Select Committee on Treasury Minutes of Evidence


Examination of Witnesses (Questions 240 - 259)

THURSDAY 6 DECEMBER 2001

MR GEOFFREY DICKS, MR DAVID WALTON AND MR MARTIN WEALE

Chairman

  240. May I welcome you to this macro-economic section? I shall start with a general question to all of you. Thereafter we are focusing questions on one speaker but if anybody wants to come in on the question, so be it. Has the Treasury made a full and fair assessment of the uncertainty surrounding the global outlook when devising the PBR forecasts for the economy and the public finances? Is the overall balance of risks to these Treasury forecasts to the upside or the downside?
  (Mr Walton) The Treasury forecasts are actually quite similar to the recent forecasts the Monetary Policy Committee made in the Inflation Report. They are broadly in line in that sense. They are a bit more optimistic than our own forecasts, but the important thing to remember is that the fiscal rules the Government has are expressed over the entire economic cycle. If it turns out to be the case that the economy over the next year or so is weaker than the Treasury expects, as long as that is a cyclical shortfall which you can recover in future years, then it should not really change the Chancellor's assessment of what he needs to do for taxes and spending. It is important to distinguish that point about the medium term. As far as the world economy itself is concerned, there is still quite a lot of uncertainty. Financial markets are taking the view that we are pretty much at the bottom and that they are beginning to anticipate that we shall see quite a reasonable recovery in global activity. The view of myself and my colleagues at Goldman Sachs is that it will probably take a little bit longer for the world economy to see a recovery and that the recovery when it comes may be a little more subdued than financial markets are expecting. As a result, we have slightly weaker growth forecasts. If you take it over a run of years, over the next three or four years, the actual average level of growth we expect in the UK is pretty much the same as the Treasury expects, it is just that the timing is slightly different.
  (Mr Dicks) There was a lot of comment at the time on the Chancellor's forecasts. Next year is very difficult, very uncertain, but there was particular comment on the strong growth forecast for the year 2003. I do not have a lot of problem with that. With the amount of policy stimulus, fiscal and monetary, which is going on in the United States, in Europe and the United Kingdom, I would guess that on a one to two-year timescale the global economy will be moving ahead quite rapidly. We can argue about how far it goes backwards in the present quarter and maybe in the first half of next year, but on the medium-term timescale, the idea that the economy is growing at three per cent or faster than that, given that we are going to have a hiatus next year, does not worry me at all.
  (Mr Weale) The statistical answer to your question on whether the Treasury has given a good assessment of the risks must be no. Unlike the Bank of England and, I have to say, the National Institute, they do not give us any indication of what the probability of particular outcomes is. If they want to give an indication of the risks the economy faces, then they ought to have tables showing that in their forecast and I hope it is an omission which they will remedy at some point in the not too distant future. Moving on to the question on whether I have any real difficulty with the Chancellor's forecasts, the answer has to be no, basically because it is broadly similar to my own view of the likely evolution of the economy. The rapid growth which he is forecasting in 2003 is perhaps a bit more rapid than I am looking for, but on the other hand we know forecasting at that time horizon is uncertain and it is silly to get exercised about a quarter of a percentage point, particularly when we are talking about the year after next.

Mr Beard

  241. Do you think the Treasury is correct in its assessment of where the economy is now relative to its trend?
  (Mr Weale) The Treasury is excessively confident in the way that it describes the trend and the idea of a clear trend. As far as I could see, although quite a lot of assumptions have been audited by the National Audit Office, the question of the trend is not one which at least is listed as having been audited and I think it should be examined in greater detail. If I was constructing a prudent forecast, I would assume that there is a trend rate of growth, an average rate of growth, but no reference to trend level. I would say let us suppose that the economy continues from where it is now and in some sense bygones are just bygones. During a period of a boom you might say that would be too optimistic, it would give a Panglossian view of the economy, but in constructing a cautious estimate at a time of weak economic growth, it would seem to be more prudent than what the Treasury has actually done which is build a fairly strong cyclical recovery in revenues into the economy in 2003-04 and then continuing into 2004-05. They may be right, it may be that this cyclical recovery in revenues does happen, but I should have thought they were excessively confident about that.

  242. So they are erring on the side of optimism rather than being cautiously optimistic.
  (Mr Weale) On this occasion they are erring on the side of optimism and not discussing the possibility that the weakness in tax revenues may be semi-permanent.

  243. Taking the situation overall in 2002, do you think the upside risks predominate or the downside risks predominate out of the Treasury's forecasts?
  (Mr Weale) I am now inclined to think that they are fairly evenly balanced. I could see consumer spending growth being stronger than they predict. They predict a level savings ratio. If the interest rate stays at four per cent then I could see people going out and borrowing even more. That is a factor which could be quite powerful on the upside. Obviously world trade, the world performance could be weaker than the Treasury is assuming and we have what has become the perennial question of Government spending and whether they actually spend as much as they say they are going to. If you like, there is the world trade factor, there may be more concerns in the business sector which may discourage investment but offsetting those you have to say now that there is an upside risk on consumption.

  244. On Tuesday when Gus O'Donnell[4] was here he said that the Treasury's latest GDP growth forecasts had a 40 per cent greater standard deviation than normal. Do you think that the higher-than-normal risk around the growth forecasts is fully captured in the Treasury's range of opportunities?
  (Mr Weale) Given that he said that I should wonder why the sort of range they published was similar to what we are normally told. I may have missed the relevant points in the document, but I must say I did not notice that in the document I read. It is very helpful if the Treasury is saying things like that and it would be even more helpful if the calculations were put in the public domain.

  245. Would you say that was another indication that things were rather optimistic?
  (Mr Weale) Not necessarily that they are optimistic but if they think there is greater uncertainty than is usually the case, then they should give us probability ranges so that people can understand the way they see the risks.

  246. How confident do you think we should be that the global economy will show some signs of recovery in 2002?
  (Mr Weale) Now I am hoist by my own petard. I ought to be giving probabilities and I am afraid I am not going to. It is right that the United States' economy will start to recover early next year. Perhaps here I am a bit more optimistic than David Walton. Looking at the growth rate from the first quarter of next year, we may see moderately rapid growth in the United States which of course is a powerful influence on the world, even though the average for 2002 will not be much higher than for 2001. I am moderately confident, but I am afraid not able to give any probabilities or chances to it.

  247. The UK economy faces entry to the global slowdown with a current account deficit of about 1.5 per cent of GDP. Do you agree with the Treasury's expectation of a deterioration in the current account in 2002?
  (Mr Weale) The current account is likely to deteriorate for the obvious reason that if we are growing faster than the rest of the world, then our imports will be rising faster than our exports. One of the difficulties in analysing the current account is the rather erratic behaviour of some of the invisible components. They do mean that simply focusing on the conventional balance for goods and services normally gives you an excessively gloomy view of the overall current account but equally they do make it rather difficult for a forecaster to forecast.

  248. Will a weaker external position for the United Kingdom automatically mean that sterling will fall?
  (Mr Dicks) No, one certainly could not say that any economic phenomenon has automatic consequences for exchange rates. Exchange rates do have lives of their own and simply because the external account is likely to weaken, I certainly would not say that sterling is likely to fall.

  249. We could not rely on exports taking over if domestic demand started to fall.
  (Mr Weale) If domestic demand started to fall, if consumers went back to their savings habits of five years ago, unlikely for the reasons I have given but if that happened, then we certainly could not rely on being pulled out of a very slow period of growth or a recession by export sales.

Mr Plaskitt

  250. May I pursue the assumptions which are underlying the forecasts a bit further? I am looking at Table 2.2 on page 21 of the report and at the same time Table A9 which is on page 160. It seems to me that underlying the Chancellor's fairly optimistic assumptions about keeping growth going, is a belief that in 2002 growth is strongly supported by central government consumption. As you can see on page 160 there is a 4¾ per cent figure down for 2002, a very big figure against any of the others in that line. That drops right back in 2003 to two per cent but what then picks up the stimulus is export which shrivels to almost no activity in 2002 but surges back to about seven per cent in 2003. It is rather neat. It is almost Keynesianism to perfection. It is a central government stimulus in the first of these two years and that tails out as the world economy picks up. Am I right in that general reading of what is underpinning the Chancellor's assumption? If I am right, do you think those are reasonable assumptions to make?
  (Mr Weale) May I say to the first point yes, you are and one can add to that that included in the investment figure is substantial growth in Government investment. So altogether in 2002 the Government is adding about 1.3 per cent of demand to the overall growth of 2.3 per cent. It is one of the biggest Keynesian exercises that has ever been tried in this country. What is assumed in 2003 is in essence that world activity returns to normal and at the moment that is a reasonable assumption.

  251. Table 2.2 on the world economy shows world trade picking up from 1¾ per cent 2002 to 7¾ per cent the next year. Are there precedents for world trade recovering that quickly?
  (Mr Dicks) It was growing at a double digit rate last year.

  252. I know it was, but are there precedents for a recovery? I know the level has precedents. What I want to know is whether there is a precedent for so rapid a pickup from the slowdown.
  (Mr Dicks) Given the policy stimulus I would say yes. Once things turn.

  253. Has that been the case in the past?
  (Mr Dicks) Yes. The history of economic forecasting is that we always miss the speed of the upturn, we miss the speed of the deceleration. Most forecasters tend to come back to something approaching trend and we tend to lose those troughs and peaks in the cycle and the speed at which we move up and down through the cycle.

  254. You are not concerned about the implied rapidity of that recovery. It does not look odd.
  (Mr Dicks) No. What I am concerned about and this was the gist of the note I sent to you on Monday, is the forecast for public spending. Martin has alluded to these forecasts already. To summarise the note I sent you: why is it always jam tomorrow? Every budget, the budget of 2000, the budget of 2001, the Chancellor tells us he is going to increase the real volume of Government consumption by four per cent. Last year the outturn was 1.5 per cent. Undaunted he came up with 4 per cent in this year's budget; according to the PBR it is going to be three per cent but the average of the first three quarters is only 1¾ per cent. Undaunted yet again next year it is 4¾ per cent. A legitimate question of the Chancellor or of the Treasury is: why is it always jam tomorrow? Why do they forecast these big increases in public spending? They are always point forecasts, there is never an error band about these because they are not subject to normal forecasting error because they are plans, yet it never happens. I have offered an explanation this year, which is that the private labour market has been so buoyant that it has been impossible or very difficult for the public sector to recruit teachers, doctors, nurses against the competing claims of the private sector. That of course may change inasmuch as the private sector is probably a net shedder of labour going forward and the public sector will have a better chance to recruit the key personnel the public spending plans are based up. I should like to know whether that is the Treasury's explanation for why they have not managed to increase Government consumption. If you look at investment, it is even more pronounced. In the budget they said that general Government investment this year would rise 43.5 per cent. Now, six months later, 21.5 per cent. How can you plan to do something at 43.5 per cent, something you have control over yourselves, and come back six months later and say you have done less than half of what you were going for?

  255. Is this not a bit of the oil tanker scenario? Government investment and consumption has been so tightly constrained and borne down on for decades and now when you come along and you push the tiller it actually takes a while for the system to respond. Crudely, it is not used to spending, it is not used to investing and perhaps the systems are not there and the people with the skills to do it are not there. Eventually, if you just keep on the pressure, maybe the thing will start to flow, then your problem might be trying to rein it back in. It that not the case?
  (Mr Dicks) Maybe, but it has not happened yet.
  (Mr Walton) What this does show is that fiscal policy is not a good instrument for fine-tuning the economy. More by luck than by judgement we happen to have in place quite aggressive fiscal plans which happen to be supporting the economy just when it needs it. It is very difficult to know precisely whether you are going to spend the amount you plan. Even though notionally you have control over this you do not always spend what you intend. It is also a lesson for other countries. The US now is debating a very sizeable fiscal expansion which will not take effect probably until the spring of next year at the earliest, just at the time when the US economy is probably recovering. These numbers are always going to be imprecise, but this is quite an object lesson in the caution of using fiscal policy as a very strong tool for fine-tuning the economy.
  (Mr Weale) May I offer the antithesis of Mr Plaskitt's view that, public investment having been so low for so long, you might think it would be quite easy to identify the things which needed doing and then get on with them.

  Mr Plaskitt: I am not denying that for one moment. What I am asking is whether, once you have identified that, there are the people there who know how to set about doing it? Are the systems in place which know how to channel the money to those targets? It may be that they have not been there and they have to be put back in place, a culture has to be changed before you hit those targets with the money which is now there. That is all I am saying.

Mr Laws

  256. David, I want to ask you about your very interesting paper which you provided for us. There seem to be two components of this: one, optimism on the public finances in the short term and then somewhat deep pessimism in the medium term. Turning to the first of those, you point out in your note that the growth forecasts in the PBR were not changed a lot from the last budget, yet the borrowing forecasts deteriorated quite significantly and disproportionately. What do you think is behind that and do you think it credible that the budget forecast for this year and next year has come down so much?
  (Mr Walton) Most of the deterioration in the Treasury forecast is on tax receipts and that is coming through. We are seeing tax receipts coming in at a much lower pace so far this year than was expected at the time of the Budget and the Treasury's forecast for this year seems quite reasonable for tax receipts. Where they may find that the outturn is a little better this year is that in recent years government departments have struggled to spend the amount of money that has been allocated to them. If you look at the running total for Government spending so far this year, it is coming in rather lower. In other words, for the Government's forecast to be hit implies quite a sharp acceleration in the pace of public spending for the rest of this year. The more worrying thing is this shortfall in tax receipts. At the end of the day, on the spending side whether or not you spend it this year or next year, once it is there as a firm commitment presumably at some point the spend will take place. What is less clear is whether or not you get the tax receipts back. If you just look at the assumptions the Treasury has made for economic growth, and in Table B7 they show what that should mean for tax receipts, they basically say that for these very small changes they have made to their economic growth forecast, the maximum hit to tax receipts should be £2 billion in 2002-03 and then it is essentially reversed again thereafter. Whereas essentially they are expecting a £10 billion shortfall in tax receipts but then they expect to get most of that back again by the end of the period. That may happen, but equally in the past the Treasury has been inclined, when tax receipts have come in more buoyantly than expected, to build that into their base line going forward. What they have not done this time round is build in the undershoot in tax receipts going forward. In a sense they have been a little less cautious in their projections for tax going forward than in the past and if it turns out that these tax receipts do not rebound then they could find themselves with rather less medium-term comfort on the public finances than they thought.

  257. Because you think they may undershoot a bit on spending, you think they are going to be okay on their public finance forecast for this year and that the public borrowing will be slightly lower than expected and there may be a small surplus. Then you are pretty dramatically gloomy about next year. I think from your note what you are saying is that we are going to have zero public borrowing more or less this year and then we are going to have a deficit of about £20 billion next year, which is a pretty dramatic shift, particularly given that the Treasury is not all that pessimistic on growth, it is not as though they are forecasting a recession. You pick out a number of issues in your note, which you think may account for this. One of them is that maybe they are not going to get back these tax revenues they are not getting this year. You are also a bit pessimistic about spending, that the forecasts are sensible in relation to spending.
  (Mr Walton) There are three things as far as our forecast is concerned relative to the Treasury's. One is that we actually expect growth to be a bit weaker both this year and next year, so that cyclically reduces receipts next year and you get that back in future years. So that is one reason for pessimism. The second reason is that I am just a little bit more cautious about whether you do get the bounce back in receipts that the Treasury believes. On the corporation tax side in particular you could quite easily get a situation where there is a further deterioration in corporation tax revenues, given the downturn in profits which has taken place. The third factor on spending is that to the extent you do get an undershoot in spending this year—and I am assuming about a £3 billion undershoot in spending—then under the Government's end-year flexibility scheme in principle that £3 billion could be added to the existing plans for next year. So you get additional borrowing from that source. To the extent that the budget balance this year may be about £3 billion better just because public spending undershoots, then it is £3 billion worse as that money gets spent next year.

  258. You then have two other maybe slightly longer-term areas for pessimism, firstly the technical point that the new tax credits are not yet in the numbers. The second thing is that you point out that the Government's medium-term assumption for the growth of public spending is roughly the trend rate of growth of the economy, whereas in fact that is immensely unlikely if the Government is going to put more into health, education, transport and defence spending is probably not going to go down. That could also put quite an upward pressure on Government's borrowing forecast.
  (Mr Walton) On the tax credit point the package for pensioners is already costed and in the Government's projections. Then there are these additional tax credits for families with children, the childless families on low incomes and for research and development. The Institute for Fiscal Studies would have a better estimate of the cost but I would have thought they would cost at least as much as the pensioner package, possibly slightly more. Then the more fundamental point is this one about the long-term trend in spending. Conventionally the Government is assuming that beyond the current spending round, current departmental spending rises by 2.5 per cent a year and annually managed expenditure grows by 1.75 per cent a year. Current spending in total is growing by no more than 2.25 per cent a year in the period after the end of the current spending round runs out. If you look at what is planned for spending now in the three years from 2000-01 through to 2002-03, you are seeing current spending growth somewhere of the order of 3.5 per cent per year in real terms. The very simple point is what is more likely to be seen, a continuation of that kind of growth which is planned for the current three-year period or a reversion to a much more subdued rate of growth? Given the aspirations on health and on education, it seems to me that it is probably reasonable to make an assumption that public spending is going to grow something like 3.25 per cent a year for current spending. If that happens, it follows that the outlook for public finances is going to be somewhat worse unless the Government is prepared to raise taxes in some areas to meet that spending.

  259. Since 1997 Government has been in a very favourable position on the public finances and the surprises have tended to be the positive side, borrowing lower, bigger surpluses, war chests to spend and so forth. What you seem to be suggesting is that in this Parliament and perhaps throughout this Parliament the news on borrowing may disappoint and the Government may find itself struggling to meet its borrowing targets as opposed to wildly bettering them as it was in the last Parliament.
  (Mr Walton) It can still go both ways. The Treasury would say they are assuming quite cautious estimates for GDP growth, if trend growth turns out to be a bit higher then you will get additional tax revenue and so on. There are certainly arguments which go the other way as well. To the extent that tax revenues for the first time since this Government came to office are disappointing and we never know fully why tax revenues come in to a greater extent or to a lesser extent, but quite often when they do come in one way or the other they tend to persist. To the extent that tax revenues are disappointing at the moment, there is a reasonable chance that could continue. To the extent that the Government has promised additional tax credits, then that is using up a lot of its room for manoeuvre within the existing spending framework. The implication is that if they do want to continue a rate of current spending similar to what we are seeing at the current time, then there is not going to be that much room for manoeuvre within the existing public finance projections to fund that, if they want to continue to meet their fiscal rules. I am sure that the fiscal rules are going to remain pretty paramount. That probably means that if they do have strong spending aspirations then we are going to have to look around for tax revenues to finance them.


4   Managing Director, Macroeconomic Policy & International Finance, HM Treasury. Back


 
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