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April 22, 2003

The Post Budget Debate
by Andrew Smithers

Press comment on the budget has been sharply divided. Most writers have been scornful of the Chancellor's economic forecasts, while a few believe that he will be vindicated. The key feature of both views is their naivety. With regrettably few exceptions, neither opponents nor supporters have yet twigged the essential folly of Gordon Brown's whole approach.

The Chancellor wants attention to be focussed on the cyclically-adjusted budget deficit rather than its current level and the press have been silly enough to oblige him. From a political view this has great advantages. It confuses the issue and distracts attention from his forecasting failures.

From the viewpoint of economic management, however, it has many faults. There are three key problems in the Chancellor's approach. First, we don't know where we are in the cycle. Second, we don't know the trend growth rate of the economy. Third, tax revenue with unchanged tax rates is subject to structural as well as cyclical fluctuations.

In current circumstances, ignoring these points leads the defenders of Gordon Brown even more astray than his detractors. For example, one of the former has written that "If we believe that Britain's trend growth rate is between 2.25 and 2.75%, (as almost all economists believe), then a period of sub-par growth such as 2000 to 2002 must be followed by a period of unsustainably rapid expansion. It is a matter of simple arithmetic."

This is nonsense. First, output could have been above trend and merely fallen back into line over the past two years. Secondly, the trend could have moved downwards because of the poor growth in productivity, to which, as I pointed out last week, the Chancellor has been a major contributor.

Economists are almost universally scornful of the idea that we can know where we are in the cycle. A recent paper by Anthanasios Orphanides and Simon van Norden underlined this in stark terms.

Another problem illustrated by quotation lies in the implicit assumption that it makes no great difference to budget planning if the trend growth rate of the economy is 2.25% or 2.75%. Unfortunately it is very important, as the resulting error becomes increasingly serious over time. If the trend growth rate of the economy is over-estimated by 0.5% p.a., the resulting loss of revenue will increase the budget deficit by 0.2% p.a.

If tax planning, both for the past three years and looking forward, is based on such a misjudgement, then this feature alone will produce a tax revenue shortfall of 1% of GDP two years out.

The practical issue is not whether the Chancellor has got his sums wrong, which he clearly has, but whether this is bad for the UK economy. The world today needs every stimulus that it can get, so it could be argued that Gordon Brown's imprudence is Britain's good fortune.

In fact this is unlikely to be true. Had the Chancellor's past budgets been prudent in fact rather than in spin, the Bank of England's monetary policy would have been more accommodating. This could have made the housing bubble even worse, but, since interest rates are low by historic standards, it is more likely that the major benefit would have been through a lower exchange rate.

Had the UK economy been managed better, sterling would be lower and investment higher. Both of which would greatly benefit our long-term growth prospects. We would also have the ability, which is now almost certainly lacking, of using fiscal policy to boost the economy should the world fall into serious deflation.

Andrew Smithers
Smithers & Co.

Smithers & Co. Ltd. provides advice on international asset allocation to about 100 clients based mainly in Boston, London, New York and Tokyo. Our work is based on the fundamental belief that no one's judgement is better than their information. We believe that our clients' decisions will be helped if we can provide them with important information that is not otherwise available to them. We therefore concentrate on research which aims either to tackle issues in greater detail and thoroughness than is otherwise available or to tackle issues of importance which seem to have been generally overlooked. Examples of the former include our work on stock market valuation, the profit distortions arising from the use of employee stock options and the underlying secular problems of Japan's economy. Examples of research into areas which have otherwise been largely overlooked include our work on the Japanese life insurance industry.

Our approach to research is also different. The standard approach bases market projections on economic forecasts of major economic aggregates, such as GDP and inflation. Stock market, bond and currency forecasts are then derived from the way these estimates differ from the consensus. We consider this approach to be flawed in two ways. It places excessive reliance on the ability of any particular analyst to produce forecasts which are consistently better than average. It also ignores the evidence that stock markets tend to lead economies, rather than the other way around. In contrast, we put greater emphasis on "information arbitrage", in which we include identifying factors which have been overlooked, drawing on data and academic research which have not yet been exploited and pointing to inconsistencies in the implicit forecasts of different markets.

Andrew Smithers, founder of Smithers & Co., is also columnist for London's Evening Standard and the Tokyo Nikkei Kinnyu Shimbon's Market Eye, and is regularly quoted in the New York Times, Barron's, Forbes, The Economist, The Independent, and the Financial Times.

Copyright © 2002-2007 Andrew Smithers

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