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Loosening the fiscal belt? Not so fast

Izabella Kaminska has posted this very interesting FT Alphaville blog on a recent Capital Economics report on the output gap (h/t Duncan Weldon). If – and it’s a very, very big if – the output gap is still about 6 per cent of GDP then current fiscal consolidation plans are far too tight. Capital Economics estimates the level of unnecessary fiscal consolidation at 2.5 per cent of GDP, or £35 billion.

If that were true, the whole political debate on the structural deficit and how to deal with it would change overnight. The chancellor would be sprung from his self-imposed traps and Labour could forget about inheriting a fiscal vice in 2015.

Unfortunately, none of that seems at all likely.

IPPR’s senior economist Tony Dolphin sees hope ‘only on a long-term perspective’. He writes:

‘I find some of the smaller estimates of the output gap totally implausible: how can it be less than 1 per cent when unemployment is up by 1 million since the recession began and (here I agree with Capital Economics) when there is little evidence of domestic inflation pressure in 2007? But the larger estimates, like Capital Economics’ own, assume that the economy’s trend growth rate is back to where it was before the recession, around 2.5 per cent. The evidence from other countries that have experienced recessions caused by asset busts is that trend growth is lowered for a considerable period.

I would guess that the OBR’s estimate – which is the only one that matters – is too low. If this view proves ultimately to be correct then the OBR will have to gradually alter its view – and thus its estimate for the amount of fiscal tightening needed. But barring a Damascene conversion on the part of Robert Chote, this will only happen after growth has been stronger for a period, unemployment has fallen and inflation has not increased – which is to say, not this side of an election.

One plausible scenario, therefore, is that we are stuck with the current aggregate deficit reduction target for four or five years, but somewhere in the middle of the next parliament it becomes apparent that it is too high. If we have stuck to the Coalition’s current path, that means there could be scope for some reversal of the spending cuts (or tax reductions) in the second half of the next parliament. More likely, if planned deficit reduction has been delayed again then it might turn out that the plans can be revised so that no more cuts are needed.

Of course, this is just one possible scenario. Before anyone gets too optimistic, we must remember that people were saying about Japan in the 1990s what Capital Economics is saying about the UK now. However, it turned out that trend growth in Japan was lower than even the most pessimistic estimates, so the output gap was smaller and Japan has a debt:GDP ratio in excess of 200 per cent.’

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