Analysis of the Chancellor’s Spending Review
“A billion here, a billion there, and pretty soon you’re talking real money.” These words, attributed to former US Senator Everett McKinley Dirksen, seem appropriate now as across the world public debt has reached an all-time high.
They are also relevant for the UK, where today the Chancellor unveiled his one-year-ahead spending plans and the Office for Budget Responsibility (OBR) produced their latest official economic forecasts. At a time of continued uncertainty, these plans and projections will frame consensus thinking on the key economic and policy issues.
Confirming the cost of the pandemic
Today’s statement put some official, up-to-date numbers on what we already know, namely that the economic cost of the pandemic is huge. The key message is that the economy and the public finances are in a fragile state but that the policy stance being taken is as good as one could hope for.
The OBR’s latest economic forecasts appear credible, although I think growth may be higher than they expect next year. The OBR points to the economy contracting 11.3% this year, before recovering by 5.5% next and 6.6% in 2022. Growth then is expected to decelerate to 2.3% in 2023 and 1.7% in 2024. These forecasts would be consistent with the economy not returning to its pre-crisis level until the final quarter of 2022. They are also consistent with unemployment peaking in the second quarter of next year, at 2.6 million or around 7.5%.
While high, this would be slightly less than was initially widely feared.
Two characteristics demand closer attention
There are many facets to the forecasts, but two warrant attention. One, is that the rebound in household consumption and in business investment are expected to be spread over two years, with consumer spending up 7.5% next year and 9.7% in 2022, while the rise in business investment is delayed to 2022 when it is forecast to increase 13.7% and then 9.7% in 2023.
The second characteristic is that the rebound loses momentum, particularly as we approach the next UK election scheduled for 2024. The challenge post-pandemic remains very much as it was before: how to raise the economy’s trend rate of growth.
Moreover, the fiscal numbers are likely to prove very sensitive to the state of the economic cycle and unless the economy grows at a stronger, sustained pace, the overhang of public debt will persist, and that could pose future policy challenges on tax and spending.
The question constantly asked is how much will be pandemic cost in fiscal terms, and how will it be paid for? Today, the Chancellor answered the first part. The spending boost to address the pandemic will be £281 billion this year and £55 billion next. As a result, the rise in public sector net debt in 2020-21 will be £473 billion. Already the ratio of debt to GDP has risen above 100%, the highest since 1960-61. This headline ratio is expected to rise further in coming years, despite economic recovery.
A necessary fiscal response
Given the uncertainty, the margin of error on fiscal projections is high. For instance, Government spending is already expected to be £54 billion more that was expected by the OBR in July, while in contrast, tax and other receipts are now expected to fall £57 billion, and while considerable, this is £32 billion less than the full forecast back in July. While we cannot be certain about the full fiscal cost, we are at least certain that it will be huge.
In the face of a global health and economic crisis the UK’s generous fiscal response has been both necessary and justified. I felt the Chancellor got the balance right between avoiding complacency over difficult policy choices ahead and avoiding panic about the size of the debt now and in coming years.
It is right to use fiscal policy as a shock absorber, to avoid premature tightening and to direct spending towards infrastructure investment and maintaining public services. Also, it was welcome to see the commitment to increase the minimum wage and still pay a wage rise to those on low incomes in the public sector.
The main focus has to be on a pro-growth agenda that reduces unemployment and allows the economy to recover at a stronger pace. The challenge, though, is what lies further ahead. If inflation remains low – and this is one of the big unknowns – then interest rates and yields can stay low.
Important to ensure a credible reduction of debt
Although the ratio of debt to GDP is set to rise in coming years this should not prove onerous to service by historical standards. It is expected to peak around 2024 and can then be reduced gradually over time. Allowing the debt-to-GDP ratio to rise significantly during the crisis is one thing, but it is important to ensure it does not escalate out of control and is reduced, credibly and sensibly, thus keeping financial markets onside over time.
Once the economy has started to recover, the debt-to-GDP ratio will peak and then the budget gap should be closed, ideally through higher tax revenues as the economy recovers.
What then for the markets? Sterling’s near-term performance will be heavily influenced by the outcome of the Brexit talks, where a trade deal is expected but is not certain. Despite the policy stimulus from unconventional monetary and fiscal policy, tough choices about future fiscal policy remain. Meanwhile, with interest rates at close to zero, markets are not pricing fully for risk and it is far from clear what constitutes a risk-free asset.
Despite this, the likelihood of a vaccine, alongside an economic rebound next year and continued stimulus from monetary and fiscal policy should provide a constructive backdrop for financial markets over the next year.
Please note, the value of your investments can go down as well as up.