It has reduced its estimate for trend growth in recent years and thus reduced its estimate of the output gap. Because of this, it thinks more borrowing is “structural” and less “cyclical” than it previously thought.:
By 2015-16, we expect PSNB to have fallen to £53 billion or 2.9 per cent of GDP, compared to the £29 billion or 1.5 per cent of GDP that we forecast in March. The extra borrowing is primarily structural rather than cyclical, in other words it will not disappear as the economy recovers.
This in turn has put pressure on Osborne to tighten policy in order to meet his self-imposed target of balancing the structural current budget in five years’ time.
I have four problems with this:
1. It makes policy pro-cyclical. If estimates of trend growth fall when growth is weak, then the desire to balance the structural budget imposes fiscal tightening in bad times*.
And it’s not just fiscal policy that becomes pro-cyclical. So does monetary policy. A lower output gap estimate means - other things equal - a higher forecast for inflation and hence, under inflation targeting, less justification for loose monetary policy.
Luckily, it’s not clear that the Bank shares the OBR’s pessimistic view of spare capacity; it seems more optimistic about inflation than the OBR. But this is a happy accident. A policy framework that depends upon the monetary and fiscal authorities having different views is not sustainable.
2. The distinction between “cyclical” and “structural” borrowing does nothing to answer the key question, which is: will the gilt market remain content to finance borrowing? It might be that the gilt market is happy to finance even “structural” borrowing, insofar as this is the counterpart of weak long-run growth and hence poor returns on equities. Or maybe not. Merely labelling borrowing “structural” doesn’t help.
3. The concept of a structural deficit leaves unanswered the question: how, exactly, does a fiscal tightening reduce the deficit?
What I mean is that a structural deficit implies that, if the economy were at its trend level of output, the private sector would be saving more than it invests: this is the counterpart of the government’s deficit. To reduce the structural deficit thus requires that private sector investment rises and/or savings fall. But how does fiscal tightening achieve this?
4. Forecasts of the structural deficit rest upon two huge uncertainties - and it’s not clear that they offset each other: an uncertain estimate of the output gap (and sensitivities of spending and revenues thereto); and the usual uncertainties surrounding any fiscal forecast. I’m with Simon Ward on this: “it is troubling that the fiscal framework pivots on a concept subject to huge empirical uncertainty.”
I suspect that the notion of a structural deficit is playing an ideological role - one that‘s a little analogous to the reasons why the Greeks and Italians have “technocratic“ governments. A pseudo-scientific claim to expertise is being used to disguise what is, in fact, a judgment, that borrowing is too high and can and should be reduced by fiscal policy.
* It’s not good enough to claim that Osborne’s new tightening is back-end loaded, with spending cuts in 2015-17. The anticipation of future tightening might depress activity now.