The UK’s main deficit is in productivity

You wouldn’t think that too much economic growth would be a problem for the Chancellor. But according to FT replication of official models used by the OBR earlier this week, it may well be. Essentially, we are already starting to exhaust the gains from economic recovery. We are using up spare capacity and unemployment is coming down, leaving little room to grow more in the absence of a substantial uptick in productivity.

This is a problem because it means that much less of the Government’s deficit can be expected to evaporate through growth in the economy and tax revenues.  In fact, we’re already on back on trend, and the trend isn’t looking so great.  Hence headlines last week about George Osborne’s £20 billion black hole in the finances as we head into Budget week, with speculation as to how the OBR would deliver the news on George Osborne’s ability to meet his fiscal targets in five years’ time.

We shouldn’t get too carried away by this. The OBR models are pretty uncertain anyway. Firstly, there is a huge range in estimates by other forecasters of the “output gap”, which measures the amount of spare capacity in the economy, and which underlies this calculation. The OBR’s last estimate of the output gap in 2013 came out as 2.3%; other forecasters estimated that in fact the output gap was over double this, others estimated it was less than half. The difference is enough to put the estimate of the cuts George Osborne needs to make out by tens of billions. Secondly, the OBR themselves don’t tend to take the results of their models at face value; in their last report, they estimated the output gap to be larger than the numbers indicated by their two models. Finally, there is a fair bit of overshooting on deficit reduction already implicit in the plans, so at least some of the hole – if there is one – could be absorbed. But whilst the public spending estimates that the models come out with are uncertain, the change that the calculations are picking up – a narrowing in our capacity to grow further – is likely to be reflecting something very real about our underlying levels of productivity. It also confirms statistics from elsewhere that all point towards the UK having a productivity problem. Of the G7 countries, only Japan has lower output per worker than the UK.

This is the most worrying aspect about the FT calculations. Taken with other evidence, the potential for our prosperity to increase in the future is looking uncertain. Productivity needs to become the priority for the Chancellor. This is not a debate about sensible management of public finances versus more spending. As the SMF pointed out in the run-up to the Autumn Statement, the OBR’s other main report – the Fiscal Sustainability Report – shows that even on current deficit reduction plans public sector net debt will start to creep up again by 2030, driven by an ageing population. The size of the increase is one that will dwarf what we have seen so far. One factor that can change this is a significant uplift in productivity. Focusing on productivity is sensible management of public finances.

On one of the FT’s calculations, output is already 1 per cent above its sustainable level, i.e. we’re above the level of output that is sustainable in the long-term. Translation: we’re in a boom already. But if this is what a boom feels like, we don’t have much to look forward to.


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