Why George Osborne repeatedly misses his own targets

Once his long career as Chancellor is over, George Osborne may reflect that his biggest weakness was for self-imposed targets. If benefits reform had been tackled independently of a need to hit an arbitrary Government borrowing target, his personal position would now be much more secure.

The principle of targets was established at the beginning of his period in office in 2010, in his Charter for Budget Responsibility, and was enshrined in law. The Government borrowing target was originally for a balanced budget by 2015 but this was missed by 5% of GDP. So a new target was set, again for a balanced budget by the end of the Parliament, this time by 2019-20.

Underlying these goals is an even more controversial principle — that once a zero deficit has been reached, the Treasury should aim at an annual financial surplus each year “in normal times” and hence continually run down its cumulative debt. Such ideas have become internationally fashionable among advanced economies. In Germany, the idea of a balanced budget with no annual deficit on average has been part of the federal constitution since 2009 and starts to bite this year.

An important part of the Chancellor’s targeting strategy is the Office For Budget Responsibility. Set up in 2010, the OBR is an independent public sector body built out of the pre-existing monitoring and forecasting sections of the Treasury. Its remit is to report on and examine the sustainability of the public finances. The Treasury takes into account the OBR’s initial views on the deficit and makes adjustments in its Budgets and Autumn Statements to ensure that the OBR always predicts the fiscal targets will be met. Many of these adjustments are to take effect in the final year of the Treasury’s five-year spending plans and often involve implausible jumps in spending or revenues that chop and change with each successive OBR Outlook.

So why are the targets so often missed? Attempts to cut deficits through reductions in public spending are a bit like trying to run up a down escalator. Government finances are not like family finances. If a family cuts its spending, its income is usually unaffected and its savings rise. Government spending, in contrast, is always someone’s income. Cutting public spending reduces incomes and hence tax revenues. The deficit may fall, but more slowly and fitfully than the OBR predicts. Also, if all major economies pursue austerity, as the US and the eurozone currently do, then markets for all countries’ exports grow slowly, if at all.

Tax revenues are again reduced and plans to shrink the deficit are undermined. Deficits are thus not within the Government’s control. If households and companies together wish to save, the Government will have a deficit. This is not an assumption about human behaviour. It is a law of arithmetic.

Many commentators appear to take the OBR’s forecasts as close to gospel because the OBR is independent. Independence is not the issue here but competence is. Few realise the OBR forecasts are essentially arbitrary assumptions and should be presented as one of a wide range of possible scenarios.

The problem arises because the OBR bases its forecasts for GDP (and hence tax revenue and much else) on just two simple and controversial assumptions. The most important is about the future growth of labour productivity. The other is on the future of labour supply. The stagnation of productivity is the UK’s biggest economic problem. Prior to 2007, productivity grew at close to 2% every year. Since 2007, it has not grown at all. A hiatus of this length has not occurred since modern records began after the Second World War.

Despite eight years of no growth, the OBR continually expects it to resume in the next year and continue indefinitely. Last November, in conjunction with the Chancellor’s Autumn Statement, it expected productivity to grow from then on at 2.2% a year. This underpinned its GDP forecast of close to 2.4% every year for as far forward as it looks. By this year’s March Budget, it was obvious this was over-optimistic and its assumption for productivity growth has been reduced to 2% a year, making the deficit target much harder to reach.

Why assume 2% a year? Who knows? The reasons given by the OBR for this downgrade are superficial. Economists’ understanding of productivity is poor. The lack of growth since 2007 is known as the “productivity puzzle”. The OBR has little idea of why productivity has stalled or what it will do next. Its published forecasts are no better than a stab in the dark, but are reported with great seriousness.