Comment

The Covid phoney war shows no sign of ending 

This week the OBR will publish its latest forecast, but the Chancellor’s fiscal plan still remains all at sea

Wednesday will be a big day for economic news. Before you get excited, let me say that I don’t think there will be much good cheer. The Office for Budget Responsibility (OBR) will publish its latest forecast for the economy and the public finances. This is unlikely to make happy reading.

At the same time, Rishi Sunak, the Chancellor, is set to announce planned government spending for next year, both the overall total and the allocation across individual departments.

The task that faces the OBR is pretty difficult at the best of times but forecasting in today’s conditions is especially perilous. Since it last made a full forecast in March, an awful lot has happened, to put it mildly. At that point it said that GDP growth this year would be plus 1.1pc. By July, its “central scenario” was minus 12.4pc.

This week’s figure may be somewhat better than that, something like minus 11pc – the biggest drop in GDP for 300 years.

But what is really difficult is forecasting beyond this year. The OBR probably compiled its numbers before the recent encouraging news about vaccines. Accordingly, it may well deliver a forecast based on the assumption that a fully effective vaccine will not be available in the near future.

If so, you could conclude that its near-term forecasts will prove to be overly gloomy.

Read more: Let’s not pretend a vaccine means a miracle cure for the economy – Warner

Braced for Brexit

As if coronavirus didn’t generate enough uncertainty, the OBR also has to cope with Brexit. Given recent news, it may well adopt the working assumption that the UK secures a free trade deal with the EU. In fact, if the bush telegraph is to be believed, we may even hear or shortly afterwards that a deal has been agreed.

Actually, whatever the OBR assumes about Brexit, this is unlikely to be a game changer. The really important judgment that it must make is about what the level of GDP will be when the economy has returned to operating at full capacity – once we are over the virus and any initial Brexit shock.

I expect the OBR to be pretty cautious and to suggest that in four or five years’ time the economy will be operating some 2-3pc below where it would have been without the virus. It may well say that in order to meet the Government’s current fiscal targets, the Chancellor needs to close a fiscal hole amounting to about 2pc of GDP, or roughly £40-50bn per annum.

The truth of the matter is that we are currently in a sort of phoney war. Things cannot go on like this forever but they can go on like it for quite a few months more. At some point next year, the Chancellor has to face some glaring fiscal choices.

Controlling the deficit

Contrary to the furore about paying down the national debt, as I argued last week, I am sure that he needs to make no early attempt to do this. We should just live with a higher ratio of government debt to GDP, as we have in the past.

What concerns me is the deficit. It is this that determines how rapidly the stock of debt rises. Even here we can and should sometimes put up with a deficit to finance genuine investment projects. We can also live with a high current deficit for a time, thereby causing the debt stock to rise without a corresponding increase in national assets – which is exactly what we have been doing.

But this has to stop at some point. Once the initial crisis is overcome and the economic recovery is secure, the Chancellor’s objective should surely be to bring first the current deficit and subsequently the overall deficit down gradually to somewhere near zero, with the result that the stock of debt stabilises.

That would enable it to fall back steadily over time as a share of GDP.

This is where the OBR’s prognostications are going to be key. As the economy recovers, the deficit will naturally tend to fall but if the economy is going to be significantly smaller in the future then, even when the virus is well and truly over, the recovery probably won’t be enough to bring the deficit down to zero.

Spend vs save

Meanwhile, the Government has recently been lavish in its spending promises, with little sign of parsimony ahead. Last week we heard that it is increasing the allocation to defence by just over £16bn over four years. Spending on the NHS and education are ring-fenced, as is spending on overseas aid, although the rumours are that this spending is set to be cut. On top of existing plans, the “levelling up” agenda is bound to cost umpteen extra billions.

If government largesse were to continue unabated, then this would leave the Chancellor with little choice but to increase taxes significantly.

Yet swingeing tax rises would be a disaster for the economy and would assuredly not deliver political benefits. Members of Boris Johnson’s Government frequently aver that there will be no return to “austerity”, by which they mean “cuts” in government spending.

Yet there do not need to be absolute cuts in order to square the circle. There just has to be stringency, whereby current spending in several key areas does not go up relentlessly.

It is rumoured that most public sector workers are about to undergo a pay freeze.

In these straitened circumstances that seems appropriate. Similarly, the pensions triple lock, a policy conceived in very different times, should surely be sent to the knacker’s yard.

This week the Chancellor may want to play safe by saying next to nothing on politically difficult issues of fiscal strategy. But before very long he will have to come clean. His instincts appear to be sound.

At some point pretty soon the Treasury has to assert itself over the believers in the Magic Money Tree. If it doesn’t, then we will all have to become reacquainted with the delights of funny money.

Roger Bootle is chairman of Capital Economics

[email protected]

Read more: Sunak faces spending review ‘litmus test’ to level up a Covid-ravaged UK

Fantasy Fund Manager is back for Season 2, giving you the chance to win a £10,000 grand prize and £100 weekly prizes. Find out how to play here. Only available for Telegraph subscribers.