The key chart
The key message
In its “Economic and fiscal outlook”, the Office of Budget Responsibility (OBR) delivered mixed messages for the UK economy and public finances.
The headlines are likely to focus on the forecast that the government’s borrowing will narrow to -1.1% GDP by 1Q27. This would be the lowest budget deficit for 25 years (£32bn) and music to the ears for a Chancellor who believes in his moral responsibility to balance the budget.
The forecasts assume (1) dramatic role reversals in the position of the UK government vis-à-vis the household (HH) sector and (2) sustained and significant current account deficits throughout the forecast period. They also present a more subdued outlook for business investment.
The key risks lie in the assumption that, in the face of falling real incomes, HHs will maintain consumption via reducing their savings ratio to a record low and/or increasing borrowing further (despite high HH debt ratios).
Beyond these risks, there are two further problems with these latest OBR forecasts:
- First, the assumed end-position envisages BOTH domestic sector sectors running persistent net deficits beyond 4Q22, leaving the UK reliant on the RoW as a net lender. Such a scenario appears neither attractive nor sustainable;
- Second, and more fundamentally, the implied shift away from public debt to private debt reflects the persistent flaw in conventional macro thinking that typically ignores the risk associates with private debt while seeing public debt as a problem rather than a solution.
Faced with these two problems, I believe that the greatest value in these forecasts lies in the insights they provide into the key drivers and assumptions that lie behind current policy and thinking. From there, we can all form our own views as to the likelihood of them being achieved in reality…
Good news for Rishi, but…
The OBR provided good news for Rishi Sunak, the UK Chancellor, in its latest “Economic and fiscal outlook” published on Wednesday 23 March 2022.
The UK government’s net borrowing position has already narrowed to -10.1% GDP (3Q21) versus previous expectations of -11.4%. More significantly, the OBR expects this to narrow to -1.1% by 1Q27 compared with previous forecasts of -1.5% (see chart above). This would represent the lowest budget deficit for 25 years (£31.6bn). Music to the ears for a Chancellor who believes in a moral responsibility to balance the budget.
Key OBR assumptions
The key assumption behind the OBR’s forecasts is that the HH sector moves from its traditional role as a net lender to the rest of the economy to being a sustained net borrower (see chart above).
Such a transition would involve remarkable role reversals from a period when the “Government took exceptional measures to protect HH incomes from the full effect of one crisis (the pandemic) to one in which imported cost rises force HHs to save less to cushion the blow to real spending” (OBR, March 2022).
In short, to move to a net lender position, HHs would need to either reduce their savings and/or increase their borrowings.
The OBR forecasts a more dramatic reduction in the HH savings ratio than previously, to a record low of 2.8% by the start of 2023 (see chart above). This would allow HHs to maintain their consumption levels in the face of the expected fall in real incomes.
To support this assumption, the OBR notes that HHs have, “saved around £230bn more than in the equivalent period before the pandemic, of which around £185 billion is held in highly liquid deposits.” This is true but much of these excess savings have accrued to HHs that already have sizable savings, have higher incomes, and are much older. Such HHs typically spend less from an extra savings they accumulate.
With the OBR also forecasting that the savings ratio will remain at around 5% through their forecast period, below the LT average of around 8%, the risks to this assumption lie to the downside, in my view.
The OBR argues that, “in practice the lower savings ratio will reflect some HHs running down excess savings while other take on more debt.” In that context, it is worth noting that the HH debt ratio has fallen from its peak of 97% GDP in 1Q10 to 88% GDP at the end of 3Q21. Nonetheless, it remains above the BIS maximum threshold level, above which debt becomes a drag in future growth (see chart above).
While the cost of servicing debt remains very low, the overall debt ratio suggests that HHs may be reluctant to increases borrowing levels dramatically from current levels.
In another example of assumed role reversals, the OBR expects the NFC sector to remain a net lender until 2Q25 (see chart above). Note that NFC sectors are typically net borrowers while HH sectors are typically net lenders.
The OBR notes that, “since the start of the pandemic, business investment has been weak and recovered more slowly than other elements of expenditure.” In the 4Q21, business investment remained over 10% below its pre-pandemic peak and almost 3% below the OBR’s previous forecast. In its downward revision, the OBR expects, “investment not to recover to its pre-pandemic peak until the end of 2022 – nearly a year later than GDP as a whole”.
With both UK domestic sectors forecast to run simultaneous net deficits, the OBR assumes (by definition) that the ROW’s net surplus (ie, the UK’s current account deficit) will remain significant and of a similar size to the years before the pandemic. In other words, the UK will remain reliant on the RoW as a net lender. No change from previous forecasts there.
Conclusion
The OBR’s forecast that the UK’s budget deficit will fall to just over 1% GDP (£32bn) in 2026-27 will be welcome news for Rishi Sunak. This would represent the smallest budget deficit (£32bn) for 25 years.
Viewed from a sector balances perspective, these forecasts assume dramatic role reversals in the position of the UK government vis-à-vis the HH sector (and to lesser extent between the HH and NFC sectors) and sustained and significant current account deficits. The key risks to these forecasts lie in the assumption that, in the face of falling real incomes, HH will maintain consumption via reducing their savings ratio to a record low and/or by increasing their borrowing further (despite HH debt ratios).
Beyond the risks to key assumptions, there are two further problems with the OBR forecasts.
First, the assumed end-game envisages BOTH domestic sector running net deficits from 4Q22 onwards leaving the UK increasing reliant on the RoW as a net lender. Such a scenario appears neither attractive nor sustainable (see chart above).
Second, and more fundamentally, the implied shift to replace public borrowing with more private borrowing reflects the flaw in conventional macro thinking that typically ignores the risks associated with private debt while seeing government debt as a problem rather than as a solution.
Faced with these two problems, I believe that the greatest value in these forecasts lies in the insights they provide into the key drivers and assumptions that lie behind current policy and thinking. From there, we can all form our own views as to the likelihood of them being achieved in reality…
Please note that the summary comments and charts above are extracts from more detailed analysis that is available separately.