OBR-la-di, OBR-la-da

Labour’s first budget was better than it seems

Watching Rachel Reeves deliver the first Labour budget for 14 years was a strange experience. I worked on the last one, at the very beginning of my career.

This one, I watched from the virtual sidelines with my welfare stakeholder hat on. There was so much to be disappointed by. But for some reason… I wasn’t.

Maybe that’s because I’m still just enough of an insider to have learned or deduced well in advance that the first Reeves budget wasn’t going to address even the dumbest and cruellest welfare policies that Labour has inherited from the Conservative Party. Exasperation was baked in.

But that’s not quite it. I was annoyed, but not at Labour. I felt the Chancellor succeeded in charting a path to a more hopeful future through terrain that had seemed impassable. Only the first few steps have been taken, but a way forward is now in sight.

I’m not even particularly angry at the Conservative front bench, despite a lack of contrition from the departing Rishi Sunak and Jeremy Hunt proving that they are just as unfit to govern as their predecessors were, and indeed their successors will be. The time to worry about the Tories will come again, but right now they’re irrelevant.

Reader, it was the Office for Budget Responsibility (OBR) that really got my goat.

Watchdog

I was an early OBR-watcher, having seen the body first established in opposition by George Osborne and then transposed into the machinery of government after 2010.

The fledgling OBR sometimes made judgements which worked in favour of the government’s agenda, but I don’t think it did so because of a partisan commitment to the Conservative Party’s interests or an overt ideological agenda. The OBR may have got things wrong, but not because it was corrupt or dogmatic.

And the OBR did become a thorn in the Conservatives’ side, initially by telling us that austerity wasn’t working, and even more forcefully after the 2016 Brexit vote. The OBR imagines itself as sitting in the macroeconomics mainstream, and there was no way to sugar-coat the macroeconomic destructiveness of both of these gambles with the UK’s economic health.

The problem really is not what the OBR did, but what it didn’t do. It didn’t tell us whether the fiscal rules and targets Osborne adopted were sound. It didn’t protest when the rules and targets were tweaked. It was not the OBR’s place to judge.

For this reason, the OBR used to do something rather frustrating. While it detailed the impact that the government’s fiscal events would have, or would not have, its default assumption was that the economy would quickly resume its regular path of growth. The coalition government could be actively harming productivity and inhibiting investment in the short term, but in the medium-to-long term, governments are pretty much interchangeable.

This of course also helped the coalition government enormously. No matter how disastrous their economic policies, they could maintain the sense that the storm would soon pass. The OBR probably thought they were being impeccably apolitical, basing their forecasts on the laws of economics. But Osborne and co. knew they could extract political advantage from this institutional naivety, with the OBR implicitly signing off on the narrative that austerity would make us great again, eventually.

The OBR isn’t like this anymore. Brexit was a wake-up call, I guess. And the institution was bolstered by Liz Truss and Kwasi Kwarteng’s failed attempt to sideline it. The OBR is now more confident about using its own judgement.

But the more things change, the more things stay the same. As Ben Clift argues in his excellent 2023 book, becoming more independent and authoritative hasn’t made the OBR more impartial; so-called depoliticisation means the politics underpinning OBR judgements matters a great deal more.

Not budging

The OBR’s judgement on the Reeves budget is that it will not enhance growth as much as the Chancellor might like.

As the October 2024 fiscal and economic outlook argues:

Compared to our March forecast, growth is forecast to be an average of a quarter percentage point higher this year and next. This reflects stronger GDP and real wage growth in recent quarters, and the net fiscal loosening in this Budget. Growth is then weaker between 2026 and 2028 as these temporary effects fade.

In short, growth might increase in the short term – but as a result of tailwinds emerging under the Sunak government, as well as the boost to demand that Labour’s extra spending will produce. By the end of the forecast period, growth will be lower now than was expected before the election. (This doesn’t mean GDP will be lower, rather that OBR thinks Labour is instead bringing forward an increase in output so that it rises sharply sooner before decelerating.)

Source: https://obr.uk/docs/dlm_uploads/OBR_Economic_and_fiscal_outlook_Oct_2024.pdf

What is going on here? Were Sunak and Hunt right, after all?

LOL, no. The key issue is that the OBR is underestimating the non-linear impact that public investment in infrastructure might have on the growth trend.

I’m being a little mean. Because the OBR has changed its ways, to some extent, with greater recognition of the increased output that results from public investment (further discussed here). But it has not gone far enough. As Carsten Jung shows here, the OBR is still not taking into account the ‘second round effects’ in which ‘businesses and households respond to higher public investment by increasing investment and labour force participation’.

Jung draws upon the recent US experience, and the work of Valerie Ramey, to show that the returns to investment in terms of positive impact on GDP could be double what the OBR is expecting over the forecast period.

The wisdom

Having watched the OBR consistently and wrongly predict that business investment was just about to start increasing, despite fiscal consolidation, in the Osborne era, it is jarring to see it claim now that business investment is likely to fall as a result of increased public investment:

we judge that the loosening is consistent with a slightly higher path for interest rates than in our pre-measures forecast, raising both Bank and gilt rates by a quarter percentage point across the forecast and at all maturities. Higher interest rates help to bring demand back into line with supply over the forecast period and account for some of the crowding out of business investment by raising the cost of capital.

The judgement here is highly complex. But we are effectively being told that, rather than public investment incentivising business investment as the mainstream economics literature now suggests, higher public investment will lead to higher interest rates and therefore lower business investment because borrowing costs will rise.

While it is alarming to see highly loaded metaphors like ‘crowding out’ being used in ostensibly technocratic reports to describe the state/market relationship, in fairness the OBR’s judgement isn’t entirely out of kilter with the mainstream. The debate among economists is really about how strong the counterveiling ‘crowding in’ and ‘crowding out’ forces are in different contexts.

We need to look beyond the economics mainstream to properly critique this paradigm. In my research with John Evemy and Ed Yates, for example, we show that the assumption of a transmission mechanism between monetary policy and business investment grossly simplifies why large businesses choose to invest (or not). Growth-enhancing investment is driven by their revenue far more than borrowing costs.

The other key thing the OBR misses is the possibility that, via public investment and other mechanisms of intervention, governments can facilitate structural economic change.

This is Industrial Policy 101. The specific how, what and where decisions around public investment could steer the economy towards currents of future prosperity that improve growth prospects, or at least enable it to better withstand growth-destroying shocks. Focusing only on the aggregate numbers will produce an excessively simplistic account.

It is not within the OBR’s remit to judge how successful Labour will be in this mission. It is of course reasonable to argue that the government is not going far enough. But it is nevertheless the case that Labour has an industrial strategy that it hopes will deliver a macroeconomic uplift.

Image credit: HM Treasury (CC BY-NC-ND 2.0)

One of the ironies is that Reeves is now in a position to challenge the Treasury’s longstanding aversion to industrial policy – the department has always been more malleable to ministerial direction than prevailing views on Treasury orthodoxy suggest. Yet she is being held back by the fact that some of the Treasury’s core functions were carved out when the OBR was created, handing authority to officials beyond her direct influence, purely to suit the political interests of previous Chancellors.

With the economy being forecast to grow more slowly, pressure for further fiscal consolidation will now ramp up (see for example the response to the Budget by the Institute for Fiscal Studies).

All this said, there is a decent chance that the OBR’s forecast will be proved right, even if its judgements are proved wrong. We can expect shocks that the UK is not (yet) equipped to cope with: the climate crisis is upon us, and the consequences of a second Trump presidency are unpredictable.

Growth cannot be taken for granted, even if the government’s strategy is broadly the correct one. But the OBR should take no comfort from being inadvertently right – and it does need to review whether it has assessed Labour’s plans (for which the party has a whopping democratic mandate) appropriately.

And it is worth pointing out, finally, that there is an area where both the government and the OBR are wrong. The budget’s cuts to welfare spending – e.g. freezing Local Housing Allowance rates, and accepting the savings to disability benefits planned by the Conservatives – are not a sideshow to the main economic policy events. A threadbare welfare state is growth-inhibiting because it undermines the human foundations of productivity.

Maybe the OBR needs to be a little more open to evidence on what really drives growth. But so does the Labour government.