Potential growth, potential problems: how do the UK’s public finances stack up?

UK Chancellor Jeremy Hunt is scheduled to deliver his first full budget on 15 March 2023.

While the immediate drama of last September’s ‘mini-budget’ and Hunt’s credibility-restoring autumn statement may have subsided, Britain’s leaders still face difficult choices.

Prime Minister Rishi Sunak and Hunt must make these decisions in a context that, while perhaps not as nightmarish as some of the forecasts of late 2022, is still challenging and presents multiple potential political flashpoints.

The chief ameliorative factor is the downward trend in energy prices from their peaks of last year – but even this is unlikely to prove the economic panacea Britain is looking for.

We calculate that the fall in gas prices is likely to save the government as much as £10 billion, but these savings could be wiped out by slowing growth. The OBR has already signalled it is to cut its medium-term growth expectations of 1.7% by between 0.2 and 0.5%[1], while the Bank of England (BoE) has revised its estimate down to 0.7%[2].

Difficult choices

These consistently low growth estimates in turn suggest fiscal deficits are more structural than cyclical. Low-growth economies are generally likely to either require lower interest rates or accept higher inflation so they can service their existing debt burdens. Interest rates in the UK are currently moving into ever more restrictive levels as the BoE attempts to bring inflation under control, but the shape of the yield curve indicates that they will revert to lower levels in the future.

If the government does opt for more fiscal tightening, yields are likely to decline as there would be limited supply of gilts. Faced with a weaker economy, the BoE may cut rates to offset this weakness. However, we think this may be difficult in the near term, and it may still be constrained by the lingering effects of a supply shock.

Should the government opt to run higher deficits, meeting the current fiscal rules will be significantly more challenging and the bond market will have to absorb much higher levels of gilt issuance going forward.

We think it is likely that the budget retains the two new fiscal targets that guided the Autumn Statement:

• To have underlying debt falling as a share of GDP in 2027-28 (two years later than the previous target)
• To have public sector net borrowing below 3% of GDP in the same year[3].

However, these targets can change and are not as binding as they may seem: if they are not revised before the budget, there is every chance they will be in the future. The OBR estimated in its last economic and fiscal outlook that the first target had a 59% chance of being hit, and the second 48%[4].

Meanwhile, in the months since these November forecasts, new data has suggested that borrowing may be up to £30bn less than previously forecast[5], which should ease at least some of the pressure in decisionmakers.

The long view

British policymakers face a number of constraints to their decision making that could act as structural fetters to the UK economy for some time to come.

Chief among these is the simple number of people available to take their places in the workface. Based on UN projections of fertility rates, the working age population is very close to its peak:

This demographic dividend-in-reverse is already a significant thumb on the scale: there is estimated to be a shortfall in the UK of as many as 330,000 people to perform all the roles available, mostly in low-skilled positions[6].

Brexit appears to account for lower immigration to the UK from the EU; while immigration from non-EU countries has increased, it has not proved enough to compensate for this fall. Many of these immigrants are students, whose contribution to the economy is limited in the short term, and policy choices have made it more difficult for many overseas students to remain in the UK after they have graduated.

If the workforce isn’t set to grow, that leaves boosting productivity as the alternative strategy for boosting growth. The UK’s issues in this regard are well-known, with productivity still far below the pre-2008 trend line even 15 years on.

Again, Brexit is a key element of the context: the OBR has estimated it will dent productivity by up to 4% over the next 15 years[7] thanks to trade friction. Restoring the UK to the c.0.75% annual productivity growth we saw in 2018-19 would represent a significant policy achievement, one the BoE forecasts as unlikely before 2024[8].

Investment, the third pillar of any programme for growing the economy, is also in an unfortunate position, and Brexit appears again to be a complicating factor. Business investment in the UK flatlined between the 2016 referendum and the end of 2019, and there has been no discernible catchup post-Covid (or since the trade deal that came into effect in early 2021).

Businesses require confidence and a degree of clarity in the future if they are to invest.

Weak investment is a key factor in weak GDP growth, which in turn weighs on tax revenues and creates the need for the corrective measures Rishi Sunak and Jeremy Hunt are taking. This chain of causation continues: if government capex is cut as aggressive as we saw after the global financial crisis, it could create a negative accelerator effect. Falling demand could in turn further disincentivise investment in a negative feedback loop with effects it could be difficult to overcome.

Growth prospects

Whether it’s growing the workforce, increasing productivity or investing for the future, the UK faces obstacles in all conventional channels to economic growth.

In the medium term, even if we assume productivity growth reaches its 2018-19 levels of 0.75% and the labour supply grows by 0.25%, we think the economy would still only grow around 1% in the medium term. This year, we expect GDP to actually decline by around 1%. In our view, the BoE forecast is fairly realistic, while even the lower reach of the OBR’s likely new forecasts, at 1.2%, strikes us as somewhat optimistic.

Few of these figures are encouraging and together they add up to a forbidding set of problems for policymakers to solve. Repairing the UK’s public finances will require creativity, innovation – and not a small amount of luck.

[1] https://blinks.bloomberg.com/news/stories/RP0HIQCEX0QQ

[2] https://www.bankofengland.co.uk/monetary-policy-report/2023/february-2023

[3] https://obr.uk/docs/dlm_uploads/CCS0822661240-002_SECURE_OBR_EFO_November_2022_WEB_ACCESSIBLE.pdf

[4] https://obr.uk/docs/dlm_uploads/CCS0822661240-002_SECURE_OBR_EFO_November_2022_WEB_ACCESSIBLE.pdf

[5] https://www.ft.com/content/22e1f703-802b-44f9-a1ce-cc3ca3a51de9

[6] https://www.cer.org.uk/insights/post-brexit-immigration-uk-labour-market

[7] https://obr.uk/docs/dlm_uploads/Fiscal_risks_and_sustainability_2022-1.pdf

[8] https://www.bankofengland.co.uk/-/media/boe/files/monetary-policy-report/2023/february/monetary-policy-report-february-2023.pdf