Monday, November 29, 2010

Facing Up To The Doomsday Machine

So what have we learned from today's autumn fiscal report from the Office for Budget Responsibility?

First, the OBR under Chote still thinks George is on track to deliver what he promised in June:
"Our best judgement is that the Government has a better than 50 per cent chance of meeting its mandate for a cyclically-adjusted current budget balance in 2015–16 and of achieving its supplementary target of seeing public sector net debt fall between 2014–15 and 2015–16."
Spot that "better than a 50% chance"? To listen to Will Hutton and the BBC's other "neutral commentators" you'd think the OBR had said "less than 50% chance". The fact is that despite everything previous Chancellors have promised, there are never any certainties in fiscal forecasting. "Better than 50%" really does mean George is on track.

Indeed, on the OBR's forecasts, things could well turn out better, because they reckon the downside risks to growth - the ones stressed by the BBC - are evenly balanced by the upside "risks". That is, growth could turn out higher than the central forecast, boosting tax revenues and cutting welfare payments. The OBR thinks there's a 1-in-3 chance that the government will actually be in surplus (ie repaying debt) by 2015-16:

As for the OBR report itself, it's in a different league from anything HM Treasury has previously published. It provides much more detail on the underlying assumptions, and for the first time gives some chapter and verse on BOM's old friend the Doomsday Machine (aka the risk that debt interest payments grow faster than the government's ability to finance them out of current revenues).

On that, the headline message - trumpeted by everyone from the Chancellor down - is encouraging. It is that debt interest payments are now expected to be lower than forecast in June - £18.6bn lower over the forecast period as a whole (2010-11 to 2015-16). So that's definitely good.

But we shouldn't get carried away. Debt interest still increases from £43bn this year to £63bn by 2015-16. Moreover, the OBR lifts the lid on the underlying drivers of its debt interest projection. And there we discover that what's driving the reduction in costs is not some big cut in borrowing, but a cut in the assumed interest rate the government will have to pay.

Here's the OBR's chart comparing June and November's assumptions on the average interest rate HMG will have to pay on the majority of its new bond issues (so-called conventional gilts):

As we can see, November's assumed rate is lower throughout the forecast period (by an average 0.24%). And it's the assumed lower rates that drive the bulk of the saving.

Now those lower rates reflect what has happened in the gilt market since June, so fair enough. Especially since George can argue that it's his "tough choices" that have given the market confidence to cut his borrowing rate.

But as we all know, rates that go down can also go up - especially if the market gets the jitters on inflation. So what happens then?

Again, the OBR report tells us. It includes a handy ready reckoner (Table 4.20) that shows what happens if the interest rate on gilts increases by 1% from what has been assumed. An it's not pretty - a 1% increase throughout would add £15bn to debt interest costs (and although we can't quite tell from the OBR table, with higher gilt yields there would almost certainly be other associated increases, reflecting for example, higher interest rates on National Savings).

One of the most interesting sections is on the long-term fiscal outlook, where an unchecked Doomsday Machine at full revs can do some real damage.

The key long-term issue is one we've blogged many times - too many old people, and not enough workers to support and look after them. The healthcare and pension costs of the old people increases inexorably, the tax revenues generated by the young fail to keep pace, and government borrowing goes through the roof.

The OBR has cranked some numbers looking out to mid-century showing how this could impact public sector debt. It reckons that even if all future governments maintain the same degree of fiscal restraint as George (a highly unlikely proposition given past experience), the cost of all those old people will push debt up to 100% of GDP by 2050:

But concerning though it is, that projection almost certainly understates the problem. Not only does it exclude all those off-balance sheet Enron debts, but others have projected much higher debts by mid-century (eg the Bank for International Settlements recently projected UK official public debt at 550% of GDP by 2050 - see this blog).

This is a serious problem - and Tyler speaks as one who will be part of that problem. Something will have to be done, and none of the options are going to be popular.

The OBR says it is taking a much closer look and will be reporting back next year. We very much hope that they give it to us straight - much straighter than the "fiscal sustainability" reports the Treasury have issued in the past, which have basically made out everything's fine.

Minds need to be concentrated on Doomsday.

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