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21 Mar 2014

UK budget 2014: hope is yet to triumph over doubt

Stephen King

by Stephen King

HSBC Group Chief Economist

UK budget 2014: hope is yet to triumph over doubt

The UK government is changing tax rules to benefit and encourage savers

When an economy enters a prolonged period of lower-than-expected growth, there is bound to be a fight over the spoils. In the UK's case, George Osborne has decided to prioritise the interests of the older generation, as shown in Wednesday's budget statement. Politically, that is not surprising. All political parties yearn for the support of the baby-boomers: there are lots of them and they are now of an age where they can reliably be expected to head down to the polling stations to cast their votes.

In truth, Mr Osborne has to confront a stark economic reality. If the Office for Budget Responsibility's (OBR) forecasts are anywhere near accurate, the UK economy is condemned to a remarkably weak pace of economic growth in the coming years. The OBR believes the UK's unexpected strength last year was cyclical, not structural, and is not yet prepared to proclaim a renaissance in medium-term growth prospects.

Mr Osborne has focused a lot of his budget on the need to reinvigorate business; if productive potential is to pick up, the UK needs more investment and more exports

The OBR estimates that "potential" output grew only 1.2 per cent last year, a lamentable performance compared with the long-term average and a sign that total factor productivity is currently moribund. Admittedly, the OBR hopes that productivity will accelerate in coming years but it has little confidence in that view: in its words, "much of the loss of productivity over the recession was structural and will not return even as the economy recovers and the financial system returns to full health. Since it is difficult to explain the abrupt fall and persistent weakness of productivity in recent years, it is also hard to judge when or if productivity growth will return to the rate consistent with historical trends."

One implication of all this – not spelt out by the Chancellor but hinted at in the Bank of England's (BoE) recent Inflation Report – is that UK interest rates are set to remain very low, not so much because monetary policy will be loose but, rather, because economic growth is set to remain very weak on a structural basis (think, for example, of Japan's experience in recent decades). It is for that reason that, with regard to austerity, Mr Osborne can only promise more of the same. Even if the recent cyclical news has been better than expected, the OBR is not convinced that the UK is about to enter "escape velocity".

This, in turn, poses an intriguing challenge for the BoE. Mark Carney, the Governor, is clearly hoping for a more powerful recovery but, if the OBR is right, there are limits to how much of a recovery the UK economy will really be able to sustain. It is not difficult to imagine a further acceleration in demand in the short term – the OBR suggests a pick up in wages in response to a tightening labour market will help support consumer spending, alongside a chunky increase in household debt – but whether supply is able to respond in a convincing fashion is another matter altogether. After all, the OBR thinks the output gap in 2014 will be a modest 1.4 per cent, which does not leave much room for manoeuvre. Structurally, interest rates deserve to remain low (trend growth is lower). Cyclically, some could think monetary policy might need a little tweak (there is less spare capacity). It is hardly surprising, then, that forward guidance has left many people more than a little confused.

Gazing through the OBR's numbers, it becomes easier to see why Mr Osborne has delivered a "budget for savers". If interest rates are set to remain very low structurally, savers will lose out. Fiscal policy can help alleviate those losses (but only at the expense of austerity elsewhere).

Under these circumstances, Mr Osborne has focused a lot of his budget on the need to reinvigorate business; if productive potential is to pick up, the UK needs more investment and more exports.

All in all, this looks like a budget designed to subsidise savers when the outlook for savings appears particularly bleak. Whether higher savings will, in turn, allow the UK economy to rebalance towards investment and exports is, however, another matter altogether. Even if the Chancellor is hopeful, the OBR clearly has its considerable doubts.

This article is based on a version that was originally published by the Financial Times on 19 March 2014.
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