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Authors: Robert Chote
If the picture painted by the Treasury in this year's Budget is correct, we are currently suffering a "bust" without having enjoyed a "boom". The official story is that after the dramatic ups and downs of the late 1980s and early 1990s, the current government kept activity in the economy impressively close to its "Goldilocks" level - neither too hot nor too cold - until a virulent strain of banking flu arrived unpredictably from the US and pushed us into recession, as well as sharply reducing the economy's long-term productive potential.
We can see this version of history in Chart 1. This shows the Treasury's estimates of the "output gap" - the difference between the actual level of economic activity and the Goldilocks level consistent with stable inflation. At the time of last year's Budget, activity in the economy was expected to remain pretty close to its sustainable level. In this year's Budget we see the Treasury permanently reducing its estimate of that sustainable level by 5% (or £70 billion in today's money) between mid 2007 and mid 2010, relative to the path assumed in last year's Budget. It then expects the actual level of activity to fall another 5% below even that reduced estimate of the economy's potential.
This picture helps the Treasury explain: first, why we are about to see such a dramatic increase in government borrowing, and; second, why a large proportion of that extra borrowing will not disappear without a policy squeeze as the economy returns to its Goldilocks state. But those of a cynical disposition may suspect that this particular depiction of history is also designed to avoid casting an unflattering light on the quality of macroeconomic management during Gordon Brown's decade as Chancellor of the Exchequer leading up to the crisis.
An alternative view of history is that the productive potential of the economy did not go into sudden and unpredictable decline in mid-2007, but rather that the Government - among many others - consistently overestimated the potential of the economy in the good years, lulled into a false sense of security by global disinflation.
We can see this version of history in Chart 2. As an alternative to the Treasury's belief that the productive potential of the economy grew by almost 3½% a year in Labour's first term and then by roughly 2¾% a year thereafter until the crisis hit and trend growth fell to 1% a year for three years, we can assume that the productive potential of the economy grew at 2.6% a year throughout. We would still expect to see economic activity running 5% below its potential in 2010, as the Budget predicts, but we would also see that it had been running roughly 3% to 4% above potential from 2000 to 2007.
If the considered view of history is that the Treasury missed a boom of this magnitude, it will cast a much less flattering light on Mr Brown's record as Chancellor. It would certainly suggest that he should have been running a much stronger fiscal position during this period. But it also poses much more awkward questions about the goals of monetary policy. During this period the Bank of England's Monetary Policy Committee was instructed to keep retail or consumer price inflation low and stable - and did a much better job that most people would have predicted beforehand. The Treasury's view that the economy was at its Goldilocks level in 2006-07 was also supported by a range of evidence that overall pressures on retail price inflation were subdued.
If the missing boom manifested itself in asset and credit markets - rather than those for labour, goods and services - then to do what we can to promote stability in the future the Bank will have to be given a rather more opaque and multi-faceted target to pursue than it has been required to pursue to date.
View all Observations in the series
Does offering higher teacher salaries improve pupil attainment?
In new work published today, IFS researchers analyse the impact of offering higher teacher salaries on pupil attainment. We examine salary scales and pupil attainment in primary schools in and around London. For these schools, and for the salary differences of just under 5% that we observe, we do not find evidence that higher salary scales for teachers have much impact on pupil attainment. This suggests that if individual schools offered salary differentials on this scale across-the-board, they would not necessarily attract more effective teachers.
The next five years look better but tough fiscal choices remain for Scotland
The latest public finance forecasts published by the Office for Budget Responsibility (OBR) in December presented a better outlook for the UK than had been suggested by their March forecast. This is good news for the UK and Scotland in the short-term but much of the improved short-term outlook comes at the expense of reduced scope for economic recovery after 2018–19. Also the one area of greater weakness in the OBR’s latest forecast – revenues from oil and gas production – has substantially more adverse consequences for Scotland’s fiscal position than for the UK as a whole. In short, the new forecasts do little to diminish the tough choices that will face Scotland (and, to a lesser extent, the UK) if it is to achieve long-run fiscal sustainability.
50p tax – strolling across the summit of the Laffer curve?
Ed Balls and Ed Milliband have cited recent HMRC statistics which show those paying the 50% income tax rate are estimated to have paid some £10 billion more in tax over the three years 2010-11 to 2012-13 than was projected to be the case back in 2012 when HMRC analysed how much the tax was raising. Is that an indication that the 50p rate was more successful in raising revenue than HMRC concluded in their analysis?