The UK’s fiscal watchdog – the Office for Budget Responsibility (OBR) – has published its latest assessment of the risks facing the UK’s public finances. In a document that runs to nearly 300 pages, 90 fiscal risks are detailed. But inevitably most attention has focused on the OBR’s ‘stress test’ of the implications for the UK’s public finances of leaving the EU without a deal.
This was the first time the organisation has looked at the implications of no deal. Ordinarily the watchdog is constrained to consider only stated government policy, meaning they have assumed “the UK makes an orderly departure from the EU…into a transition period”. But once every two years it comprehensively considers risks to its central forecast. With the two candidates vying to be prime minister having ramped up their rhetoric on no deal, this outcome is clearly an important risk.
Despite what some newspaper headlines suggested, the OBR did not produce its own forecast of the likely macroeconomic hit from no deal. It will not do that until it judges a no deal Brexit to be the most likely outcome of stated government policy.
Instead, it simulated the fiscal impact of one of the no deal scenarios outlined by the International Monetary Fund (IMF) in April. That scenario suggests the UK economy would be 4% smaller in the short-term and 2.9% smaller in the long-run under no deal than if the UK left with a deal. OBR chair Robert Chote descibed it as “relatively benign", in that trade barriers would rise but there would be no disruption at ports.
Other no deal scenarios – including a second published by the IMF and the ‘disorderly’ and ‘disruptive’ scenarios envisaged by the Bank of England last autumn – would have larger fiscal consequences. Chote said that the OBR’s 2017 stress test showed borrowing rising by £100 billion a year and provided some indication of what might happen in the event of a much more disorderly no deal.
But even in the mild scenario chosen this year, the OBR suggests government borrowing would be around £30 billion a year higher (or roughly twice as large) in a no deal scenario than it would be with a deal. The extra £9 billion or so of revenues from new tariffs would not be enough to offset the revenues lost from other taxes – income tax and VAT – as the economy contracts.
That higher borrowing would reduce the headroom that the next chancellor would have against the currently stated fiscal mandate, which requires that cyclically-adjusted borrowing must be below 2% of GDP in 2020-21.
The OBR’s March forecast suggested the Government had £26.6 billion of headroom, while the latest stress test suggests this would be reduced to £22.7 billion. The impact on this fiscal headroom is surprisingly modest, given the overall expected increase in borrowing. That is because much of the increase in borrowing predicted in the short-term is judged by the OBR to be cyclical (that is, the result of temporary economic weakness) rather than structural.
Extra borrowing would stop the Government meeting its other main near-term fiscal target – that debt should fall as a share of GDP between this financial year and next. The OBR’s figures suggest that even this relatively benign no deal would leave debt continuing to rise over the next couple of years.
These figures understate the full fiscal cost of leaving without a deal. Some of the impact has already been felt, with economic growth having been slower over the past three years – various methods suggest the UK economy is now around 2-2.5% smaller than it would have been had the referendum vote gone the other way. Most economic analyses also suggest further economic and fiscal costs would materialise beyond the five-year period that the OBR’s latest analysis looks at.
The OBR’s analysis has inevitably attracted some criticism and has been branded part of ‘Project Fear’. But its contribution should be welcomed: it highlights the fiscal risks for a government choosing to pursue no deal. The weight of economic evidence suggests that leaving without a deal would increase trade barriers and depress economic growth in the longer-term relative to leaving with a deal or remaining in the EU.
But as Sir Charlie Bean – a member of the OBR’s decision-making committee – said, there are a lot of moving parts that will affect the outcome in the short-term and little or no basis on which to predict the probability of how many of the parts might move. Faced with this sort of uncertainty, scenario analysis helps policymakers understand the sort of risks they face.
It is for politicians to choose what policy to adopt. But any government should adopt that policy in the knowledge of, and prepared for, what might happen next.