The key chart
The key message
The latest OBR forecasts for the UK economy and public finances support my argument that recent UK policy responses to the Covid-19 pandemic were timely, necessary and appropriate and that the UK government will maintain an increasingly interventionist role in the UK economy.
However, from my preferred “financial sector balances perspective” there are obvious risks to their forecasts for UK growth and for the level of government borrowing. First, they assume unprecedented levels of dynamism from both the UK household and corporate sectors and behavioural trends from these sectors and from the RoW that contrast sharply with those seen after the GFC. Second, while the OBR claims that “sectoral net lending positons return to more usual levels,” this does not make them sustainable.
In short, the latest forecasts point to a post-Covid, post-Brexit UK economy returning rapidly to persistent private and public sector deficits and an increasing reliance on the RoW as a net lender. Really…?
The charts that matter
The Office for Budget Responsibility (OBR) published its latest “Economic and Fiscal Outlook” yesterday (25 November 2020) in which it set out its forecasts for the UK economy and public finances to 1Q26. I have analysed these forecasts from the perspective of UK financial sector balances ie, the financial relationship between UK households (HHs), corporates (NFCs), government (GG) and the rest-of-the-world (RoW). As explained in a series of posts earlier this year, this approach builds on the key accounting identity pioneered by the late Wynne Godley that states that:
Domestic private balance + domestic government balance + foreign balance (must) = zero
The OBR’s analysis supports my view that the UK government’s policy response to the Covid-19 pandemic was timely, necessary and appropriate. The OBR expects the cost of government support to total £280bn in 2020, pushing the deficit to £394bn (19% GDP), the highest level since 1944-45 and the debt ratio to 105% GDP, the highest level since 1959-60. Seen through the context of financial sector balances, the OBR concludes that, “The spike in government borrowing [the green line above] …has meant that household and corporate incomes have not fallen nearly as fast as their output or expenditure.” Note that the OBR expects the household financial surplus [the blue line above] to rise to a historically high level of over 11% GDP, and the corporate balance to move from a deficit to a historically high surplus of 2.5% GDP.
The support provided to households and businesses has prevented an even more dramatic fall in output and attenuated the likely longer-term adverse effects of the pandemic on the economy’s supply capacity. And the Government’s furlough scheme has prevented a larger rise in unemployment. Grants, loans, and tax holidays and reliefs to businesses have helped them to hold onto workers, keep up to date with their taxes, and avoid insolvencies.
OBR, November 2020
The OBR forecasts also suggest that the UK government will continue to play an important part in economic activity. They predict that the government’s net borrowing peaks at -19% GDP in 1Q21, falls below -5% by 4Q22 and trends at around -4% GDP to 1Q26. These new forecasts imply higher levels of government borrowing than previously expected (note, there is no mention of balanced budgets or austerity). For government borrowing to fall in line with these expectations, HH and NFC spending have to rise more into line with income.
From a sector balances perspective, this is the point at which alarm bells begin to ring.
Turning to the key HH sector first, the OBR forecasts assume that the financial surplus will peak at just under 14% GDP in 1Q21 and then fall rapidly to under 2% GDP by 3Q22 in line with the previous March 2020 forecasts. The HH savings rate is expected to fall sharply from 28% GDP in 2Q20 to “settle at around 7.5% over the medium term.” This is below the average savings rate of 9% recorded between 1986 and 2019. The OBR argues that forced savings have played a greater role in the rise of HH savings than previously thought. Their new forecasts assume that, “more of the boost to HH finances from forced saving during the lockdown is spent as the economy returns to normality.” On this basis, the OBR now expects private consumption to return to its pre-virus peak by the middle of 2022, much earlier than they forecast in July 2020.
To put these assumptions into a historic context, post the GFC, the HH sector’s financial surplus peaked at 6.1% GDP in 2Q10. It took 25 quarters for the surplus to fall below the 2% GDP level that the OBR now assumes HH will achieve in six quarters and sustain from 3Q22 onwards. Put simply, these forecasts ignore historical evidence from the UK and elsewhere that suggest that HH behaviour takes time to adjust from extreme shocks and implies obvious downside risks to the newly revised consumption and GDP forecasts, in my view.
Turning now to the NFC sector, businesses reduced investment during the pandemic and moved into financial surplus in 3Q20. The OBR assumes that this surplus will peak at 3.2% GDP in 1Q21 and settle at a deficit of around 2.5% GDP out to 1Q26. In other words, the forecasts assume both (1) relatively high future investment levels and (2) a relatively dynamic adjustment. Again for context, after the GFC, the NFC sector ran net financial surpluses for 17 consecutive quarters between 1Q09 and 1Q13.
Finally, the OBR observes that, “over the medium term, sectoral net lending positions return to more usual levels.” While they may be usual in the sense that they are not new, that is not the same as saying that they are sustainable. The latest forecasts not only assume dynamic adjustments by the HH and NFC sectors but they also assume a sustained period during which combined private and public sector deficits are offset by increasing Row surpluses.
In other words, the current forecasts imply a return to persistent sector imbalances with the UK increasingly reliant on the RoW as a net lender (see Imbalances and dependencies).
Conclusion
If we assume that the OBR forecasts become the base case priced into UK assets, then financial sector balances point to downside risks to growth expectations, upside risks to the level of borrowing, inflation staying below target out to 1Q26 and rates remaining lower for longer. Plus ca change…
Please note that the summary comments and charts above are extracts from more detailed analysis that is available separately.