Sterling and the Recovery

Should we take any notice of the new forecast from the Office for Budget Responsibility (OBR), which George Osborne was so pleased with last week? After all, the economic models that forecasters use failed dismally in predicting the crisis and would again if there was another one.

Though a lot of work is being done to try and improve the financial and monetary sectors of economic models, there is a long way to go. The models being used now are pretty much the same as those of 3-4 years ago. And, even when they embody better understanding of the financial sector, forecasters may warn of crises but they are unlikely to have them in their central projections.

The OBR, headed by Robert Chote, with Steve Nickell and Graham Parker as fellow members of its budget responsibility committee, is aware of this. “Prospects for growth in the medium term are inherently uncertain,” it says. Its job is to try to steer through that uncertainty.

Much of the criticism of its new forecast, out last week, is that it is too optimistic. Some of that criticism, it is worth noting, came from economists who have been far too pessimistic about the recovery so far. The OBR, indeed, had to revise up its forecast for this year from 1.2% to 1.8%.

Economic forecasts are as much about the past as about the future. That is not just a question of economists needing aan accurate picture of the past in order to peer into the future but the fact that precedent plays as important a role in economics as it does in the law. So the OBR, in looking at what might happen over the next few years, has examined the record of previous recoveries. So far, against expectations, this recovery has been stronger than after past recessions. But the next few years will be weaker, it says, than the recoveries of the 1970s, 1980s and 1990s. Unusually, there will not be a single year in which growth hits 3%.

It may be that this is too pessimistic a view and that history does repeat itself and we get a 3% year, or two, as in past recoveries. It may that the OBR has underestimated the impact of the fiscal tightening and weak credit conditions and we get a more subdued recovery.

That is where the debate should be. It is not remotely implausible to predict years of economic recovery, even after a big crisis and deep recession. Those who said there would be no recovery, who have gone quiet recently, had little knowledge of economic history.

There is a lot in the OBR report, enough for several columns. Let me concentrate today on just three interesting aspects of its assessment.

The first is the rebalancing of the economy I wrote about last week, and for which encouraging evidence was provided last week by the purchasing managers’ survey for manufacturing; it showed the strongest overall picture since 1994 and the best for jobs since 1992.

We had such a rebalancing in the first half of the 1990s on the back of sterling’s post-ERM (European exchange rate mechanism) devaluation. The current account went from big deficit to balance in an export-led recovery. It came to an end and went into reverse in the second half of the decade, partly because the pound rose sharply, more than reversing its earlier fall.

The new forecast assumes sterling’s fall since autumn 2007 will be locked in. The move from a significant overvaluation vis-a-vis the euro to the current undervaluation of perhaps 10% (sterling’s fair value is around 1.30 to 1.35 euros) is an essential ingredient in what you could call a devaluation-led recovery.

The trouble is that this can only ever be an assumption. At some point in every previous recovery there has been a tendency for the pound to rise. It happened immediately after the IMF rescue in 1976 and, eventually, in the 1980s and 1990s.

The euro’s problems this time add an additional dimension. What happens to the eurozone matters because of the impact on Britain’s banks, export markets and the financial markets. But Europe’s woes, if they resulted in a sharp weakening of the currency, would remove one of the planks of recovery.

The OBR is assuming sterling stays close to current levels for the next five years, so that between a quarter and a third of growth comes from net exports. If the pound rises then either growth is slower or, as in one of its alternative scenarios, it comes in an unbalanced economy.

Another interesting thing was the new, headline-grabbing prediction for public sector jobs. Instead of 490,000 job losses by 2014-15, we now have 330,000, with an additional 80,000 expected in 2015-16.

The logic behind the new forecast is hard to fault – the October comprehensive spending review had smaller reductions in departmental budgets and bigger cuts in welfare than in the June emergency budget – though the changes went further than expected. The new plans are for real cuts of 19% in non-ringfenced departments, not 25%, so you might have expected job losses to be reduced by a fifth, not a third.

The other surprise, at face value, is that the OBR is predicting fewer state job losses over the next few years than in the 1990s. As it notes, public sector employment fell by 550,000 between 1992 and 1998, when there was considerably less fuss about such job losses.

Part of the answer is that it has discovered that 150,000 of the job losses in the 1990s were due to classification changes, bringing the 1992-98 figure down to 400,000. Even so, limiting job losses to that period’s numbers will require public sector managers to be clever.

Finally, the new forecast suggests the coalition will have a good story to tell at the next election in May 2015, if tuition fees and other tensions allow it to hold together that long.

The budget deficit will have been all but eliminated. The chancellor’s March 2015 budget will look forward to public borrowing of just 1% of GDP over the following 12 months and the cyclically adjusted deficit will have returned to surplus. Public sector net debt will have peaked at under 70% of GDP and be heading lower.

Does that mean all the hard work will be done? Even if these forecasts are exactly right – and we can guarantee they will not be – the long-term challenges wlll remain. Public sector net debt by the middle of the century could be zero, or it could be 100% of GDP. The difference is determined by whether this government and its successors can address the costs, in health spending, long-term care and pensions, of Britain’s ageing population.

My regular column is available on – this is an excerpt. 

Originally published at David Smith’s EconomicsUK and reproduced here with permission.