods are entirely sufficient, and in some sense optimal. Importantly, this debt management strategy is completely consistent with a permanent deficit – all that matters is that the public debt grows at a rate equal to, or slightly less than, nominal GDP. With interest rates currently at their lowest level for an exceptionally long period of time – and likely to remain there – it is even possible to achieve this with a permanent primary deficit.